BUSINESS CYCLE - Managerial Economics

Many important economic time series are regularly influenced by cyclical and seasonal variations. It is worth considering these influences further, because the treatment of cyclical and seasonal variations plays an important role in economic forecasting.

Business Cycles in Managerial Economics

What Is the Business Cycle?

The profit and sales performance of all companies depends to a greater or lesser extent on the vigor of the overall economy. As shown in Figure, business activity in the United States expands at a rate of roughly 7.5 percent per year when measured in terms of GDP. With recent inflation averaging 4.5 percent per year, business activity has expanded at a rate of roughly 3 percent per year when measured in terms of inflation-adjusted, or real, dollars. During robust expansions, the pace of growth in real GDP can increase to an annual rate of 4 percent to 5 percent or more for brief periods. During especially severe economic downturns, real GDP can actually decline for an extended period. In the case of firms that use significant financial and operating leverage, a difference of a few percentage points in the pace of overall economic activity can make the difference between vigorous expansion and gut-wrenching contraction. One of the most important economy-wide considerations for managers is the business cycle, or rhythmic pattern of contraction and expansion observed in the overall economy. Table shows the pattern of business cycle expansion and contraction that has been experienced in the United States. During the post–World War II period, between October 1945 and March 1991, there have been 9 complete business cycles. The average duration of each cyclical contraction is 11 months, when duration is measured from the previous cyclical peak to the low point or trough of the subsequent business contraction. The average duration of each cyclical expansion is 50 months, as measured by the amount of time from the previous cyclical trough to the peak of the following business expansion. Clearly, periods of economic expansion predominate, which indicates a healthy and growing economy.

Gross Domestic Product, 1959–Present

Gross Domestic Product, 1959–Present

Business Cycle Expansions and Contractions

Business Cycle Expansions and Contractions

On any given business day, a wide variety of news reports, press releases, and analyst comments can be found concerning the current state and future direction of the overall economy.

The reason for intense interest is obvious. Whether the current economy is in a state of boom, moderate expansion, moderate contraction, or sharp decline, there is sure to be widespread disagreement among analysts concerning current or future business prospects. This reflects the fact that, despite intense interest and widespread news coverage, the causes of economic contractions and expansions remain something of a mystery. Why the economy shifts from boom to bust and how such shifts might be predicted and controlled are still largely beyond our knowledge. Hopefully, the ever-increasing quality of economic data and the amazing power of computer hardware and software will unlock further mysteries of the business cycle during the next few years. In the meantime, changes in the pattern and pace of economic activity remain a matter for intense debate and conjecture.

Economic Indicators

Whereas cyclical patterns in most economic time series are erratic and make simple projection a hazardous short-term forecasting technique, a relatively consistent relation often exists among various economic variables over time. Even though many series of economic data do not exhibit a consistent pattern over time, it is often possible to find a high degree of correlation across these series. Should the forecaster have the good fortune to discover an economic series that leads the one being forecast, the leading series can be used as a barometer for forecasting short term change, just as a meteorologist uses changes in a mercury barometer to forecast changes in the weather.

The Conference Board, a private research group, provides extensive data on a wide variety of economic indicators or data series that successfully describe the pattern of projected, current, or past economic activity. Table lists 10 leading, four roughly coincident, and seven lagging economic indicators of business cycle peaks that are broadly relied upon in business cycle forecasting. Figure shows the pattern displayed by composite indexes of these leading, coincident, and lagging indicators throughout the 1980s and 1990s. A composite index is a weighted average of leading, coincident, or lagging economic indicators. Keep in mind that the weights (standardization factors) used in the construction of these composite indexes will vary over time. Combining individual data into a composite index creates a forecasting series with less random fluctuation, or noise. These composite series are smoother than the underlying individual data series and less frequently produce false signals of change in economic conditions. Notice how the composite index of leading indicators consistently turns down just prior to the start of each recessionary period. Similarly, notice how this data series bottoms out and then starts to rise just prior to the start of each subsequent economic expansion. Just as leading indicators seem to earn that description based on their performance, coincident and lagging indicators perform as expected over this period.

The basis for some of these leads and lags is obvious. For example, building permits precede housing starts, and orders for plant and equipment lead production in durable goods industries. Each of these indicators directly reflects plans or commitments for the activity that follows. Other barometers are not directly related to the economic variables they forecast. An index of common stock prices is a good leading indicator of general business activity.

