Stylized Facts Regarding the Business Cycle
“Business Cycles: Theory, History, Indicators and Forecasting” Victor Zarnowitz, 1992, University of Chicago Press “Macroeconomics”, A. Abel & B. Bernanke, 1998 Stylized Facts Regarding the Business Cycle in General Stylized Facts Regarding the US Business Cycle Growth Cycles v/s Business Cycles Three Intuitive Theories of the Business Cycle Points/Notation
stands for “change in”. Thus, x is the change in x. A boom/expansion is a period during which economic activity is increasing. It is the A slump/recession is a period during which economic activity is decreasing. A „procyclical‟ variable is a variable whose value increases during an expansion and falls during a recession, i.e., it follows the movement of the business cycle. A similar definition applies to the term „countercyclical‟. The term „cyclicality‟ refers to either the degree of procyclical or countercyclical behavior of the variable.
Upper case variables usually stand for the levels of the variable. Lower case variables usually stand for the natural logarithm of the variable. „Leading‟ variables are those variables whose peaks (for procyclical variables) or troughs (for countercyclical variables) occur just before the peak in GDP, i.e., just before the peak in the business cycle. „Coincident‟ variables are those variables whose peaks or troughs occur around the same time as the peak in GDP, i.e., the peak in the business cycle. „Lagging‟ variables are those variables whose peaks (for procyclical variables) or troughs (for countercyclical variables) occur just after the peak in GDP, i.e., just after the peak in the business cycle.
Underlying Theories As you go through these next few pages, you will be compelled to wonder if there is some underlying theory that connects all these facts. To save you the suspense – there isn‟t! So stop worrying about how to make sense of ALL that you read below and make sure you understand the points individually. Some of them can be joined together but making sense of all them is beyond the scope of even today‟s understanding of the business cycle.
STYLIZED FACTS REGARDING THE BUSINESS CYCLE IN GENERAL
Variable Production Industrial Production Expenditure Consumption Business Fixed Investment Residential Investment Inventory investment Government Purchases Labor Market Variables Employment Unemployment Average Labor Productivity Real Wage Money Growth and Inflation Money Growth Inflation Financial Variables Stock Prices Nominal Interest Rates Real Interest Rates Source: The Conference Board
Direction
Timing
Procyclical
Coincident
Procyclical Procyclical Procyclical Procyclical Procyclical
Coincident Coincident Leading Leading –
Procyclical Countercyclical Procyclical Procyclical
Coincident – Leading –
Procyclical Procyclical
Leading Leading
Procyclical Procyclical Acyclical
Leading Lagging –
LEADING, COINCIDENT AND LAGGING INDICATORS: B.E.A. Roughly Coincident Lagging I. Investment in Fixed Capital and Inventories Housing starts + residential Production of business Business expenditure for new fixed investment investment plant and equipment Contracts and orders for plant Machinery and equipment Manufacturing and trade and equipment sales* inventories Change in business inventory II. Consumption, Trade, Orders and Deliveries New orders for consumer Production of consumer goods goods and materials Manufacturing and trade sales Change in unfilled orders of durable goods* Speed of deliveries Index of consumer sentiment III. Employment, Production and Income Ave. workweek; overtime Non-agricultural employment Average duration of hours (manufacturing) Unemployment rate unemployment Accession rate; layoff rate GNP; personal income Long-term unemployment (manufacturing) Industrial Production New unemployment insurance claims Productivity (output per hours) Rate of capacity utilization IV. Prices, Costs and Profits Bonds prices* Stock prices* Sensitive materials prices* Profit margins Total corporate profits New cash flows V. Money, Credit and Interest Monetary growth rates* Change in liquid assets* Change in consumer credit* Total private borrowing* Real money supply Unit labor costs Labor share in national income Leading
Velocity of money
Short-term interest rates* Bonds yields* Consumer credit outstanding* Commercial and industrial loans outstanding
Note: * indicates series in nominal terms Selection is based on US indicators published in Business Conditions Digest, BEA, US Department of Commerce.
STYLIZED FACTS REGARDING THE US BUSINESS CYCLE Most industries respond to the business cycle – agriculture does not.
This seems very reasonable given that agricultural goods are necessities and are more related to size of the population and not the business cycle. Again, it is important to keep in mind that even among the industries that do respond to the business cycle have different elasticities with respect to the business cycle.
Stylized Facts About:
Wages and Prices Monetary Variables Output, Investment, Inventories and Employment Consumption Financial Variables
Wages and Prices
W (nominal aggregate wages) and P (aggregate prices) are less sensitive to in AD (aggregate demand). With the US moving more towards production of services has reinforced this low sensitivity of W and P to AD. This decreased sensitivity to AD is also due to the staggered setting of wages1 in the US.
Discussion
Prices of finished goods move less than average production costs. Average production costs (1) above trend during a slowdown and (2) during the late stages of recession and the early stages of an expansion. This suggests that average production costs „lag‟ the business cycle.
The lagging behavior of average production costs reflects the coincident behavior of L (labor) productivity and sluggish W (due to staggered wages). Due to this explanation, total
(profit) is a leading variable but the lead-time of total profit is shorter than the lag-time of
average production costs. Discussion Imperfect competition (unlike perfect competition) implies „markup‟ pricing2.
This markup is strongly procyclical and leads by long intervals.
Discussion
Variance of industrial prices is greater than the variance of retail prices and W.
