A brief bit about the economic cycle...
The economic cycle is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle.
Expectations matter hugely for businesses - and changes in business sentiment have important macroeconomic effects at different stages of the economic cycle.
Boom
- A boom occurs when real national output is rising at a rate faster than the trend rate of growth. Some of the characteristics of a boom include:
- A fast growth of consumption helped by rising real incomes, strong confidence and a surge in house prices and share prices
- A pick up in demand for capital goods as businesses invest in extra capacity to meet strong demand and to make higher profits
- More jobs created and falling unemployment and higher real wages
- High demand for imports which may cause the economy to run a larger trade deficit because it cannot supply all of the goods and services that consumers are buying
- Government tax revenues will be rising as people earn and spend more and companies are making larger profits – this gives the government money to increase spending in areas such as education, the environment, health and transport
- An increase in inflationary pressures if the economy overheats and has a positive output gap
Slowdown
- A slowdown occurs when the rate of growth decelerates – but national output is still rising
- If the economy grows without falling into recession, this is called a soft-landing
Recession
A recession means a fall in the level of real national output i.e. a period when growth is negative, leading to a contraction in employment, incomes and profits.
A simple definition:
- A fall in real GDP for two consecutive quarters i.e. six months
A more detailed definition:
- A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and retail sales.
There are many symptoms of a recession – here is a selection of key indicators:
- A fall in purchases of components and raw materials (i.e. intermediate products)
- Rising unemployment and fewer job vacancies available for people looking for work
- A rise in the number of business failures and businesses announcing lower profits and investment
- A decline in consumer and business confidence
- A contraction in consumer spending & a rise in the percentage of income saved
- A drop in the value of exports and imports of goods and services
- Large price discounts offered by businesses in a bid to sell their excess stocks
- Heavy de-stocking as businesses look to cut back when demand is weak – causes lower output
- Government tax revenues are falling and welfare benefit spending is rising
- The budget (fiscal) deficit is rising quickly
Recovery
- This occurs when real GDP picks up from the trough reached at the low point of the recession.
- The state of business confidence plays a key role here. Any recovery might be subdued if businesses anticipate that it will be temporary or weak in scale.
- A recovery might follow a deliberate attempt to stimulate demand. In the UK we have seen
- Cuts in interest rates – the policy interest rate fell to 0.5% in the Autumn of 2008 and they have stayed at this low level since then
- A rise in government borrowing
- A policy of quantitative easing (QE) by the Bank of England to pump more money into the banking system in a bid to increase the supply of loans – now worth more than £375 billion.
Why is GDP growth difficult to forecast?
When economists make forecasts about the future path for an economy they have to accept the inevitability of forecast errors. No macroeconomic model can hope to cope with the fluctuations and volatility of indicators such as inflation, exchange rates and global commodity prices.
- Uncertain business confidence levels
- Fluctuations in exchange rate
- External events e.g. volatile oil and gas prices
- Uncertain reactions to macro policy changes
- Rate of business job creation hard to forecast
So, just to make sure.....
Right!!!! Now we can consider how expectations affect the business/economic/trade cycle
Business expectations can affect
1/ The willingness to go ahead with capital investment projects
2/ Decisions over employment levels
3/ The desired level of stocks - which in turn affects short term production decisions
The expected returns from capital investment are determined by the demand for and the price of the output generated by an investment and also by the costs of production. A rise in demand will increase the potential revenue streams that a business can expect from a new project. Similarly, a change in the costs of purchasing the capital inputs the costs of training workers to use new capital and in maintaining the capital stock will also affect the expected rate of return.
The importance of business expectations and uncertainty
• There is always uncertainty about the expected rate of return particularly when demand is volatile and sensitive to changes in interest rates, the exchange rate and incomes.
• The rate of return from an investment is also influenced by the rate at which a new capital project depreciates over time and the effects of changes in corporation tax on profits.
• The cost and availability of finance is important, as higher costs of finance (e.g. higher interest rates) require greater returns from the investment to ensure that it is profitable.
Key evaluation point - uncertainty about future levels of demand is nearly always the main factor driving investment decisions - hence the risk of a negative accelerator effect during an economic slowdown or recession.
Maybe you're a STAR STUDENT and want to take these thoughts a bit further...
The idea that business cycle fluctuations may stem partly from changes in consumer and business confidence is controversial. One way to test the idea is to use professional economic forecasts to measure confidence at specific points in time and correlate the results with future economic activity. Such an analysis suggests that changes in expectations regarding future economic performance are important drivers of economic fluctuations. Moreover, periods of heightened optimism are followed by a tightening of monetary policy.
Indicators of consumer confidence have been at depressed levels in recent months. Business sentiment is also low, reflecting uncertainty about U.S. fiscal policy and the perception that economic weakness may be prolonged. This lack of confidence raises the risk that pessimism can become entrenched and self-reinforcing, further damping the nascent recovery.
The idea that changes in consumer and business confidence can be important business cycle drivers is an old but controversial idea in macroeconomics. It assumes that confidence reacts not only to movements in economic fundamentals but is itself an independent cause of economic fluctuations distinct from those fundamentals. In recent decades, cycles of boom and bust in Japan, East Asia, and the United States have focused renewed attention on the question of confidence. These experiences suggest that optimism about the future helped fuel economic booms and that subsequent buildups of pessimism contributed to the busts. Moreover, these episodes fostered intense debate about the role of monetary policy in boom-and-bust cycles. Central banks have been sharply criticized for stoking the booms and inflating confidence by setting excessively accommodative monetary policy.
