Riga Technical University

Course paper in macroeconomics

BUSINESS CYCLES

Author:
..............
Supervisor: Muhammad
Shakeel

Riga 2015

Contents
Page
1. Business cycles.....................
.........................................01
1.1Gross Domestic Product (GDP)
....01
1.2 Micro Vs Macro ..
..02
2. Phases of the Business Cycle..
.02
2.1 Phases of business cycle - expansion ..
03
2.2 Phases of business cycle
peak.........................................................................................04
2.3 Phases of business cycle slow down
(contraction).................................................05
2.4 Phases of business cycle recession
(Trough)...........................................................06
3. Recession and Depression..
...07
4. Causes of Business Cycles.....
.08
4.1 Business Investment.
.08
4.2 Interest Rates and Credit.
...08
4.3 Consumer Expectations.
..08
4.4 External Shocks.
08
4.5 Internal causes in economy
...09
4.6 External
causes..
09

5. Types Of Business Cycles...

.10
5.1 Major
Cycles.
...10
5.2 Minor
Cycles.
...10
5.3 Long wave cycle.
.10

6. Characteristic of Business Cycles .

....11
6.1

It

occurs

periodically11
6.2 It is all embracing.
..11
6.3 It is wave-like..
..11
6.4 The process is cumulative and self-reinforcing....
...11
6.5 The cycles will be similar but

not

identical.12

7. Business Cycle Forecasting.13-14

7.1

The

Ten

Leading

Economic

Indicators..

...15

8. Types of Forecasts and Its Method to measure ....

....16
8.1

There

are

three

types

of

forecast..16
8.2

Types

Of

Methods.....16

9. Business Cycle Theories............

...17

Forecasting

9.1Endogenous.....
17
9.2 Endogenous theories..
...17
9.3 Exogenous..
..17
9.4 Exogenous theories..
......17

10.The Austrian School

theory......................................................................................................18
Conclusions and recommendations
List of sources
Appendices

Business Cycles

1. Introduction:
The business cycle is the downward and upward movement of levels of gross
domestic product (GDP) and refers to the period of expansions and
contractions in the level of economic activities (business fluctuations) around
its long-term growth trend.
The economy follows the Business Cycle regularly.

Fig.1
Fig.2

1.1 GDP (Gross Domestic Product)

Def. The total value, in dollars, of all final goods and services produced
within the nation each year

Abbreviated as the GDP

If the GDP is larger than last year

the economy is expanding (getting bigger)

If the GDP is smaller, the economy is shrinking (getting smaller)

Fig 1.1

01

1.2 Micro Vs Macro

Microeconomics: The study of personal or small finances.

Individuals, families or businesses

Macroeconomics: The study of economic systems on a large scale

National or Global economies

2.0 Phases of the Business Cycle.

Expansion (Growing)
Peak (Top)
Contraction (Shrinking)
Recession/Trough (Bottom)

Fig 2.0

02

2.1 Phases of business cycle - expansion

During a period of expansion:

Wages increase

Low unemployment

People are optimistic and spending money

High demand for goods

Fig. 2.1

Businesses start

Easy to get a bank loan

Businesses make profits and stock prices increase

In an economic expansion, businesses experience record sales and

profits. They can hardly keep up with demand. In anticipation of a
continued sales growth, inventories are built up and production
facilities are expanded.

This creates demand for suppliers of raw material and equipment. The
equipment takes time to be built and installed. Banks are willing to
lend given the bright predictions of continued cash flows. A large
number of loan applications push banks to raise interest rates which
companies can afford to pay.

Companies find it difficult to hire all the employees they need, and are
forced to pay higher wages, for instance, for overtime hours. But, that
is not a serious problem in light of healthy sales and profits.

03

2.2 Phases of business cycle peak

When the economic cycle peaks:

The economy stops growing.

GDP reaches maximum
Fig 2.2
Businesses cant produce any more or hire more people
Cycle begins to contract

Furthermore, a strong consumer demand justifies raising prices for

many products. With higher wages, employees are still able to buy in
spite of higher prices; moreover, anticipation of continued employment
encourages them to use consumer credit if their income is insufficient.

The overheating of the economy is evident in shortages of employees,

materials, equipment, loan able funds and products.

These shortages imply inflation. Because of difficulties in obtaining

resources, this is no longer a good time to start a business even if sales
appear encouraging. Prices, wages and interest rates continued rise
puts eventually a stop to further expanding product demand, new
hiring and new lending. The economy has reached its peak.

