NATIONAL INCOME

Basic concepts:
Micro Economics: It explains the behavior of an individual unit of an economy. E.g. a consumer, a
firm, an industry, a market.
Macro Economics: deals with the economy as a whole with respect to output, income ,the general
price level, foreign trade, unemployment, and other economic aggregates.
A Production Unit: means the owners of factors of production joining hands by forming a unit with
the objective of producing a good or a service.
Factor Owners: It respects to the individual owners of four factors of production- land, labour, capital
and entrepreneurship.
Factor income: refers to the income created in production units as a joint effort of factor owners.
Leakages: In the process circular flow of income, firms and households save a part of their income,
this is called Leakages.
Injection: when firms borrow for investment in plant and equipment etc. it increases production
capacity and is called injections.

DEFINITION:- It is a science of measuring the aggregate output and income of an economy OR National
income is that part of the objective income of the community including of course, income derived from abroad
which can be measured in terms of money.
IMPORTANCE OF NATIONAL INCOME
1- Help to check the level of production on time to time.
2- Explain the immediate causes of level of production.
3- Share the long run course which the economy which the economy is following
4- Provides basis of formulating and application of public policies to improve the performance of economy.
CIRCULAR OF NATIONAL INCOME
-From produce goods and services sale to house holds.
- House hold produce resources and raw material and sale to firm.
- Firm made payment to house hold against their service.
-House hold made payment to firms against their goods.

PROBLEMS OF COMPUTATION NATIONAL INCOME

1- Lack of statistical required information.
2- Double counting problem.
3- Unpaid services (Housewife, sewing, house painting by others etc..)
4- Foreign Firm income.
5- Untrained people of work of data collection.
6- Illiteracy of masses
7- Second hand sale
IMPORTANCE OF CALCULATING OF NATAIONAL INCOME
Calculation of national income is very important because of the following reasons:
1- It makes easy to judge the performance of economy during a given period of time.
2- It helps in assessing the economic freedom and welfare enjoyed by the people.
3- It helps in making inter- spectral comparison
4- It is very important for any economies, which wish to develop as national income acts as yardstick and helps
in developing economic plans.
5- It shows how income is distributed among various categories of people.
National Income Accounts: It is the systematic statistical record of the money value of goods and services
produced by various producing sectors of an economy. It also shows distribution of national income among the
various factors of production as well as final consumption expenditure incurred. The estimation of national
income accounts is based on double entry system of accounting.
Functions of national income Account~ :- It has the following two main functions.
1. It shows the special economic achievements of the country.
2. Provides basis for the critical evaluation and appraisal of the economic policies.
Uses of national income accounting :1. It shows the distribution of national income among various factors of production.
2. Provides information about the contribution of various sectors to national income.
3. It provides information about the changes in the structure of an economy.
4. It helps in the appraisal of strength and weaknesses of an economy.
5. It provides information about the changes taking place in standard of living, distribution of income and
structural changes in national income.
6. It enables to compare the national income of one country with other countries of the world.

Circular flow of National Income: It is a pictorial illustration of interdependency between the major
sectors of the economy.
Two -Sector Economy
Factor Services

Factor Market

Factor payment
Firm
Household

Goods and Service

Payment of Goods & services
Product Market
Circular Flow of Income in a Two Sector Economy
1. The circular flow in a two sector economy will keep on flowing without end as there is no leakage from and
injection in the income stream.
2. Whatever is produced by firms is consumed by the household sector.
3. Factor payments by firms are equal to factor income of household sector.
4. Whatever is the factor income of the household sector is spent on consumption.

NATIONAL INCOME AGGREGATES

CONCEPTS: ECONOMIC TERRITORY
Economic territory includes the followinga)-Political frontiers including territorial waters and air space
b)-Embassies, consultants, military bases etc. located abroad
C-Ships, aircrafts etc., operated by the residents between two or more countries
d)-Fishing vessels, oil and natural gas rigs etc, operated by residents in the international waters or other areas
over which country enjoys exclusive rights or jurisdiction.
RESIDENT
A resident, whether a person or an institution, is one whose centre of economic interest lies in the economic
territory of the country. In which he lives or is located.
DEPRECIATION (Consumption of fixed capital)
It refers to the fall in the value of fixed capital goods due to normal wear and tear and foreseen obsolescence.
INDIRECT TAXES
The burden of these taxes is shifted to buyers. Since the burden indirectly falls on buyers. They are called
indirect taxes e.g. sales tax, excise duty etc.

