BUSINESS CYCLES

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BUSINESS CYCLES

• Recurring changes in the level of business and
  economic activity over time
• Economy grows,
• reaches a peak,
• begins a downturn
• followed by a period of negative growth
  (recession)
• Ends in a trough before the next upturn

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• To be considered a cycle, NBER has 4 Factors
• 1. Depth and Rebound (Amplitude)
• Economic activity must show a
• significant decline followed by a rebound
• Length of Recessions and Recovery (Duration
• Should be at least one year (to avoid any
  seasonal fluctuations)

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• 3.Impact on the Economy (Diffusion)
• Must be broadly based throughout many industries
  and economic activities
• Displacement and Utilization
• Classify the cycle by degree of severity or
  strength

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• Measures the degree of disruption from recessions
  and degree of utilization from expansions
• 2 common displacement measures
• Unemployment capital utilization
• Business Cycle Dating Committee of the NBER
  delineates business cycles in the US

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• A second NBER definition is
• Deviation cycle
• Or
• More commonly, Growth cycles
• Growth cycle is a significant deviation around
  the trend rate of change
• Short term fluctuations in aggregate economic
  activity
• Must meet the same duration criteria applied to
  business cycles

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Measuring Business Cycles

• The BC is analyzed by the following procedures
• NBER A growth cycle method
• Shumpeter An equilibrium points method
• EPA (Economic Planning Agency) Diffusion Index
• Australian Deviation cycle high and low growth
  rates

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BOOM
Slowdown
Expansion
slowdown
P
S
S
Trend
G
E
T
E
dec
inc
Normal lower bound
Recession
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• Example
• Product sales rarely grow in a constant fashion
• There may be an underlying trend but
• There are likely to be deviations from this trend
• Deviations could be the result of cycles in the
  data

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MSV
Schumpeter
above
Upswing phase
Recession Phase
Equilibrium
Inflection point
Inflection point
Inflection point
be l ow
Revival
Depression phase
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• Each phase is defined as follows
• Recession
• A period of decline in aggregate economic
  activity lasting at least one year with widely
  diffused effects on the economy
• Recovery
• A rebound period in aggregate activity
  characterized by relative stable prices,
  expanding output and productivity

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• Cycles will always occur so we need to work out
  ways of
• predicting the timing,
• predicting the amplitude
• Providing suitable planning responses from a
  corporate point of view

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• Why Cycles?
• Because of the existence of a lag between a force
  and the response to that force
• Lags in business and economic forces and the
  response to those forces
• e.g.
• Change in demand level and corporate response in
  terms of higher output

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• Demand increases
• Business executive may not recognize change
  immediately
• May be reluctant to change output unless she
  knows that demand will endure
• Takes time for production to fully adjust to
  demand
• In the meantime, stock levels have dropped
• Production will have to rise further to build
  stocks back up

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• The lag between action and reaction continues to
  apply
• It takes time for production to react to the
  satisfactory levels of stock
• By the time production returns to satisfactory
  level, stocks are way up.
• So production is reduced below demand to reduce
  stock
• Back to original situation and cycle repeats
  itself again

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5 Types of cycles

• Agricultural or Cobweb Cycles
• Inventory or Kitchin Cycles
• Fixed Investments or Juglar cycles
• Building or Kuznets Cycles
• Kondratieff Cycles

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Agricultural or Cobweb cycles

• Best known sector cycle in economics
• Cobweb pattern Nicholas Kaldor
• Regular fluctuations occur in agricultural
  production because
• The following periods production is determined
  by current or past prices
• The current price is determined by current
  production

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Inventory or Kitchin or Metzler Cycles

• Inventory fluctuations are caused by holding of
  inventories.
• We hold inventories to
• Smooth production
• Product more cost-effective lot sizes
• To buffer stock and prevent lost sales due to
  insufficient stock
• To take advantage of lower prices

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Metzlers Model

• Assumption
• System is in equilibrium
• MPC 0.6
• Income production for expected sales,
  inventories and investment
• In current period, desired inventories are equal
  to a difference between actual and expected sales
  in the preceding period

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Metzlers Conclusion

• Total income approaches equilibrium
• Inventories lag behind income

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Fixed Investment Cycles or Juglar Cycles

• Clement Juglar analyzed a behaviour of fixed
  investments
• Fixed investments business expenditures on
  equipments and structures
• Conclusion
• Fixed investment has a longer life than
  inventories.
• Fixed investment cycles is from 7 11 years