04

2.3 Phases of business cycle contraction or Recession

During a period of contraction:

Unemployment increases

Banks stop lending money

Number of jobs decline

People are pessimistic (negative) and stop spending money

Fig 2.3

Businesses cut back production and layoff people

Sales are no longer expanding. The economy starts slowing down. The
slowdown is mild at first. As sales stop increasing, inventories pile up.

Companies can adjust to that by reducing orders for raw materials,

avoiding overtime and resorting to sales promotions.

Suppliers start to feel the pinch and are forced to lay off a few workers.
These lay-offs are seen as a signal of potential hard times ahead.

Employees prefer to set aside some wages, and reduce their

consumption. Sales start to drop as consumer demand shies away.

Companies are now burdened by the loans they took out to install new
equipment. Their profits shrink with decreasing revenues, still high
employee salaries, and a large overhead.

The hardest hit are the manufacturers of equipment who see their
orders dwindle. Fewer and fewer businesses are started. Often, plans
to open business are cancelled. Some firms go out of business.
05

2.4 Phases of business cycle Trough

When the economic cycle reaches a trough:

Economy bottoms-out (reaches lowest point)

High unemployment and low spending

Stock prices drop

Pessimism and hardship are widespread. If the loss of income is not too
severe it is called a recession, otherwise it is branded a depression.

Firms try to survive as they can sell off the inventory on hand. More
bankruptcies are observed, but the number and the size of the bankrupt
firms are bottoming out.

All prices, interest rates and wages are at their lowest.

Unemployment is ubiquitous. The unemployed are ready to take any job.

The contraction has run its course. The economy has reached its trough.

Fig 2.4

06

3.0 Recession and Depression

A prolonged contraction is called a recession (contraction for over 6

months). Recession is a decline in the Gross Domestic Product (GDP)
for two or more consecutive quarters.

Fig 3.1
Fig 3.2

A recession of more than one year is called a depression. A depression is

any economic downturn where real GDP declines by more than 10
percent. A recession is an economic downturn that is less severe.

Fig 3.3
Fig 3.4

07

4.0 Causes of Business Cycles.

4.1 Business Investment

When the economy is expanding, sales and profit keep rising, so companies
invest in new plants and equipment, creating new jobs and more expansion.
In contraction, the opposite is true

4.2

Interest Rates and Credit

Low interest rates, companies make new investments, adding jobs. When
interest rates climb, investment dries up and less job growth

4.3 Consumer Expectations

Forecasts of an expanding economy fuels more spending, while fear of a
recession decreases consumer spending

4.4 External Shocks

External Shocks, such as disruptions of the oil supply, wars, or natural
disasters greatly influence the output of the economy

Ex. 1992-2000 was the longest period of expansion in U.S. history. Early in
2001, signs of contraction appeared, though the Bush administration denied
it. The Sept. 11th 2001 terrorist attacks quickly caused the business cycle to
shift into a contraction.

08

Fig
Fig.4

Fig.4a
Fig.4b
4.5 Internal causes in economy

changes in consumption and investments

changes in economic policy (monetary policy and fiscal policy)

4.6

External causes

demographic changes

political reasons

inventions and innovation

09

5.Types Of Business Cycles.

The capitalist economy has pass through numerous business cycle.
Following are the types of business cycle.

Major Cycles(8-10)Years
Minor Cycle(2-3) Years
Long wave Cycle (50-60)Years

5.1 Major Cycles:

These are the wide oscillation of business activity and are characterized by
serious depression, seven different business cycle were seen during 18701937.

5.2 Minor Cycles:

These are of relatively mild intensity characterized by downward movement.

Between 1947 to 1983 rapid economic growth was four times interrupted by
minor, Mild down swing.

5.3 Long wave cycle:

Long wave business cycle or trade cycles are 50 to 60 years duration. The
upswing period of long swing cycle can contain several minor and even
major cycles. The primary element in long wave business cycle is the price
movement

10

6. Characteristic of Business Cycles.

6.1 It occurs periodically
The business cycle occurs periodically in a regular fashion. This means the prosperity
will be occurring alternatively.

6.2 It is all embracing

The business cycle implies that
the prosperity or depression effect of
the phase will be affecting all industries
in the entire economy and also affecting
all industries in the entire economy and

Fig.a

also affecting the economies of other countries. It is international in character. The Great
Depression of 1929 is an example of this.