SUBSIDIES
Subsidies are financial assistance by government to enterprises on production of a certain commodity.
The effect of subsidies is to bring down the price like: indirect tax it is also generally passed on to the
consumers.
NET FACTOR INCOME FROM ABROAD (NFIA)
NFIA equals factor income received by resident from abroad less factor income paid to non residents.
GDPmp is the values of contribution to production by all the production units located with in the economic
territory of a country, undiminished by consumption of fixed capital and indirect tax.
NDPnp is the values of contribution to production by all the production units located with in the economic
territory of a country. Diminished by consumption of fixed capital but undiminished by net indirect tax.
NDPfc is the values of contribution to production by all the production units located with in the economic
territory of a country , diminished by consumption of fixed capital and net indirect tax.
GDPmp Consumption of fixed capital = NDPmp
NDPmp net indirect tax = NDPfc
GDPfc + net indirect tax= GDPmp
A national aggregate is a statistical measure of the contribution of residents of a country towards economic
production carried out both inside and outside the economic territory of the country.
GNPmp is the values of the contribution of residents of a country towards economic production undiminished by
consumption of fixed capital and net indirect tax.
NNPmp is the value of contributions of residents of a country towards economic production diminished by the
consumption of fixed capital but undiminished by net indirect tax.
NNPfc is the value of contribution of residents of a country towards economic production diminished by
consumption of fixed capital and net indirect tax.

GROSS NATIONAL DISPASABLE INCOME (GNDI)

GNDI = GNPmp + Net current transfers from abroad.
NET NATIONAL DISPLOSABLE INCOME (NNDI)
NNDI = NNPmp + Net current transfers from abroad.
DISPOSABLE INCOME AGGREGATES OF PRIVATE SECTOR
Income from DP accruing to the private sector = NDPfc
- Income from property and entrepreneurship accruing to government administrative departments.
- Saving of non-departmental enterprises.
PRIVATE INCOME
Private Income = Factor incomes accruing from NDPfc to the private sector
+ Net factor income from abroad.
+ National debt interest.
+ Net current transfers from government.
+ Net current transfers the rest of the world.
PERSONAL INCOME
Personal income = private income Retained earning of the private corporate sector Corporate income tax.
PERSONAL DISPOSABLE INCOME
Personal Disposable Income
= Personal Income Direct taxes paid be households
- Miscellaneous receipts of government administrative departments.

CONCEPTS USED IN MEASUREMENT OF NATIONAL INCOME

MEASUREMENT OF NATIONAL INCOME
Some of all factors of payment made against production in the economy. There are three methods of measuring
national income: Production, Income distribution and Final expenditure methods. There are various concepts in
addition to the ones already explained, involved in these methods. These concepts are explained below:

METHOD OF COMPUTING NATIONAL INCOME

1- PRODUCT METHOD:- Economy is divided in various parts of production. Production of each part is
computed, adding the value is called Gross National Income.
2- INCOME METHOD:- By adding the income of all individuals in a country during save period.
3-EXPENDITURE METHOD:- By adding consumption and investment & expenditure of all individuals &
Govt.

Intermediate Consumption/
Intermediate products:
Intermediate products refer to those goods and services which are purchased during the year by one
production unit from other production units and completely used up, or resold, during the same year.
Final Expenditure:
Final expenditure refers to the expenditure incurred on final products.
Goods and services purchased, or own produced, for the purposes of consumption and investment are
final products.
Final expenditure refers to the expenditure on goods and services meant for final consumption and
investment.
Value of output:
Value of output equals quantity of output produced during the year multiplies by the price per unit.
Value of output = Sales + closing stock Opening stock
Or
= Sales + Net change in stock
Value added:
Meaning:
Value added is a measure of contribution of a production unit to the domestic product. Value added, in
fact, is value added to the intermediate products.
GVAmp = Value of output Intermediate consumption
NVAmp = GVAmp deptreciation
NVAfc = NVAmp indirect tax + subsidies
NVAfc = Wages + rent + interest + profits
= Factor payments.

