The Business Cycle

The Business Cycle

Introduction

• The business cycle involves ups and downs in economic activity.
• A key question is whether a 9% month-to-month annualized increase in consumer prices is unusual.
• The answer depends on the stage of the business cycle.

What is Money?

• Money is a tool for exchanging resources for goods and services.
• Four functions of money:
  • Medium of exchange
  • Unit of account
  • Standard of deferred payment
  • Store of value
• Various items have been used as money throughout history, including:
  • Woodpecker skulls
  • Cowrie shells
  • Stones
  • Pecus
  • People
  • Tobacco
  • Wampum
  • Corn
  • Animal teeth
  • Bark
  • Cloth
  • Barley
  • Beads
  • Butter
  • Feathers
  • Fish
  • Fur
  • Liquor
  • Oats
  • Peas
  • Paper
  • Pieces
  • Sal
  • Tobacco
  • Strings
  • Whale teeth
  • Metals

Economic Indicators

• Economic indicators need to be placed in proper context to aid decision-making at micro and macro levels.
• Key economic indicators:
  • Inflation: An upward movement in the average level of prices
  • Demand-Pull Inflation: Aggregate demand exceeds aggregate supply, causing consumers to bid up prices.
  • Cost-Push Inflation: Sustained increases in production costs cause prices to rise.
  • Gross Domestic Product (GDP): The main measure of overall economic activity.

Gross Domestic Product (GDP)

• Definition: The value of all final goods and services produced within a nation's borders.
• Two types of GDP:
  • Nominal GDP: Measured in current prices.
  • Real GDP: Takes inflation into account by measuring GDP in constant prices.
• Following other economic indicators is necessary to track and understand the business cycle, even though GDP is a broad measure of economic activity.

The Business Cycle

• A business cycle consists of ups and downs in economic activity.
• Economic activity is like ecological activity, with fluctuations brought about by seasonal changes (but the analogy is not perfect.)
• Ups and downs in economic activity are irregular and unpredictable, like a roller coaster ride.
• Graphs illustrating real GDP (RGDP) year-to-year percentage change show irregular growth rates in actual U.S. RGDP.
• Forecasts suggest that the U.S. economic expansion would slow sharply in 2025 and remain below the long-term average.

Economic Activity and Market Participants

• Market participants are responsible for activity in a business cycle.
• Market participants include:
  • Households: Ordinary people who work and consume goods/services.
  • Firms: Businesses that produce goods and services.
  • Government: Consumes and produces goods and services.

Business Cycle Stages

• The business cycle has four distinct stages:
  • Stage 1: Trough to Recovery
  • Stage 2: Recovery to Expansion
  • Stage 3: Expansion to Peak
  • Stage 4: Peak to Contraction
• The stages and turning points:
  • Stage 1: Trough to Recovery
    • Economic activity is contracting, possibly due to a downturn in demand.
    • Firms layoff workers, reduce production, and cut prices due to excess goods on hand.
    • The economy is in a state of recession.
    • Falling prices revive demand, and economic activity bottoms out at the trough turning point.
  • Stage 2: Recovery to Expansion
    • Economic activity is slowly expanding.
    • Incomes start to rise as more people return to work, and demand increases without price cuts.
  • Stage 3: Expansion to Peak
    • The economy is nearing full capacity.
    • Increasing incomes lead to increasing demand, increasing pressure on production, increased bank activity to finance production expansion, and an increased need for workers (which leads to another increase in incomes).
  • Stage 4: Peak to Contraction
    • Firms and households can borrow money and spend more than they earn using the credit market.
    • Production levels become dependent on the continued availability of credit.
    • Consumers’ debt burdens become so heavy that they must reduce their consumption.
    • Demand falls, inventories of unsold goods build up, and economic activity peaks (peak turning point). The contraction part of the business cycle begins.