6.3 It is wave-like
The business cycle will have a set pattern of movements which is analogous to waves.
Rising prices, production, employment and prosperity will become the features of upward
movement: Falling prices, employment will become the features of the downward movement.

6.4 The process is cumulative and self-reinforcing

The upward movement and downward movement are cumulative in their process. When
once the upward movement starts, it creates further movement in the same direction by feeding
on itself. This momentum will persist till the forces accumulate to alter the direction it persists in
the same direction leading to the worst depression and stagnation till it is retrieved to gain an
upward movement.

11

6.5 The cycles will be similar but not identical

Different cycles and waves in the business cycles will be similar in general feature, but
they are not identical in all respects. A typical cycle constructed by making, as it is where, a
composite photograph of all the recorded cycles would not materially differ in form varies
widely from any one of them. But this typical cycle is not an exact replica of any individual
cycle. The rhythm is rough and imperfect. All the recorded cycles are members of the same
family, about among them are no twins.

Fig. Characteristics of business cycle

12

7. Business Cycle Forecasting

BUSINESS

FORECASTING

is

an

estimate

or

prediction

of

future

developments in business such as sales, expenditures, and profits. Given the

wide swings in economic activity and the drastic effects these fluctuations
can have on profit margins, it is not surprising that business forecasting has
emerged as one of the most important aspects of corporate planning.
Forecasting has become an invaluable tool for businesspeople to anticipate
economic trends and prepare themselves either to benefit from or to
counteract them.

Fig.7

If, for instance, businesspeople envision an economic downturn, they can cut
back on their inventories, production quotas, and hirings.
If, on the contrary, an economic boom seems probable, those same
businesspeople can take necessary measures to attain the maximum benefit
from it. Good business forecasts can help business owners and managers
adapt to a changing economy.

13
The current state of the economy and where it might be headed in the near
future is of utmost concern to entrepreneurs who are interested in launching
new ventures. For example, if the economy is nearing a recession, it might
not be a good time to start a new company.
Cycle forecasting is the process of making predictions about the future of
the economy by analyzing economic data.

Fig. 7a

Fig. 7b
14

7.1 The Ten Leading Economic Indicators

Average workweek of production workers in manufacturing

Average initial weekly claims for state unemployment

insurance
New orders for consumer goods and materials
Vendors performance
New orders for capital goods
New building permits issued
Index of stock prices and Money supply
Spread between rates on 10-year Treasury bonds and

Federal funds
Index of consumer expectations
Hours of production workers in manufacturing
New claims for unemployment insurance
Value of new orders for consumer goods

S&P 500 Composite Stock Index

New orders for plant and equipment
Building permits for private houses
Fraction of companies reporting slower deliveries
Index of consumer confidence
Change in commodity prices
Money growth rate (M2)

15

8. Types of Forecasts and Its Method to measure.

8.1 There are three types of forecast,

Economic forecasts

Technological forecasts

Demand forecasts

Fig 8.1

8.2 Types of Forecasting

methods,

can be measured by two

Qualitative method

Quantitative method

Fig 8.2
16

9.Business Cycle Theories

9.1Endogenous

Starts from within the model

Endo- inside, source

Genous- born

9.2 Endogenous theories

o
o
o
o
o

Innovation theory: innovation leads to saturation.

Psychological theory: alternating optimism and pessimism
Inventory cycle theory: inventory and demand not in sync
Monetary theory: changes in money supply by Federal Reserve
Under consumption theory: or overproduction

9.3 Exogenous

From outside of the model

Exo- outside

Genous- born, source

9.4 Exogenous theories

o The external demand shock theory: effect of foreign
economies
o War theory: war stimulates economy; peace leads to
recession
o The price shock theory: fluctuations in oil prices

17

10.The Austrian School theory

The Austrian School says that recessions are caused mainly by central
government intervention in the money supply.
Austrian School economists conclude that, if the interest rate is held
artificially low by the government or central bank, then the demand for
loans will be higher than the actual supply of willing lenders, and if the
interest rate is artificially high, the opposite situation will occur.
This pricing misinformation leads investors to misallocate capital,
borrowing and investing either too much or too little in long-term
projects.

Fig .10.a
Fig 10.b

In Austrian theory, depressions and recessions are positive forces inso-much that they are the market's natural mechanism of undoing the
misallocation of resources present during the boom or inflationary
phase.
Austrian School economists point to the dot-com investment frenzy
and the U.S. housing bubble as modern examples of artificially
abundant credit subsidizing unsustainable mal investment.

18

Conclusions and recommendations