CONCEPTS USED IN INCOME METHOD

FACTOR PAYMENTS:
Factor payments are the payments made by production units to factor owners for the services rendered by them
to these units.
These are:
1) Compensation of employees
2) Rent and royalty
3) Interest
4) Profit
In addition, in practical estimates, there is another category called mixed income of the self-employed.
COMPENSATION OF EMPLOYEES:
Compensation of employees is the total remuneration in cash, in kind and in the form of social security
contributions by employers, payable by an enterprise to the employees in return for the work done by them
during an accounting period.
RENT AND ROYALTY:
Rent is defined as the amount payable, in cash or in kind, by the tenant to the landlord for the use of land for
production.
Royalty is defined as the amount payable to the landlord for granting the leasing rights of subsoil assets only.
INTEREST:
Interest as a factor payment is defined as the amount payable by a production unit for the use of money
borrowed.
PROFIT:
Profit as a factor payment, is the amount payable to the owner of the production unit for his entrepreneurial
abilities.
MIXED INCOME:
Mixed income, in national income accounting, means income payment by production units having elements of
more than one type of factor payments.
OPERATING SURPLUS:
The sum of rent royalty, interest and profits is called operating surplus.
CONCEPTS IN EXPENDITURE METHOD
FINAL EXPENDITURE
Final expenditure means expenditure on final products, i.e., on consumption and investment. It includes:
(a) Private Final Consumption Expenditure (PFCE)
PFCE is the sum of final consumption expenditure by households and PNPISH for satisfaction of wants of
the residents of a country.
(PN PISH: Pvt. Non- Project institution serving household)).
(b) Government Final Consumption Expenditure (GFCE)
GFCE is the expenditure incurred by general government on providing free services to the people e.g.
Government charities, donations, etc.
(c) Gross Domestic Capital Formation (GDCF)

GDCF is addition to the stock of capital undertaken by production units

located within economic (domestic) territory of a country.

COMPONENTS:
(i) Fixed Capital Formation
It is in the form to acquiring capital assets like building, machinery, equipments, etc. having a life of more than
one year. Such assets are called fixed capital assets.
Fixed capital formation can be classified into three distinct categories:
(a) Undertaken by business enterprises, (b) on construction of houses and (c) undertaken by general
government.
Expenditure on fixed investment by business enterprises in on building, machinery, equipments, etc. A
business enterprise undertakes such investment with the intention of earning profit.
Expenditure on residential construction, i.e., on houses, is undertaken by households. In national income
accounting, it is treated as fixed investment, and the house owner treated as a producer of housing services.
Expenditure undertaken by general government (and not government enterprises) on construction roads,
bridges, dams, buildings, etc, in public interest, is also treated fixed investment, called public fixed investment.
(ii) Investment In Stocks (Inventory Investment)
Inventory investment means the expenditure incurred on adding to stocks of raw materials, semi-finished goods
and finished goods. It equals closing stock less opening stock.
GDCF = GDFCF + Change in stocks
NDCF = GDCF Consumption of fixed capital
NDFCF = GDFCF Consumption of fixed capital
(d) Net Exports
Net exports equal exports less imports.
Net exports = Exports Imports
Expenditure on Domestic Product:
The sum of PFCE, GFCE, GDCF and net exports is expenditure on domestic product. It is technically called
GDPmp. It is nothing but the value of final products produced by the production units located within the
economic territory of the country.
METHODS OF MEASUREMENT OF NATIONAL INCOME
INTRODUCTION:
There are three methods of estimating national income. These are production, income and expenditure methods.
PRODUCTION METHOD:
Product Approach:
According to this method the money value of all the final goods and services will add up to GNP from which
capital
consumption
and
net
indirect
tax
(indirect
tax
subsidy)are
deducted.
N.I
=
GNP
Capital
Consumption
Indirect
Tax
+
Subsidy
where,
GNP = sum of Pi Qi
Qi = Final Goods and Services
Pi = Prices of Qi
Precautions:
1.Avoid double counting.

