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business cycles
periods of economic expansion have been followed by periods of contraction in a pattern
reflect fluctuations in economic activity as measured by the level of activity in such variables as the rate of unemployment and the GDP
business cycles go through four stages:
expansion
peak
contraction
trough
gross domestic product (GDP)
the market value of all final goods and services produced within a country in a given period of time
to account for inflation, GDP in the United States is based on a constant dollar
expansion or recovery
economic expansion: increasing business activity in sales, manufacturing, and wages
peak: GDP increases rapidly, businesses reach productive capacity, and the economy cannot expand further
contraction: business activity declines from its peak.
- recession: mild, short-term contraction.
- depression: longer, more severe contraction
trough: business activity stops declining and levels off
recession definition: decline in GDP for two or more consecutive quarters
depression definition: decline in GDP for six consecutive quarters
expansions are characterized by increasing consumer demand for goods and services, possibly leading to an:
increasing rate of inflation
increasing industrial production, generally leading to
- a decreasing unemployment rate as hiring accelerates
- falling inventories
- rising stock markets
- rising property values
- increasing GDP
peaks are characterized by:
a decrease to the GDP growth rate
a decrease to the unemployment rate, but a slowdown in hiring
a slower rate of growth in consumer spending and business investment
an increase to the inflation rate
contractions/recessions in the business cycle tend to be characterized by:
rising numbers of bankruptcies and bond defaults
decreasing working hours and increasing unemployment rate
decreasing consumer spending, home construction, and business investment
falling stock markets
a decrease to the inflation rate
rising inventories (a sign of slackening consumer demand)
a negative growth rate for the GDP
troughs tend to be characterized by:
a change from negative to positive GDP growth rate
a high unemployment rate and increasing use of overtime and temporary workers
a possible increase in spending on consumer durable goods and housing
a moderate or decreasing inflation rate
Practice Question
If the Consumer Price Index (CPI) is down but consumer demand is up, the economy is likely in which stage of the business cycle?
A. Trough to expansion
B. Peak to contraction
C. Recovery to trough
D. Contraction to trough
Answer: A. As prices trend downward and consumer demand increases, the economy is recovering from a trough (the bottom) to expansion, choice A. As demand continues to increase, assuming supply remains constant, upward pressure will be put on prices through the expansion to the peak.
cyclical industries
highly sensitive to business cycles and inflation trends
most cyclical industries produce durable goods, such as heavy machinery and automobiles, as well as raw materials, such as steel
during recessions, the demand for durable goods declines as manufacturers postpone investments in new capital goods and consumers postpone purchases of automobiles
countercyclical industries
tend to turn down as the economy heats up and to rise when the economy turns down
gold mining has historically been a countercyclical industry
growth industries
most industries pass through four phases during their existence: introduction, growth, maturity, and decline
an industry is considered in its growth phase if the industry is growing faster than the economy as a whole because of technological changes, new products, or changing consumer tastes
social media and bioengineering are examples of current growth industries
because many growth companies retain nearly all of their earnings to finance their business expansion, growth stocks usually pay little or no dividends
defensive industries
least affected by normal business cycles
companies in defensive industries produce nondurable consumer goods like food, pharmaceuticals, tobacco, and energy
public consumption of these goods remains steady throughout the business cycle
during recessions and bear markets, defensive stocks decline less than other stocks
during expansions and bull markets, defensive stocks may advance less
investments in defensive industries involve less risk and lower returns
sector rotation involves moving into defensive stocks when a contraction is expected
Practice Question
An investor fears a coming recession. She would probably invest in
A. biotech
B. steel producers
C. drug companies
D. home builders
Answer: C. In a recessionary period, business activity slows, so one should take a defensive position. Drug companies (pharmaceuticals) tend to have steady earnings, even in bad economic times. After all, those taking needed prescription drugs will not stop. Even OTC drugs like headache remedies and antacids will continue to be sold (some say even more in a downturn). People generally don't buy a new home when things slow down, nor do they buy new cars (much of the steel produced goes into the manufacturing of autos). Biotech companies will find that funding for experimental treatments dries up.
Practice Question
When the business cycle is in the recovery stage, what type of industry tends to perform the best?
