Chapter 16

Cyclical Fluctuations in Components of Aggregate

Demand

Cyclical Components of GDP in Order of Importance

• Most cyclical fluctuations stem from changes in capital spending. Credit terms and the stock-adjustment principle are both important.

• Fluctuations in housing and consumer durables are more closely related to credit terms; the stock-adjustment principle in those sectors is not very important.

• Inventory investment usually accounts for at least half of the decline in real GDP during recessions, but it usually drops in response to lower sales and is not a cause of recessions.

The Stock-Adjustment Principle

• Net capital stock is proportional to output. Suppose output were steady for a while, then rose because of some exogenous development. For a while, net capital spending would rise rapidly until capital stock reached its new equilibrium level. It would then stop increasing, causing cyclical fluctuations.

• This relationship can also be measured by the rate of capacity utilization; when excess capacity appears, capital spending will drop even if overall GDP is still rising.

Other Cyclical Factors Affecting Capital Spending

• The stock adjustment principle is also just another way of stating that investment will rise when the MPK is above the cost of capital, and will fall when it is below.

• The focus here is on what cyclical factors affect these terms. The main ones are:

Business sentiment and expectationsStock market fluctuations (affect both the MPK

and cost of capital)Until 1986, the tax laws were cyclically adjusted to

try and manipulate investment over the cycleThere is also some tendency for energy prices to

rise rapidly during periods of full employment, although that term is largely exogenous.

How Important are the Cyclical Fluctuations in Credit Variables?

• Interest rates invariably rise near business cycle peaks, but the key variable is the expected real rate of interest. Furthermore, if interest rates rise in response to an increase in the MPK, that will not initially reduce investment.

• Thus while interest rates are an important long-run determinant of capital spending, they are not among the leading cyclical factors.

• For firms without unlimited access to credit and capital markets, restricted availability of credit is a more important cyclical variable.

Different Cyclical Patterns in Capital Spending

• Industrial equipment is tied to rate of capacity utilization

• Transportation equipment is tied to availability of credit

• High-tech equipment is tied to the stock market• Other equipment is tied to natural resource

prices• Construction is tied to expected rate of price

appreciation

Cyclical Differences, Slide 2

• As high-tech investment becomes an increasing proportion of total capital spending, stock market fluctuations are likely to have a greater impact on the overall economy.

• Fluctuations in construction are less likely to dominate capital spending has inflation remains low and stable.

Residential Construction

• In the long run, housing starts are positively related to demographic factors and negatively related to the vacancy rate.

• In the short run, the cost and availability of credit dominate cyclical fluctuations.

• Disposable income is not a very important determinant of residential construction. When income rises, people generally bid up prices of land in desirable locations rather than buy more houses.

Housing and Credit Terms

• In each recession from 1960 through 1991, housing starts dropped sharply. However, they hardly fell at all during the 2001 recession for several reasons.

• Interest rates did not rise very much• Credit availability was not slashed• For many would-be homebuyers, the single most

important factor is whether they can qualify for a mortgage. That is usually determined by comparing the monthly mortgage payment to monthly income, with the maximum ratio set at 28% to 36%, depending on creditworthiness. As mortgage rates drop, the number of people who qualify rises, and so do housing starts.

Credit Terms, Slide 2

• Furthermore, when mortgage rates drop, more creative forms of financing proliferate, including interest-only loans and shared equity mortgages (for people who cannot afford any down payment).

• Real housing prices also have a strong negative correlation with mortgage rates. So when rates drop, housing prices rise faster. That encourages more building because profits of homebuilders rise.

Credit Terms, Slide 3

• For most consumer goods, higher prices serve as a brake on purchases, but since housing is viewed as an investment, rising prices may actually spur demand because of the likelihood of capital gains on the house – which can then be cashed out through refinancing.

• Thus lower mortgage rates spur both demand and supply of housing.

Inventory Investment

• As previously noted, inventory investment usually accounts for more than half of the decline in real GDP during recessions.