2.Avoid counting of excluded transactions

What it Measures?
In this method we measure the contributions of the different industrial sectors of the economy to GDPmp.
Steps in Measurement:
(1) Classify all the production units located in the domestic (or economic) territory into distinct
industrial sectors. The units are traditionally classified into primary, secondary and tertiary sectors.
(2) Estimate NVAfc of each industrial sector by taking the following sub-steps:
(a) Estimate value of output: it can be estimated in two ways:
(1) As sum of sales and net addition to stocks, and
(2) Quantity of output multiplied by price.
(b) Estimate value of intermediate consumption. Deduct the same from value of output to arrive at
GVAmp.
(c) Estimate consumption of fixed capital. Deduct it from GVAmp to arrive at NVAmp.
(d) Find out net indirect tax (= indirect tax Subsidies). Deduct it from NVAmp to arrive at NVAfc of an
industrial sector.
(3) Take the sum of NVAfc of all the industrial sectors of the economy. By doing so we will arrive at
NDPfc.
SNVAfc = NVAfc
(4) Estimate net factor income from abroad and add. Add the same to NDPfc to arrive at the measure
of national income.
NDPfc + NFIA = NNPfc = National income
Precautions to be taken in Making:
Estimates
While estimating national income by the value added method the following precautions must be taken:
(1) Avoid double counting of output
(2) Include value of own-account production in total output
(3) Do not include sale of second hand goods
INCOME DISTRIBUTION METHOD
Income Approach:
National income is the summation of all the annual rewards given to the four factors of production in a given
time period (one year).it can be obtained by subtracting indirect business taxes and adding subsidy from NNP. It
is also called NI at factor cost.

We

NI = NNP - Indirect tax + Subsidy

Where,
NNP = GNP - Capital Consumption
now explain the four categories

of

payments:

wages,

rent,

interest

and

profit.

(i) Wages: It includes the wages and salaries paid by the businesses and govt. to suppliers of labour. It also
include wage and salary supplements such as, payments by employers into social insurance and into a variety of
private
pension,
health
and
welfare
funds
for
workers.
(ii) Rent: It consists of income payments receive by household and business which supply property resources.
(iii)Interest: Here interest is expressed in net rather than gross terms. Net interest receive by household is
difference between the interest they receive (from saving account ,certificate of deposits and the like)and the
interest they pay(to banks for mortgages, credit cards and other loans)

(iv)Profits: It includes total gross corporate profits + proprietors income.proprietors income refers to the net
income of sole proprietorship and partnership.corporate profit consist following three items
1.Corporate
income
tax:
A
portion
will
be
claimed
by
the
govt.
2.Dividends
:
A
portion
pays
to
stockholder.
3.Undistributed Profit: These retained earnings are invested currently or in future in new plants and equipment.
What is Measures?
This method is called income distribution method, because in this method we measure the factor incomes paid
out (i.e., distributed) to the owners of factors of production by the various industrial sectors of the economy.
Steps in Measurement
(1) Classify the production units located within the economic territory into distinct industrial sectors on
activity basis.
The units are broadly classified into primary, secondary and tertiary sectors
(2) Estimate factor incomes paid out by each industrial sector.
(3) Take the sum of NVAfc i.e., the factor incomes paid out, by all the industrial sectors to arrive at NDPfc
NVAfc = NDPfc
(4) Estimate NFIA and add to NDPfc to arrive at NNPfc i.e., national income
NDPfc + NFIA = NNPfc = National Income
Precautions
Include imputed value of factor services rendered by the owners of production units.
Do not include any transfer incomes.
Do not include capital gains arising from sale of second hand goods.
Do not include income arising from the sale of financial assets.
FINAL EXPENDITURE METHOD
According to this method the money value of all expenditure on final product will add up to GNP from which
capital
consumption
and
net
indirect
tax
(indirect
tax-subsidy)
are
deducted.
NI = GNP - Capital Consumption - Indirect Tax + Subsidy
where,
GNP = C + I + G + NX
Net Income form abroad=0
We now explain four categories of expenditure:
(1) Consumption Expenditure (C):
It includes expenditure by household (a) durable goods such as, automobile, refrigerators etc, (b) non-durable
goods such as: food, shirts etc and (c) services such as doctors, education etc.
(2) Gross Investment:
It includes (a) all final purchase of machinery, equipment, and tools by business enterprise in given time periodchange in capital stock (b) all current construction (c) changes in inventories: changes in stocks of finished
goods and goods in process as well as changes in the raw material that businesses keep on hand. Inventories can
be
negative,
positive
or
zero
(3) Government Expenditure (G):
This includes all governmental spending (federal, state and local) on the finished product of business and all
direct purchases of resources such as labour etc, it excludes all govt. transfer payments, because it doesn't reflect
any
current
production.

