WHAT ARE BUSINESS CYCLES??

Business Cycle

“A Business Cycle” refers to expansion and contraction of economic activity.

A Peak is high point following a period of “Economic Contraction/Recession”.

A Trough is low point following a period of “Economic Expansion”.

Business Cycle

Alternating increases and decreases in the level of business activity of varying amplitude and length.

Business Cycle Why do we say “varying amplitude and

length?”

• Some downturns are mild and some are severe

• Some are short (a few months) and some are long (over a year)

Do not confuse with seasonal fluctuations!

Varying Duration of Expansions and Recessions

How to Measure 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 (Inflation, Employment, Unemployment. Industrial Production and Wholesale and retail sales.

U. S. Business Cycles

20

10

0

–10

–20

‘90‘801860 ‘70 1900 ‘10 ‘20 ‘30 ‘40 ‘50 ‘60 ‘70 ‘80 ‘90 ‘102000

Civil War

Recoveryof 1895

World War I

Panicof 1893 Panic

of 1907Great

Depression

Korean War Vietnam War

World War II

Expansion ExpansionRecession

The Phases of the Business Cycle

Boom

Secular growth trend

DownturnUptu

rn

Trough

Peak

0Jan.-Mar

Tota

l Out

put

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Stages of Business Cycle

Expansion: A speed up pace of economic activity.

PEAK: The upper turning point of Business Cycle.

CONTRACTION/RECESSION: A slowdown in the

pace of economic activity.

TROUGH: A lower turning point of business cycle, where a contraction turns into an expansion.

Financial Press in US defines a recession: a decline in real GDP for two consecutive quarters.As per NBER:• A recession is a significant decline in economic activity spread across the economy.

• Lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale &retail sales.

Post-World War II Recessions

Characteristics of Business Cycle

Recurring Fluctuations:

A business cycle can be defined as wavelike fluctuat-ions of business activity characterized by recurring phase of expansion and contraction in periods varying from 1 to 12 years.

At one time, business cycles were thought to be extremely regular, with predictable durations. But today business cycles are widely known to be irregular - varying in frequency, magnitude and duration.

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Characteristics of Business Cycle

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Since the Second World War, most business cycles have lasted 3-5 years from “peak to peak”.

The average duration of an expansion is 44.8 months and the average duration of a recession is 11 months.

As a comparison, the Great Depression - which saw a decline in “aggregate economic activity” from 1929 to 1933 - lasted 43 months from “peak to trough”.

Global Financial Melt Down Trough in business activity occurred in the U.S. economy in June 2009.

The Trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II.

Previously the longest postwar recessions were those of 1973-75 and 1981-82, both of which lasted 16 months.

Business Cycle TheoriesEndogenous (Internal) Theories – Business Cycles caused by events or circumstances taking place within the economy.

The Innovation Theory (Joseph Schumpeter)• New Product Introductions begin slowly with

market resistance.• However, as resistance breaks down and other

producers sense that economic profits are being made, they begin to enter the market with incre-ased investment and production and employment increase.

• Eventually the market becomes saturated and sales decline.

• Profits decline, inventories increase, production is curtailed, unemployment increases, economic downturn results.

• When a new innovation takes hold, the process begins again.

The Psychological Theory• If business is optimistic about future sales and profits, they invest, produce more, increase employment and promote an expansion of economic activity.

• When they feel that things can’t continue to get better, they begin to show signs of pessimism and reduce investment, production, cut costs (employment) and cause a reduction in economic activity

Inventory Cycle Theory:

•At the time of increased aggregate demand business owners are caught short of inventory.

• So they increase factory orders, thus causing factories to increase production, increase employment, and thus spending.

Eventually inventories become plentiful and business owners cut back on restocking, reducing factory orders and inducing factory owners to cut production schedules, control costs (including employment)

Spending declines and recession sets in until inventories are reduced to uncomfortably low levels.

Monetary Theory

• If Central Bank is concerned about inflationary pressures, it slows or stops the growth of the money supply which causes a recession (via interest rates, purchases and sales of government securities and bank loan activity)

Monetary Theory

• When is Central Bank satisfied that inflation is no longer a threat, it allows the money supply to expand at a faster rate which brings about an economic recovery (again, via interest rates, purchases and sales of government securities and bank loan activity)

Exogenous (External) Theories -- Factors external to the economy are the causes of the business cycle

The War Theory• A production surge caused by the preparation for

and war itself, cause production increases, employment increases and spending increases

• The decline in production at the end of the war reduces production, results in unemployment and reduced spending

Exogenous (External) Theories -- Factors external to the economy are the causes of the business cycle

The War Theory• A production surge caused by the preparation for

and war itself, cause production increases, employment increases and spending increases

• The decline in production at the end of the war reduces production, results in unemployment and reduced spending

The “Sunspot Theory” – W. Stanley Jevons• Storms on the sun caused periodic crop failures

• Since most of the world’s economies were agriculturally dominated. In the 1880’s, crop failures caused declines in economic activity.

• Subsequent improvements in harvest caused economic expansions until sunspot activity occurred again.

Process & Affect of a Business Cycle

Global Financial Melt Down : 2009

The United States housing bubble is an Economic bubble affecting many parts of the United Sates housing market in over half of American states.

Housing prices peaked in early 2006, started to decline in 2006 and 2007, and may not yet have hit bottom as of 2011.

What were the Shocks that Made the 2008-2009 Crisis To Severe?

The United States housing bubble was based on Subprime loans, have a higher risk of default.

If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender may take possession of the property, in a process called foreclosure.

The value of American subprime mortgages was estimated at $1.3 trillion as of March 2007.

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Increased foreclosure rates in 2006–2007 among U.S. homeowners led to a crisis in August 2008 for the subprime.

On December 30, 2008 the Case-Shiller home price index reported its largest price drop in its history.

The worst performing loans ( Subprime Loan) were securitized by private investment banks

(Morgan Stanely, Lehman Brothers & Freddie Mac & Fannie Mae ) through Credit Default Instrument (CDS). Resultantly, these banks

declared bankrupt.

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default.

The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens.

Credit Default Swap (CDS)

The Great Depression

During this time the prices of stock fell 40%. 9,000 banks went out of business and 9

million savings accounts were wiped out. 86,000 businesses failed, and wages were

decreased by an average of 60%. The unemployment rate went from 9% all the

way to 25%, about 15 million jobless people. The wholesale price index declined 33 percent

Stock market crash and financial panic Decline in spending (sometimes referred

to as aggregate demand) Over production in industry and agriculture Unequal distribution of wealth

Causes of The Great depression of USA