• During the 2001 recession, it accounted for more than 100%, which means real final sales kept rising during the downturn.

• Yet it is not necessarily the case that fluctuations in inventory investment cause recessions. They often reflect the decline in final sales that occur for other reasons.

Inventory Investment in 2001

• This argument needs some fine tuning, for if changes in inventory investment simply reflect previous sales in final sales, how could inventories decline in 2001 if final sales kept increasing?

• 1. Final sales of goods did decline; it is just that services kept rising.

• 2. The decline in profit margins intensified cost pressures and squeezed inventories.

• 3. More excess capacity meant less need to order ahead

• 4. Diminished expectations: businesses thought sales would be weaker.

Additional Determinants of Inventory Investment

• Thus in addition to reacting to previous changes in final sales, we see that inventory investment also depends on:

• Rate of capacity utilization• Expectations of how much sales will change in

the near future. Although the stock market is not a perfect indicator, it often serves as a measuring stick for these expectations.

• It is unlikely that shortages will develop in the near future, but if they are believed to be likely, additional stockpiling would occur.

Cyclical Components of Consumer Spending and Saving

• Business cycle economists used to think that sales of cars and housing would provide an accurate indication of the phase of the business cycle.

• Like so many other theories of the cycle, that fell by the wayside in late 2001, when “zero-interest” financing on new motor vehicles sent sales to an all-time record even though the economy was still in recession.

• In previous recessions, new motor vehicle sales had always dipped sharply. Yet even before these new incentives were put in place, sales had remained fairly strong during the 2001 downturn.

Interest Rates and Motor Vehicle Sales

• In 1981, when bemoaning the possible demise of Chrysler, Lee Iacocca said the three major problems with auto sales were “interest rates, interest rates, and interest rates”. Since then, changes in interest rates have been the major factor determining fluctuations in car sales.

• Why does it make so much difference? “Zero interest rate” financing in late 2001 lowered the overall cost of new cars by only about 2%, yet sales zoomed by 30%. It seems obvious that announcing a 2% price reduction would have had a much smaller impact on sales.

Motor Vehicle Sales, Slide 2

• The answer lies with the peculiarities of time payments. Given the choice between driving a 3-year old car that costs $350 per month and a brand-new car of the same make and model that also costs $350 per month, “everyone” will choose the newer car. Lower interest rates make it profitable for auto manufacturers and dealers to “swallow” the unpaid balances on existing time and lease payments.

Motor Vehicle Sales, Slide 3

• No one knows for sure what will happen to interest rates in the future. However, given a logical long-term forecast of about 3% growth and 2% inflation, it would not be unreasonable to assume that the Federal funds rate would climb back from 1% to 5%. It will not be possible for auto companies to profitably renew leases on existing terms, so even slight rises in interest rates may have a major impact on car sales in the future.

Motor Vehicle Sales, Slide 4

• It is probably overstating the case to say that income, prices, and consumer expectations don’t have any impact on new motor vehicle sales.

• However, it does seem increasingly likely that in the future, fluctuations in these sales will be dominated by changes in the cost and availability of credit.

Other Consumption

• What about the other cyclical components of consumption, where the monthly payment is not as important?

• Computers and home electronic equipment are tied more to new products than to economic conditions

• Furniture and household appliances are tied to residential construction

• Clothing and jewelry are probably the most sensitive to income. But even this category did not decline during the 2001 recession.

The Personal Saving Rate

• What about the personal saving rate, which theoretically takes all components of consumption into account?

• Published figures are distorted because they do not include realized capital gains income and cashing out the increased value of homes.

• Abstracting from the data problems, most consumers spend whatever money they have and, except for pension plans, save very little. People who do save usually make that decision independently of the interest rate, putting their money in stocks or real estate.

• To the extent that lower interest rates offer more creative financing for homes and cars, the published personal saving rate will be negatively related to interest rates