A. Countercyclical
B. Cyclical
C. Defensive
D. Growth
Answer: B. In general cyclical industries, those that follow the cycle tend to be the best performers during expansion (recovery). Countercyclical industries would tend to go in the opposite direction, and defensive industries are billed as such because they tend to be stable regardless of where we are in the business cycle. Most economists would agree that growth industries react later as the recovery gets closer to the peak.
interest rate
cost of borrowing money determined by supply and demand for loanable funds, borrower's credit quality, and loan duration
cost influenced by current and expected inflation
bonds issued by companies have fixed interest rates or coupon payments
bond prices in the secondary market fluctuate with interest rates
when interest rates increase, bond prices decrease; when interest rates decrease, bond prices increase
inverse relationship between interest rates and bond prices
nominal rate of interest
the actual rate of interest a borrower pays on the borrowed money
if inflation is expected, it is likely that interest rates are going to increase
that means that new loans, e.g., bonds, will carry a nominal rate higher than the bonds currently available
as a result, as interest rates rise, market forces will lead the price of those older, lower interest rate bonds to decline
that is because an investor's rate of return needs to be equivalent to current market conditions
yield curve
an important tool in gauging investor sentiment toward future interest rates
the difference between short and long-term interest rates normally reflects an upward sloping line
when it is an upward sloping curve, it is a positive, or normal, yield curve
the yield curve is also a reflection of investor expectations about inflation
if investors expect high inflation rates, they will require higher rates of return to compensate for the reduction in purchasing power over time
long-term interest rates are normally higher than short-term rates for a number of reasons
lenders must be compensated for the:
time value of money
reduced buying power of money resulting from inflation
increased risk of default over long periods
loss of liquidity associated with long-term investments
yield spread (credit spread)
greater risk leads to higher bond yield
analysts compare yields on bonds with same maturity but different quality to gauge market sentiment
yield spread is the difference between yields on Treasuries and corporate bonds
yield spread widens when economic conditions worsen and narrows when they improve
yield spread can also be used between issues of the same issuer
popular measurement is the yield spread between 2-year and 10-year Treasury notes
yield spread narrows when investors are optimistic and widens when pessimistic
Practice Question
A bond analyst is plotting a yield curve and notices that short-term maturities have higher yields than intermediate and long-term maturities. This is an example of
A. an inverted yield curve
B. a positive yield curve
C. a normal yield curve
D. an algorithmic yield curve
Answer: A. An inverted, or negative, yield curve is one that results when debt with short-term maturities has higher yields than those with maturities that are longer. A positive, or normal, yield curve results when the yields increase as maturities do.
fiscal policy
refers to a government's use of spending and taxation to influence economic activity
the budget is said to be balanced when tax revenues equal government expenditures
budget surplus
when government tax revenues exceed expenditures
budget deficit
when government expenditures exceed tax revenues
monetary policy
the central bank's actions that affect the quantity of money and credit in an economy in order to influence economic activity
monetary policy is said to be expansionary (or accommodative or easy) when the central bank increases the quantity of money and credit in an economy
conversely, when the central bank is reducing the quantity of money and credit in an economy, the monetary policy is said to be contractionary (or restrictive or tight)
monetary policy is under the control of the Federal Reserve Board (the Fed)
Keynesian economics
Keynesian economists recognize the importance of government intervention
he laid out how and why recessions happen and what must be done to recover from them
his strategy for recovery from a recession was for government to run deficits to stimulate demand and employment
in other words, he suggested lower levels of taxation and more government spending
classical and supply-side economics
the belief that lower taxes and less government regulation benefits consumers through a greater supply of goods and services at lower costs
holds that supply creates demand by providing jobs and wages
the prices of goods of which there is excess supply will fall, and the prices of goods in demand will rise
monetarist theory
the quantity of money, or money supply, determines overall price levels and economic activity
too many dollars chasing too few goods leads to inflation, and too few dollars chasing too many goods leads to deflation
one of the principal roles of the Federal Reserve Board is monitoring the money supply and making adjustments when necessary
tools of the Federal Reserve Board
changes in reserve requirements
changes in the discount rate
open market conditions
federal funds rate
the rate banks that are members of the Federal Reserve System charge each other for overnight loans of $1 million or more
the rate is considered a barometer of the direction of short-term interest rates
the federal funds rate is listed in daily newspapers and is the most volatile rate; it can fluctuate drastically under certain market conditions
prime rate
most preferential interest rate on corporate loans at large U.S. money center commercial banks
each bank sets its own prime rate, with larger banks generally setting the rate that other banks follow
banks lower their prime rates when the Fed eases the money supply and raise rates when the Fed contracts the money supply
Practice Question
Which of the following statements regarding significant interest rates in the U.S. economy is not true?
A. The federal funds rate is the rate the Federal Reserve charges for overnight loans to member commercial banks.
B. The prime rate is the interest rate that large U.S. money center commercial banks charge their most creditworthy corporate borrowers.
