Understanding Business Cycles
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Introduction
A typical economy’s output of goods and services fluctuates around its longer-term path. We now turn our attention to those recurring, cyclical fluctuations in economic output. Some of the factors that influence short-term changes in the economy—such as changes in population, technology, and capital—are the same as those that affect long-term sustainable economic growth. But forces that cause shifts in aggregate demand and aggregate supply curves—such as expectations, political developments, natural disasters, and fiscal and monetary policy decisions—influence economies particularly in the short run.
We first describe a typical business cycle and its phases. While each cycle is different, analysts and investors need to be familiar with the typical cycle phases and what they mean for the expectations and decisions of businesses and households that influence the performance of sectors and companies. These behaviors also impact financial conditions and risk appetite, thus impacting the setting of expectations and choices of portfolio exposures to different investment sectors or styles.
In the sections that follow, we describe credit cycles, introduce several theories of business cycles, and explain how different economic schools of thought interpret the business cycle and their recommendations with respect to it. We also discuss variables that demonstrate predictable relationships with the economy, focusing on those whose movements have value in predicting the future course of the economy. We then proceed to explain measures and features of unemployment and inflation.
- Business cycles are recurrent expansions and contractions in economic activity affecting broad segments of the economy.
- Classical cycle refers to fluctuations in the level of economic activity (e.g., measured by GDP in volume terms).
- Growth cycle refers to fluctuations in economic activity around the long-term potential or trend growth level.
- Growth rate cycle refers to fluctuations in the growth rate of economic activity (e.g., GDP growth rate).
- The overall business cycle can be split into four phases: recovery, expansion, slowdown, and contraction.
- In the recovery phase of the business cycle, the economy is going through the “trough” of the cycle, where actual output is at its lowest level relative to potential output.
- In the expansion phase of the business cycle, output increases, and the rate of growth is above average. Actual output rises above potential output, and the economy enters the so-called boom phase.
- In the slowdown phase of the business cycle, output reaches its highest level relative to potential output (i.e., the largest positive output gap). The growth rate begins to slow relative to potential output growth, and the positive output gap begins to narrow.
- In the contraction phase of the business cycle, actual economic output falls below potential economic output.
- Credit cycles describe the changing availability—and pricing—of credit.
- Strong peaks in credit cycles are closely associated with subsequent systemic banking crises.
- Economic indicators are variables that provide information on the state of the overall economy.
- Leading economic indicators have turning points that usually precede those of the overall economy.
- Coincident economic indicators have turning points that usually are close to those of the overall economy.
- Lagging economic indicators have turning points that take place later than those of the overall economy.
- A diffusion index reflects the proportion of a composite index of leading, lagging and coincident indicators that are moving in a pattern consistent with the overall index. Analysts often rely on these diffusion indexes to provide a measure of the breadth of the change in a composite index.
Learning Outcomes
The candidate should be able to:
- describe the business cycle and its phases;
- describe credit cycles;
- describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business cycle and describe their measurement using economic indicators.
1 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.