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Building cycle or Kuznet cycle (construction
cycle)

• Both short term (tied to credit markets) and
• Long term (tied to functions of demographics)
• Building cycle was constructed to understand the
  phases of the real estate cycle (which is very
  important for investment)

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• Story
• During economic booms, demand for labour
  increases which in turn puts pressure on wages
• Increased economic activity causes new family
  formations
• Sparks the demand for new housing units
• Boosts the economic output more
• Process begins again

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• Building cycle has 4 phased
• Development
• Demand picks up, and housing starts follows.
• Low vacancy rates and rising rents.
• Reaches maturity after about 3 5 years
• Aggressive bidding up of land prices is a turning
  point

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• Overbuilding
• Housing sales outpaces home sales
• Adjustment
• Builders react to declining sales and curtails
  housing starts

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• Acquisition
• Housing starts continue to decline.
• home sales are still firm
• Building activity is further reduced though
  vacancy rates have peaked

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Kondratieff Cycles (Long Wave cycles)

• Long wave cycles with durations of 45 and 60
  years.
• 4 Long wave theories in economic development
• Shumpeters three-cycles schema
• Forresters System Dynamics
• Burns and Mitchells cycle of cycles
• Rostows Stages of Long term growth

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Forecasting Cycles

• Several methods to predict turning points
• Cyclical Indexes using the decomposition method
• Econometric and MARIMA models
• Use of Composite Index based on business
  indicators
• Pressure cycles

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Cyclical indexes

• Cyclical component is the wave-like movement
  along the long-term trend
• Measure by the Cyclical Factors in the
  decomposition method
• CF Y/ TSI
• Actual data divided by Trend, Seasonal and
  Irregular
• CMA / CMAT

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• A CF gt 1 ? a deseasonlized value above long
  term trend.
• Very difficult to analyze and forecast but can
  give insights into where an cyclical variable is
  headed.
• Check the length and amplitude of the cycle and
  that may help you predict the next turning point.

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• Pay attention to periodicity and amplitude and
  make a projection.
• 1st Peak July 1976 (Q3)
• TroughJan 1979 (Q1)
• Amplitude 10 quarters
• 2nd peak, trough July 1981 (Q3), Jan 86 (Q1)?
  18 quarters
• 3rd peak, trough July 90 (Q3), Jan 95 (Q1) ? 18
  quarters

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• Average period between peak and trough is 15.3
  quarters with a standard deviation of 4.6
• Last peak was April 2003 (Q2) so expect a trough
  sometime around Oct 2005 (Q4) (about 10 quarters
  later)

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Using Business Indicators

• Operates usual up to 12 months ahead
• Aim to anticipate turning points by
• Constructing a series which displays maxima and
  minima some months ahead, as the data series you
  wish to forecast
• Leading Indicators

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• Three classes of business Indicators
• Leading Indicators
• Co-incident indicators
• Lagging Indicators

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Leading Indicators

• These indicators forecast the timing of turning
  points not the magnitude of upswing or downswing.
  
• Used to help anticipate turning points
• They are used for event-timing forecasting

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• e.g. Stock building is an important factor in
  describing the cyclical movement in industrial
  production
• Interest rates lead stock building in the economy
• Interest rates is a leading indicator of
  industrial production
• We dont rely on one time series but number of
  time series which have properties of leading
  indicators and form an index out of them

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• This guards against one series not giving the
  right information at the turning point
• Coincident Indicators
• These indicators measure how the economy
  (variable) is currently performing. An index is
  also the best measure

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Lagging Indicators

• Lags behind the general state of the economy
  (Variable) both on the up and down.
• A composite index is also computed for this
• Leading indicators change directions ahead of
  turns in the variable
• Coincident turn at about the same time as the
  variable
• Lagging follows the variable

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Selection of Leading Indicators

• Economic significance must be backed by
  economic theory
• Statistically adequate Series should not be
  frequently or heavily revised
• Historical conformity with business cycle
• Consistent patterns of rise and fall in line with
  the business cycle

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• 4. Cyclical timing records as leaders
• Must have be consistent as a leader
• Smoothness
• Data series must be smooth for turning points to
  be easily identified
• Promptness of publication
• It is of no use creating an indicator with a lead
  of 12 months if the data is published a year
  after the event.

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