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
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
2. Length of Recessions and Recovery
(Duration
Should be at least one year (to avoid any
seasonal fluctuations)
3.Impact on the Economy (Diffusion)
Must be broadly based throughout many
industries and economic activities
4. Displacement and Utilization
Classify the cycle by degree of severity or
strength
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
• 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
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
BOOM
Slowdown
Expansion
slowdown
P
S
S
Trend
G
E
T
E
inc
Normal lower
bound
dec
Recession
• 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
MSV
a
b
o
v
e
Schumpeter
Upswing phase
Recession Phase
Equilibrium
Inflection point
Inflection point
Inflection point
b
e
l
o
w
Revival
Depression phase
• 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
• 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
• 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
• 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
• 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
5 Types of cycles
•
•
•
•
•
Agricultural or Cobweb Cycles
Inventory or Kitchin Cycles
Fixed Investments or Juglar cycles
Building or Kuznets Cycles
Kondratieff Cycles
Agricultural or Cobweb cycles
•
•
•
Best known sector cycle in economics
Cobweb pattern – Nicholas Kaldor
Regular fluctuations occur in agricultural
production because
1. The following period’s production is
determined by current or past prices
2. The current price is determined by
current production
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
Metzler’s 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
Metzler’s Conclusion
• Total income approaches equilibrium
• Inventories lag behind income
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
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)
• 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
•
Building cycle has 4 phased
1. 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
2. Overbuilding:
Housing sales outpaces home sales
3. Adjustment
Builders react to declining sales and curtails
housing starts
4. Acquisition:
Housing starts continue to decline.
home sales are still firm
Building activity is further reduced though
vacancy rates have peaked
Kondratieff Cycles (Long Wave cycles)
•
•
1.
2.
3.
4.
Long wave cycles with durations of 45
and 60 years.
4 Long wave theories in economic
development
Shumpeter’s three-cycles schema
Forrester’s System Dynamics
Burns and Mitchell’s cycle of cycles
Rostow’s Stages of Long term growth
Forecasting Cycles
•
Several methods to predict turning points
1. Cyclical Indexes using the decomposition
method
2. Econometric and MARIMA models
3. Use of Composite Index based on
business indicators
4. Pressure cycles
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
• A CF > 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.
• Pay attention to periodicity and amplitude
and make a projection.
•
•
•
•
1st Peak = July 1976 (Q3)
Trough=Jan 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
• 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)
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
Three classes of business Indicators:
1. Leading Indicators
2. Co-incident indicators
3. Lagging Indicators
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
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 don’t rely on one time series but
number of time series which have
properties of leading indicators and form
an index out of them
• 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
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
Selection of Leading Indicators
1. Economic significance: must be backed
by economic theory
2. Statistically adequate: Series should not
be frequently or heavily revised
3. Historical conformity with business cycle:
Consistent patterns of rise and fall in line
with the business cycle
4. Cyclical timing records as leaders:
Must have be consistent as a leader
5. Smoothness:
Data series must be smooth for turning
points to be easily identified
6. 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.