(4) Net Exports (NX) = Export - Import :

This includes the difference between the imports and exports, called net exports. it is the component of the total
demand for our goods. it can be negative positive or zero.
What it measures ?
In expenditure method we measure the expenditures incurred on final products produced by
production units located within the domestic (economic) territory during a given year.
Steps in Measurement
(1) Classify production units into industrial sectors.
Classify them into primary, secondary and tertiary sectors.
(2) Estimate final expenditure on goods and services produced by these industrial sectors.
These final expenditures are categorized as follows:
(a) Private final consumption expenditure (PFCE)
(b) Governments final consumption expenditure (GFCE)
(c) Gross domestic capital formation (GDCF)
(d) Net exports (= Exports Imports)
(3) Take the sum of these final expenditures to obtain the measure of GDPmp
PFCE + GFCE + GDCF + Net exports = GDP mp
(4) Estimate the consumption of fixed capital and net indirect taxes and deduct these from
GDP mp - Consumption of fixed capital Net indirect tax = NDPfc
GDP mp Consumption of fixed capital Net indirect tax = NDPfc
(5) Add net factor income from abroad (NFIA) to NDPfc
NDPfc + NFIA = NDPfc = National Income
Precautions in Measurement
The following precautions are required to be taken while estimating national income by the expenditure
method:
(1) Do not include expenditure on intermediate goods and services.
(2) Include imputed expenditure on self-consumed or own account produced output used for
consumption and investment.
(3) Do not include expenditure on transfer payments.
(4) Do not include expenditure on financial assets.
(5) Do not include expenditure on second hand goods.
Real and Nominal National Income :
Real National Income: When the value of the N.I. is calculated on the basis of multiplying the output of the
year by the prices of the base year.
Real N.I. = output X Price of base year.
Nominal National income: When the value of the N.I. is calculated on the basis of multiplying the output of
the year by the prices of the current year.
Nominal N.I = output X Price of current year
Formula to calculate Real GDP:
GDP Nominal
GDP Deflator
GDP Deflator = Nominal GDP X 100
Real GDP
GDP and Welfares
Can the GDP of a country be taken as an index of the welfare of the people of that country there are at
least three reasons why this may not be correct

Distribution of GDP be concentrated in the hands of very few individuals or firms. For the rest, the
income may in fact have fallen. In such a case the welfare of the entire country cannot be said to have
increased.
Non- monetary exchanges- Many activities in an economy are not evaluated in monetary terms. For
example, the domestic services women perform at home are not paid for. This is a case of
underestimation of GDP. Hence GDP calculated in the standard manner may not give us clear indication
of the productive activity and well-being of a country.
Externalities- Externalities refer to the benefits (or harms) a firm or an individual causes to another for
which they are not paid (or penalized). Externalities do not have any market in which they can be bought
and sold.. But carrying out the production the refinery may also be polluting the nearby river. This may
cause harm to the people who use the water of the river. Hence their utility will fall. Pollution may also
kill fish or other organisms of the river. Such harmful effects that the refinery is inflicting on others, for
which it does not have to bear any cost, are called externalities. Therefore, if we take GDP as a measure
of welfare of the economy we shall be overestimating the actual welfare. This was an example of
negative externality. There can be cases of positive externalities as well. In such cases GDP will
underestimate the actual welfare of the economy. Finally we have noted that it may be incorrect to treat
GDP as an index of the welfare of the country.

Consumption

Includes spending on consumer durables (cars, household

appliances, etc.); semidurables (clothes); nondurables (food and
beverages, etc.); and consumer services (travel agents,
hairdressers, etc.).

Investment

Spending on machinery and equipment, on all construction

(including houses) and on changes in inventory. The term Ig is
used to represent gross investment i.e. before any depreciation is
taken into account.

Government
Spending

The total spending on goods and services at all levels of

government. (It does not include transfer payments or subsidies.)

Net Exports

Total value of all exports (whether of consumer goods, capital

goods, or government goods and services) less the total value of all
imports.

Wages & Salaries

Includes all benefits received and is expressed as gross

earnings before taxes or deductions.

Gross Profits

Earnings of corporations before any distribution of dividends

or payment of taxes.

Investment

Includes business interest only, and not interest on consumer

loans or on loans to government.

Interest &
Incomes

Farmers Incomes

Self explanatory.

Self employed income

Includes the income of all non farm businesses, other than

corporations (e.g. self-proprietors, and partners and also
includes some rent).

WHAT IS THE BUSINESS CYCLE?