C. The discount rate is the rate the New York Federal Reserve Bank charges for short-term loans to member banks.
D. The most active tool used by the Fed is the buying and selling of Treasury securities by the FOMC.
Answer: A. The federal funds rate is the rate that member banks charge each other for overnight loans of $1 million or more; it is not the rate that the Federal Reserve charges member banks for overnight loans.
balance of payments
measures all the nation's import and export transactions with those of other countries for the year
the balance of payments account contains all payments and liabilities to foreigners (debits) and all payments and obligations (credits) received from foreigners
trade deficit
an excess of one country's imports over its exports and is reported as part of the balance of payments figures
over time, an excessive trade deficit can lead to the devaluation of a country's currency because the country will be converting, or selling, its currency to obtain foreign currency to pay for its increasing imports
trade surplus
the opposite of a trade deficit, a trade surplus is an excess of one country's exports over its imports and is reported as part of the balance of payments figures
over time, an excessive trade surplus can lead to the strengthening of a country's currency
top-down analysis
it would look like an inverted isosceles triangle: broad on top and narrow on the bottom
the analyst starts with the broadest measure of the overall economy and then successively narrows it down to finally select the company or companies that best fit the objectives
bottom-up analysis
direct opposite of top down
start at the bottom (the point) of the triangle with the specific company and work our way up through the industry and then the economy
this analyst starts with the narrowest indicator and then steadily broadens the search
inflation
a general increase in prices as measured by an index such as the consumer price index (CPI)
inflation is caused by excessive demand and monetary expansion
excessive demand occurs when aggregate demand exceeds the aggregate supply and prices rise
monetary expansion is a rapid increase in a nation's money stock in excess of the nation's growth rate
increased inflation drives interest rates higher and drives bond prices lower
decreases in the inflation rate have the opposite effect: bond yields decline and bond prices rise, as you will learn shortly
deflation
a general decline in prices
deflation usually occurs during severe recessions when unemployment is on the rise
deflation is caused by conditions opposite those that cause inflation
basically, when the demand for goods and services is substantially below the supply of those goods or services, prices tend to drift downward (certainly not increase) to encourage an increased demand
one other possible cause of deflation is a severe shrinkage in the money supply
Practice Question
The contraction phase of the business cycle is least likely accompanied by decreasing
A. consumer spending
B. economic output
C. inflation pressure
D. unemployment
Answer: D. An economic contraction is likely to feature increasing unemployment (i.e., decreasing employment), along with decreasing consumer spending, declining economic output, and decreasing inflation pressure.
gross domestic product (GDP)
expresses the total value of all final goods and services produced within the United States during the year
GDP includes personal consumption (by far the largest component), government spending, gross private investment, foreign investment, and the total value of net exports
if imports exceed exports, that negatively affects GDP and that net amount is subtracted
the GDP measures a country's output produced within its borders regardless of who generated it
when the GDP is negative, it is generally a sign of deflation
Practice Question
A U.S.-based firm assembles electronic equipment using parts imported from Singapore. Its income statement looks like this:
Sales $60 million
Wages $30 million
Parts $16 million
Expenses $46 million
Net Income $14 million
What is this firm's contribution to the U.S. GDP?
A. $14 million
B. $30 million
C. $44 million
D. $60 million
Answer: C. The question is how we measure this firm's contribution to U.S. output. At first glance, the answer would seem to be $60 million, the total value of its sales. However, $16 million of this was produced somewhere else, so it shouldn't be counted as part of the firm's—or the United States'—output. Thus, the correct answer is $44 million, the amount of value the firm has added to the imported parts.
unemployment level
key indicator of a country's economic health and bears a relationship to inflation
consumer price index (CPI)
a measure of the general retail price level
by comparing the current cost of buying a basket of goods with the cost of buying the same basket a year ago, we can get an indication of changes in the cost of living
the leading economic indicators include the following:
money supply
building permits (housing starts)
average weekly initial claims for unemployment insurance
average weekly working hours, manufacturing
manufacturers' new orders for consumer goods
manufacturers' new orders for nondefense capital goods
index of supplier deliveries—vendor performance
interest rate spread between 10-year Treasury bonds and the
federal funds rate
stock prices (e.g., S&P 500)
index of consumer expectations
widely used coincident indicators include the following:
nonagricultural employment
personal income minus social security, veteran benefits, and welfare payments
industrial production
manufacturing and trade sales in constant dollars
lagging indicators include the following:
average duration of unemployment
ratio of consumer installment credit to personal income
ratio of manufacturing and trade inventories to sales
average prime rate
change in the CPI for services
total amount of commercial and industrial loans outstanding
change in the index of labor cost per unit of output (manufacturing)
Practice Question
Core inflation is best described as an inflation rate
A. for producers' raw materials
B. the central bank views as acceptable
C. that excludes certain volatile goods prices
D. that represents a market basket of consumer items
Answer: C. Core inflation is measured using a price index that excludes food and energy prices.