MACROECONOMIC FORCES

Characteristics of the Business Cycle:

1. Fluctuations in aggregate business activity

2. Business organizations in a market economy

3. Regular sequence of changes from expansion, downturn, contraction, recovery

4. Not periodic in duration, intensity, or scope.

5. Expansion and contraction occur simultaneously in many phases of economic activity

6. Cycles cannot be further subdivided into shorter cycles with similar characteristics

Duration of expansion, contraction, and full cycle: See Table 2-1.

1. 8 post war cycles average longer expansion and shorter contraction than 20 cycles since 1900.

2. The longest expansion occurred during the 1960s (106 months), followed by the 1980s (102 months).

3. The longest contraction was during the Great Depression beginning in August 1929 (43 months).

The Diffusion of Business Activity

1. Aggregate industrial production is procyclical (coincident indicator).

2. Components of industrial production vary widely with regard to cyclical changes. (Beer production in figure 2-1 is more influenced by long-run demographic trends than business cycle forces) (Computer production in figure 2-2 is dominated by growth factors and technological factors affecting prices). (Communication equipment in figure 2-3 lags the economy)

3. Of 20 industries examined by the Commerce Department, table 2-2 shows the number of industries experiencing a decrease around the cyclical peaks of July 1981 and July 1990. Similar patterns in industrial diffusion are observed for each cycle.

The 1970-75 Cycle (The Great Recession)

1. Table 2-3 shows the endogenous changes that took place in the economy in response to exogenous forces that increased production, income, and employment from 1970.4 to 1973.4 and then reduced production, income, and employment to 1975.1.

2. Automobile demand (units sold) by consumers led the expansion with a diffusion effect on industrial production. (A diffusion index is the percent of any number of time series that are increasing.)

3. Expansion leads to more income and employment and net business formation. Consumer confidence increases, profits expand, and expenditures for plant and equipment expand.

4. Expansion reduces the slack in the economy (GDP gap), but delivery periods lengthen, unfilled orders increase, and supply-side bottlenecks appear. With continued expansion comes higher labor costs (higher wages with declining productivity), higher financing costs (interest rates), and rising material costs, business profit rates fall.

5. Endogenous forces set the stage for a cyclical downturn, although exogenous forces led to the 1973 recession (especially OPEC cartel and higher energy prices.

BUSINESS CYCLES SINCE 1970

The 1973-75 Recession:

1. Longest and most severe post-WWII recession (16 months, 3.6% decline in real GDP, and 13% decline in industrial production)

2. Causes of recession included both demand factors and supply factors:

a. Inflation due to relatively easy monetary policy prior to 1973

b. Poor crop that drove up food prices

c. Rapid increase in energy prices due to OPEC cartel

d. Excessive inventory buildup and real estate speculation

3. Endogenous forces set the stage for recovery as inflation slowed and inventories were “worked down.” Consumer debt was repaid and adjustments were made to higher energy prices.

The 1980 and 1981-82 Recessions:

1. Higher rates of inflation and lower “real” interest rates had maintained spending for housing and consumer durables until 1979. In late 1979 the Fed switched to monetary aggregates as a monetary policy target with resulting overnight increases in nominal interest rates. Private borrowing fell over 50% during the second quarter of 1980.

2. In early July the Fed eased credit and interest rates fell resulting in renewed expansion over the 12 months from August 1980. Inflation remained in double-digit levels.

3. The Fed again turned restrictive in and, together with high rates of inflation, pushed nominal interest rates upward to about 20 percent. Housing and consumer durable demand fell by over 10 percent.

4. Cooling inflation and tax cuts enacted in 1981 led to economic recovery that continued from 1982 to 1990 (92 months).

The 1982-1990 Expansion:

1. Began in November 1992 and peaked in July 1990. Only in the second quarter of 1986 did real GDP not experience growth, although employment, real personal income, industrial production, and sales experienced uninterrupted growth.

2. Energy producing states experienced recession in 1986 in response to a sharp decline in the price of oil. 1989 was a period of slow growth in response to slowing of manufacturing and construction sectors, but the dollar devaluation and more competitive manufacturing sector helped to overcome sluggish domestic demand.

3. The financial sector was the primary source of instability with the savings and loan crisis and deteriorating quality of bank portfolios.

4. The corporate sector also became highly leveraged (dependent upon debt) as opposed to equity (junk bonds) and households also become overburdened with debt outstanding.

The 1990-91 Recession:

1. The official business cycle peak of July 1990 was not recognized until 9 months later and, in fact, real GDP did not fall until the fourth quarter of 1990. Iraq’s invasion of Kuwait occurred August 1990 and public debate centered upon the impact of US involvement on domestic economic conditions.

2. Higher debt loads by households and business and financial industry imbalances were a fundamental reason for the economic downturn. The invasion of Kuwait was probably a contributing factor.

3. The economic recovery was slow relative to prior periods and, in fact, the unemployment rate increased because economic growth in the last three quarters of 1991 was 1.4, 1.8, and 0.3 percent, respectively.

Indicator Forecasting:

1. The National Bureau of Economic Research’s indexes of leading, coincident, and lagging indicators. Selected from numerous time series (NBER number in parentheses)

2. Leading indicators include: average weekly hours of production workers (1); average initial claims for unemployment insurance (5); manufacture’s new orders in 1982 dollars (8); vendor performance measured by a diffusion index of slower deliveries (20); new private building permits (units) (29); change in manufacturing unfilled orders for durable goods in 1982 dollars (92); change in sensitive materials prices (99); stock prices, 500 common stocks (19); money supply, M2, in 1982 dollars (106); and the index of consumer expectations (83).

3. Coincident indicators include: employees of nonagricultural payrolls (41); personal income less transfer payments in 1982 dollars (51); index of industrial production (47); and manufacturing and trade sales in 1982 dollars (57).

4. Lagging indicators include: average duration of unemployment (91); the ratio of manufacturing and trade inventories to sales in 1982 dollars (77); change in index of labor cost per unit of output in manufacturing (62); average prime rate charged by banks (109); commercial and industrial loans outstanding in 1982 dollars (101); ratio of consumer installment debt to personal income (95); and the change in consumer price index for services (120.)

5. The ratio of coincident to lagging indicators and the diffusion index for industrial production are other indicators used to predict cyclical downturns.

Forecasting with Econometric Models

1. The establishment of structural equations.

2. Klein-Goldberger model was the first model based upon Keynesian real aggregate demand comprised of components of national income and product accounts. (Financial influences were purely exogenous).

3. The Daniel Suits model in 1962 shown on page 53 is also a first generation model without the financial sector.

4. Second generation models introduced the financial sector (FRB-MIT) model.

5. Later models also include the supply side of the economy.