Parkin and Bade's text "Economics" gives the following definition of the business cycle: The business cycle is
the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP
and other macroeconomic variables. If you're looking for information on how various economic indicators and
their relationship to the business cycle, please see A Beginner's Guide to Economic Indicators. Parkin and Bade
go on to explain: A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the
pendulum of a clock. Its timing is random and, to a large degress, unpredictable. A business cycle is identified
as a sequence of four phases:

Contraction (A slowdown in the pace of economic activity)

Trough (The lower turning point of a business cycle, where a contraction turns into an expansion)

Expansion (A speedup in the pace of economic activity)

Peak (The upper turning of a business cycle)

A recession occurs if a contraction is severe enough... A deep trough is called a slump or a depression.
THE BUSINESS CYCLE PHASES
Investors who beat the market recognize that phases of the business cycle are the primary determinant of stock
prices. Our stock investing system begins with an understanding of where we are in the the business cycle.
Assessing the business cycle phases is the first of five steps in our stock investing system that we use to beat the
market.
1. The Business Cycle Phases
2. Stock Market Trends
3. Stock Selection
4. Timing the Entry
5. Manage the Trade
The Phases of the Business Cycle
The phases of the business cycle are a long-term pattern of changes in Gross Domestic Product (GDP) that
follows four basic stages: expansion, prosperity, contraction, and recession. After a recessionary phase, the
expansionary phase starts again. The business cycle phases are characterized by changing employment,
industrial productivity, and interest rates. Stock analysts believe that stock price trends lead the phases of the
business cycle. The economic cycle provides the strategic framework for economic activity and investing.
Moreover, the business cycle phases affect employees, employers and investors. For example:

Expansion Phase: The economy is strong, people are employed and making money. Demand for goods
-- food, consumer appliances, electronics, services -- increases to the point where it outstrips supply.
This demand fuels a rise in prices, or inflation.

Prosperity Phase: As prices increase, people ask for higher wages. Higher employment costs translate
into higher prices for goods, fueling an upward spiral effect.

Contraction Phase: When prices get too high, consumers and companies curtail their spending, as
goods and services are too expensive. This decreases demand. When demand decreases, companies cut
expenses that includes laying off workers, since they do not need to make as many goods or provide as
much service.

Recession Phase: Decreasing demand fuels declining prices, declining GDP, and rising unemployment.
This means the economy is in a recession.

Expansion Phase begins again: Lower prices eventually spurs demand. As demand picks up, people
begin buying again, fueling the need for greater supply, expansion of credit, new jobs and a growing
economy.

When the business cycle doesn't run as expected, it can have consequences that can be as disastrous as the Great
Depression. That's why governments intervene to try to manage the economy. If it appears that inflation is rising
too quickly, the Federal Reserve (the central bank of the U.S. charged with handling monetary policy) may
decide to raise interest rates to curtail price increases. On the other hand, if the economy is performing poorly,
the government may lower taxes to spur consumption and investment and the Federal Reserve may lower
interest rates to reduce the cost of borrowing.
Interest rates and the yield curve play a very important role in determining economic activity, the phases of the
business cycle and the performance of the stock market. Higher interest rates increase the costs to businesses
and individuals. Companies must pay more to borrow money for capital investments or to fund daily business
operations. Individuals pay more for mortgages, as well as other loans they may take out to purchase products.
Higher interest rates also increase the demand for money to invest in bonds, competing for money to invest in
the stock market.
The phases of the business cycle have implications for markets and investors. Broadly, a recession often
corresponds with a sustained period of weak stock prices, or a bear market. And a healthy, expanding economy
that keeps inflation from rising too quickly often corresponds with a bull market, or period of sustained market
growth.
Sector Rotation
Fortunately, there are investment strategies for each phase of the business cycle. Sam Stovall's Sector Investing,
1996 states that different sectors are stronger at different business cycle phases. The table below describes this
theoretical model showing the phases of the business cycle.
Phase:
Full
Recession Early
Recovery Full
Recovery Early
Recession
Consumer Expectations: Reviving
Rising
Declining
Falling
Sharply
Industrial
Production: Bottoming
Out Rising
Flat
Falling
Interest
Rates: Falling
Bottoming
Out Rising
Rapidly Peaking
Yield Curve:
Normal
Normal (Steep)
(Fed)
Flat/Inverted
Flattening Out

The graph below, courtesy of StockCharts.com, shows these relationships and the alignment of the key sectors
as they respond to the business cycle. The stock market cycle tends to precede the business cycle by six months
on average, as investors try to anticipate when the market will respond to changes in the economy. This means
investors are more likely to beat the market, if they invest in the sectors that line up with the current and next
phase of the business cycle.
Sector

Rotation

Model:

Legend: Market Cycle

ECONOMIC CYCLE
As shown above the stock market is a leading indicator of the economic or phases of the business cycle. Since
the market leads the economy, investors need to pay particular attention to the early signs of a change in each
phase of the business cycle.
Many people believe that GDP is the primary indicator of the business cycle. The National Bureau of Economic
Research (NBER) gives relatively low weight to GDP as a primary business cycle indicator, since the GDP is
subject to frequent revisions after the fact. In addition, it is only reported on a quarterly basis. The NBER is the
official organization that defines when the U.S. is in a recession and when it comes out of one.
The NBER relies on indicators that are reported monthly to identify the business cycle phases including:

Employment, especially new unemployment claims;

Personal income;

Industrial production;

Sales in key sectors such as housing, autos, durable goods and retail sales;

Interest rates and the yield curve; and

Commodity prices.

By following these indicators carefully, investors can anticipate when to expect changes in the business cycle.
These indicators tend to change their trajectory over several months, giving investors ample time to identify a
change in the trend. If you believe a change in the phase of the business cycle is underway then it is time
to close out sectors that will go out of favor and start new positions in sectors that will come into favor. This
strategy will position you to beat the market using the phases of the business cycle as a guide.
The next section of how to Beat the Market discusses methods to identify the important trends in the market and
how to narrow your focus on the important sectors. Please read Stock Market Trends.
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No matter how much we try and seek a standardized solution for running a successful business, it is a known
fact that every businessperson runs his/her business based on their individual perspectives and principles, which
need not always be similar. Every business has its own set of guidelines and processes designed for its efficient
functioning, however in general any business experiences four stages: start-up, maturity, growth and decline.
Four Stages of Business Cycle: Stage One Start-up/Creation
There is a lot of planning that goes into starting any business. Stage one is the nascent phase of the business
during which the business plans and strategies are finally executed and the business organization comes into
existence. This is the stage where the business is not generating revenue but trying to establish itself in the
market and attract a stable set of investors and customers. This is the stage where the business has to invest a lot
of resources in creating the basic infrastructure and then marketing and advertising itself in the market. This is
the phase during which innovative ideas are encouraged, in order to establish a USP (Unique Selling
Proposition) for the company. It is a difficult task to have a smooth sailing business, without any struggle right
from the beginning since the early stage of business setup involves higher risks. The income in the first stages is
always lesser than the investments and hence initial stage is marked by lower profit margins for the business.
Four Stages of Business Cycle: Stage Two Growth
Once the business passes the nascent phase, it begins to find their core customers. Stage two or the growth
phase of the business is when the business establishes its niche in the market. This is the phase where the
business owners start to establish their brand identity and generate brand loyalty within their customer base
using sound marketing practices. Although the focus of this stage is to maintain the core customer group and
build trust and goodwill amongst the customers. This stage is marked by a rise in consumer demand and a
consequent requirement of increased inputs in terms of production, manufacturing, and general operations to
keep up with the rising sales and continue growth. The growth phase is thus marked by increased sales, rise in
profit
margins
and
thus
establishment
of
the
brand
name
in
the
market.
Four Stages of Business Cycle: Stage Three Maturity
Stage three is the stage where the business reaches a certain maturity level in terms of the market. The brand
identity and brand image of the business are well established at this stage. The customer base, investors, and
other important business networks are well laid at this point. The sales are either increasing or at least have
reached a considerable regular volume and require less resources for advertising to enhance sales, however
intensive marketing is a must to enhance the overall market position or at least establish the current market
position. This is the phase where the company would want to branch out into other ventures and dabble with
product innovation. This is the business stage where the profit margins are fairly stable.
Four Stages of Business Cycle: Stage Four Recession/Decline

Every business at some point of time undergoes a stage where it experiences a decline in the sales and an
overall unfavorable atmosphere in the market termed as recession. This is nothing but a period of reduced
economic activity, which results in a sharp or considerable decline in buying, selling, production, and even
employment. The company might experience reduce in profit margins or even loss depending on the market
positions. This is the phase where the company struggles to maintain its existence in the market and trying its
level
best
to
equip
itself
for
a
quick
recovery.
These are the four stages of business cycle experienced by every business big or small. Sometimes the business
flourishes and gains maximum profits, while at times the business is on the verge of a complete breakdown. It is
the attitude and the positive perspective of successful businessmen that keeps every business going through the
ups and downs and yet always aiming for the pinnacle.