Part II : Asset Building through Equity

Part  II :   Asset  Building  Through  Equity

CHAPTER 8: BUSINESS CYCLE

“THE UNSEEN FORCE THAT MOVES THE MARKET”

Embark upon an action after careful thought. It is folly to say,

"Let us begin the task now and think about it later."    

                                                                              THIRUKKURAL   Verse 467

WHAT IS BUSINESS CYCLE?

A business cycle refers to periods of expansion and contraction. A peak is the high point following a period of economic expansion. A trough is the low point following a period of economic decline.

It is a long-term pattern of alternating periods of economic growth (recovery) and decline (recession), characterized by changing employment, industrial productivity, and interest rates. Also called as economic cycle.

A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large degree, unpredictable. A business cycle is identified as a sequence of four phases:

 “Schumpeter” labeled the "four-phases" of a cycle as: 

                                   Boom – Recession – Depression - Recovery.

Depression:

 When the economy is characterized by large unemployment rates, a decline in annual income, and overproduction, it is said to be in a state of depression. The point at which the real GDP stops declining and starts expanding is the lowest point. Sooner or later, the recession will reach the bottom of the business cycle. How long the cycle will remain at this low point varies from a matter of weeks to many months. During some depressions, such as the one in the 1930s, the low point has lasted for years.

 Peak:

The point at which the real GDP stops increasing and begins its decline signifies the highest point. At the top or peak of the business cycle, business expansion ends its upward climb. Employment, consumer spending, and production hit their highest levels. A peak, like a depression, can last for a short or long period of time. When the peak lasts for a long time, we are in a period of prosperity.

One of the dangers of peak periods is that of inflation. During periods of inflation, prices rise and the value of money declines. Inflation is more of a threat during peak periods because employment and earnings are at high levels With more money in their pockets, people  are willing to spend more than before In this way, demand is increased and   prices rise.

How we 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.

What are Real GDP and Nominal GDP?

Real Gross Domestic Product measures the value of all the goods and services produced expressed in the prices of some base year. In other words, it also considers the effect of inflation on the value of goods and services.

The Nominal Gross Domestic Product measures the value of all the goods and services produced expressed in current prices. It does not consider the effect of inflation on the value of goods and services.

 Stages of Business Cycle :

Expansion: A speedup in the pace of economic activity, resulting in expansion of production and employment.

Peak: The upper turning of a business cycle is characterized by peak production, highest employment and highest inflationary pressure. Low levels of both unemployment and labour shortage push up wage rates. High levels of consumer borrowing and spending occurs. During peak, Firms work at full capacity, profit levels will be high, and inflation and interest rate will be increasing. There will be a “boom” in housing market.

Contraction: A slowdown in the pace of economic activity. During contraction, Industrial production and employment go down.

Trough: (Recession) Recession is a general slowdown in economic activity over a long period of time, or a business cycle contraction. Production as measured by Gross Domestic Product (GDP), employment, investment spending, capacity utilization, household incomes, business profits and inflation fall during recessions. Bankruptcies and the unemployment rate rises. Production and employment hit the lowest levels.

 Revival: The lower turning point of a business cycle, where a contraction turns into an expansion. Consumer confidence grows leading to increased borrowing and spending. Firms increase output, build up stock levels, Spare capacity used, then Investment increases and Unemployment falls. It may take more than a year of recovery for large changes in unemployment.

How the real economy and financial markets interact? We will discuss in the following chapter.

Dr.Felisleo

19.12.2010

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