Although the causal linkage may not be readily apparent, stock prices reflect aggregate profit expectations by investors and thus give a consensus view of the likely course of future business conditions. Thus, at any point in time, stock prices both reflect and anticipate changes in aggregate economic conditions. All of this makes macroeconomic forecasting particularly nettlesome for investors.

Economic Recessions

An economic recession is defined by the National Bureau of Economic Research (NBER), a private nonprofit research organization, as a significant decline in activity spread across the economy that lasts more than a few months. Recessions are visible in terms of falling industrial production, declining real income, and shrinking wholesale-retail trade. Recessions are also marked by rising unemployment. Although many economic recessions consist of two or more quarters of declining real GDP, it is most accurate to describe recession as a period of diminishing economic activity rather than a period of diminished economic activity. A recession begins just after the economy reaches a peak of output and employment and ends as the economy reaches its trough. The period between a month of peak economic activity and the subsequent economic low point defines the length of a recession. During recessions, economic growth is falling or the economy is actually contracting. As shown in Figure, recessions in the United States are rare and tend to be brief. The period following recession is called economic expansion. In many cases, economic activity is below normal during both recessions and through the early part of the subsequent economic expansion. Some refer to periods of less than typical economic growth as slumps, but there is no official recognition or characterization of economic slumps. In any event, expansion is the normal state of the U.S. economy.

Because economic recessions are not confined to any one sector, NBER uses economy-wide measures to assess economic activity. In principle, the best such measure is GDP, but GDP is measured only with quarterly frequency. GDP data is also notoriously prone to measurement error, and can be revised as much as a decade after its initial report. As a result, NBER maintains its own monthly chronology of economic activity to guide its description of economic activity. The broadest monthly indicator of economic activity is overall employment, and this is watched closely by the NBER as an indicator of economic vigor.

Leading, Coincident, and Lagging Economic Indicators

Leading, Coincident, and Lagging Economic Indicators

Recessions can be caused by any serious unanticipated economic or political event. For example, recessionary fears increased considerably following the tragic events of September 11, 2001. The terrorist attacks on New York City and Washington, DC, took an enormous human and economic toll. The U.S. economy is roughly 28 percent of global GDP. New York City alone contributes more than 4 percent to U.S. personal income and accounts for almost 3 percent of U.S. nonfarm employment. This awful event was a serious shock for the U.S. and global economy. In trying to assess economic consequences from the September 11, 2001, tragedies, it is important to understand economic conditions at the time of the crisis and how the economy has responded to adverse shocks in the past. Prior to the terrorist attacks, highly stimulative monetary policy in the United States pointed to recovery. Various leading economic indicators were starting to improve, but remained below the highest values reached during January 2000. The Coincident Index of The Conference Board’s Business Cycle Indicators clearly reflected tensions present in the U.S. economy when the tragedy took place. At that time, declines in U.S. industrial production and sales were almost exactly offset by rising personal income and employment. Outside the United States, only Australia displayed continuing strength in economic growth. Five important global economies—Japan, South Korea, France, Germany, and the United Kingdom—all showed economic weakness, thus placing the U.S. economy in a precarious position at a time of great national sorrow.

Composite Indexes of 10 Leading, Four Coincident, and Seven Lagging Indicators (1987 + 100)

Composite Indexes of 10 Leading, Four Coincident, and Seven Lagging Indicators (1987 + 100)

Selected Critical Economic and Political Events (1960–present)

Selected Critical Economic and Political Events (1960–present)

Table highlights several unanticipated economic and political events that have rocked the United States since 1960. These 15 events had the potential to adversely impact the U.S. economy, but they occurred during times of varying economic prosperity. These 15 events also differed in terms of political implications. For example, in the attempted assassination of President Ronald Reagan (March 1981) and the bombing of the Alfred P. Murrah Federal Building in Oklahoma City (April 1995), those responsible were quickly apprehended, and no subsequent political events followed. The Iraqi invasion of Kuwait (August 1990), on the other hand, precipitated the Gulf War. Notice how underlying economic conditions at the time of each crisis were important to their eventual economic impact. Although the tragic events of September 11, 2001, are unprecedented, it is worth noting that economic conditions on September 11, 2001, were similar to those in existence at the time of the Oklahoma City bombing (April 1995) and the Iraqi invasion of Kuwait (August 1990). In each instance, the U.S. economy was decelerating. In the case of the Oklahoma City bombing, the slowdown ended within 8 months. We now know that the U.S. economy had entered a recession (July 1990–March 1991) prior to the Iraqi invasion, so it is fair to say that neither of these comparable events caused the U.S. economy to dip into recession. Based on the information shown in Table, it is fair to say that economic trends underway before unprecedented economic and political events greatly influence their economic consequences. Obviously, the ultimate economic fallout from the terrorist attacks on New York City and Washington, DC, will not be known for quite some time.

Finally, experienced managers realize that significant time lags are often encountered between changes in the macroeconomy and their official recognition. Table shows that NBER’s Business Cycle Dating Committee usually waits 6 months to a year before officially recognizing that a major turning point in the economy has passed. This means that by the time a downturn in the economy is officially recognized, the subsequent upturn has already begun! Slow reporting, hard to decipher leads and lags in the overall economy, and unpredictable ties between economic and political events combine to make accurate macroeconomic forecasting one of the toughest challenges faced in managerial economics.

Common Sources of Forecast Information

The National Bureau of Economic Research, Inc. (NBER), founded in 1920, is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. Their research is conducted by more than 600 university professors around the country, the leading scholars in their fields.

The NBER Web site is a treasure trove of forecast information and insight and offers a host of links to valuable data resources. Consumer survey information included are the Consumer Expenditure Survey Extracts; Current Population Survey; Early Indicators of Later Work Levels, Disease, and Death; and vital statistics for births, deaths, marriage, and divorce. Links to macro data from government sources include Federal Reserve Economic Data (FRED); official business cycle dates; experimental coincident, leading, and recession indexes; and savings and investment information for 13 countries.

Long Time Lags Are Experienced Before Turning Points in the Economy Are Documented

Long Time Lags Are Experienced Before Turning Points in the Economy Are Documented

The National Bureau of Economic Research Web Site Is a Treasure Trove of Forecast Information

The National Bureau of Economic Research Web Site Is a Treasure Trove of Forecast Information

Industry data include the Manufacturing Industry Productivity Database, patent data, imports and exports by Standard Industrial Classification (SIC) category, and various IRS information. Resources for Economists on the Internet (RFE) is another extremely valuable Web site maintained by the American Economic Association and professor Bill Goffe of the Department of Economics at the State University of New York (SUNY), Oswego campus. The table of contents for RFE lists 1,265 resources in 74 sections and subsections of interest to academic and practicing economists, and those interested in economics. Almost all resources are also described in simple-to-understand language. RFE is a particularly good place to look for a broad array of business and economic forecasting resources on the Web. For example, under economic forecasting and consulting resources the reader will find the Conference Board’s Leading Economic Indicators and various other nongovernmental data; economic commentary from Bank of America Economics and Financial Reports; macro, regional, and electrical forecasts from Foster Associates; microeconomic analysis from Glassman-Oliver Economic Consultants, Inc.; global financial market and foreign exchange analysis from Wells Fargo Economic Reports; and so on. Information about economic trends is also found in leading business publications, like The Wall Street Journal and Barron’s. As shown in Figure, Barron’s survey of economic indicators depicts the rate of change in the overall level of economic activity as indicated by GDP, durable and nondurable manufacturing, factory utilization, and other statistics. Also provided are specific data on the level of production in a wide range of basic industries such as autos, electric power, paper, petroleum, and steel. Data published weekly in Barron’s include not only the level of production (what is made), but also distribution (what is sold), inventories (what is on hand), new orders received, unfilled orders, purchasing power, employment, and construction activity. Forbes magazine publishes its own biweekly index of economic activity using government data on consumer prices, manufacturer’s new orders and inventories, industrial production, new housing starts, personal income, new unemployment claims, retail sales, and consumer installment credit. To measure these eight elements of the Forbes Index, 10 series of U.S. government data are monitored over a 14-month period.

Fortune and Business Week magazines also offer regular coverage of data on current and projected levels of economic activity. The quarterly Fortune Forecast of economic activity is based on a proprietary econometric model developed by the company’s own staff economists.

The forecast data and analysis published in these leading business periodicals provide managers with a useful starting point in the development of their own expectations.

Resources for Economists on the Internet Is a Valuable Forecasting Resource

Resources for Economists on the Internet Is a Valuable Forecasting Resource

Barron’s Publishes Timely Information on Economic Indicators

Barron’s Publishes Timely Information on Economic Indicators


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