Discussion
Industrial prices are more sensitive to the business cycle than retail prices or W.
Discussion Since 1949, P has never in response to a cycle but there has been a decrease in . Interestingly, all business contractions in the US before World War II saw a in wholesale (not aggregate) prices. Discussion
W < P during recoveries (which means that employers benefit and are therefore willing to
produce more). The opposite happens during a recession which explains why producers tend to hire fewer employees and produce less.
Discussion
Output, Investment, Inventories and Employment
Size of private I is smaller than private C but the amplitude is larger.
Discussion
Variance of aggregate production is greater than the variance of aggregate sales. This implies procyclical behavior of inventories.
Discussion
Manufacturing of durables is guided by advance order and is therefore subject to large fluctuations.
Discussion
Activities that mark the early stages of I lead the downturn in N, Y and RGDP (which occur due to the downturn of the business cycle). These „activities‟ include formation of new business, contracts for commercial and industrial construction and new bond and equity issues.
Discussion I-realization (I that is already in place) keeps long after in I-commitments. The in I realizations is due to the accumulated backlog of orders. Discussion
Business expansion for new plants peak when overall contraction (of the economy) is well underway.
Discussion
In relatively short or mild cycles, the role of inventory I is extremely important. This is not true in long or deep recessions/depressions where fluctuations in fixed I carry more weight.
Discussion
in business inventory is procyclical, highly volatile and leads with small intervals.
Total manufacturing and trade inventory (level, not ) have a trend and lag the business cycle.
Discussion
Production, N and inventory have large amplitudes.
Discussion
Consumption
Consumer (installment) credit and mortgage credit (outstanding) are procyclical and leading. Net in bank loans is also procyclical but the lead time is shorter.
Discussion
Financial Variables
margins are also strongly procyclical and lead by long intervals.
Discussion
have larger amplitude than W, dividends, net (of tax) i, and rental income.
Discussion
per unit of sales (not per unit of goods produced – due to the behavior of inventories) leads in total sales.
Total leads in total sales as well but the lead-time is shorter.
Discussion
Monetary Variables
Short run i is positively related to the business cycle with a large amplitude around its own average.
In terms of basis points (1 percent = 100 basis points), the response of the short-run i to the business cycle is low if the level of i is low.
Long-run i has a stronger correlation with the business cycle but has a lower amplitude around its own average.
Discussion
Near cyclical peaks, short-term bond rates come close to or exceed long-term rates. Near cyclical troughs, short-term bond rates are much lower than long-term rates.
Discussion Bond prices lead stock prices which lead in total sales.
Discussion
Income velocity of money (equal to income + stock of currency and deposits) is procyclical.
Discussion
Monetary aggregates see slowdowns in their growth rates during mild recessions but severe recessions are associated with downturns in the growth of monetary aggregates.
Discussion
L productivity (output per hour) shows a rising trend over time. During the business cycle, L productivity fluctuates procyclically around this rising trend. Labor productivity generally leads N, Y and RGDP. Monetary Aggregates have low conformity to the cycle than other credit flows (think of the argument of the RBC camp here), the amplitude is relatively shorter but the random variation is greater. Monetary aggregates have long leads that are highly variable. The lead may sometimes be so long that inverted behavior is observed, i.e., aggregates actually decrease during expansions.
Discussion
Consumer expectations show leading patterns. Residential construction commitments have long leads at peaks and troughs. The gestation period (time to completion) of committed construction is short.
Discussion
GROWTH CYCLES V/S BUSINESS CYCLES
Growth cycles are deviations of GDP from a long-run trend. Long run trend is estimated and then eliminated. What is left is the growth cycle.
Business cycles are upward and downward movements of the levels of GDP (not deviation from a trend).
High-growth phase of a growth cycle coincides with business cycle recovery and middle expansion. The low growth phase coincides with late expansion and contraction.
Growth cycles are more numerous and symmetric than business cycles. The good news is that variables have similar behavior in analysis of growth and business cycle, i.e., the cyclicality, amplitude and variability attributes are retained for growth and business cycles alike (though the definitions change).
THREE INTUITIVE THEORIES OF THE BUSINESS CYCLE Combination of the accelerator principle and differential supply elasticities (Final Demand) at high levels of capacity utilization I in new productive facilities in demand for labor, raw materials, etc. just when they are already most in demand sharp in unit labor costs but in growth of average productivity output of different goods can be increased with differential elasticities complex increase in costs among different inputs across different industries3. (costs) > (prices) during an expansion
Theory of Non-monetary I in Consumer demand in demand for plant and equipment (Cost/Prices) Also, since I is financed initially by easy bank credit Supply of credit > supply of consumer savings Credit needs to be curtailed late in the expansion since profits fall and interest rates rise decline in lending just when the economy needs credit most general business contraction
Profit Squeeze (Cost/Price) primarily due to wages being less resistant to downward recessionary pressures than prices of finished goods Profit margins get squeezed firms shelve existing investment plans or reduce current production decrease in investment expenditure and wage income
3
For example, the input that is relatively scarce at the aggregate level may see a higher increase in its price in a highly procyclical and successful industry if that industry uses that input intensively
decrease in GDP recession
Notation W P L i I C N Y = nominal wage level = aggregate price level = increases = decreases = leads to (e.g., Money Supply nominal interest rate) = labor = Profit = nominal interest rate = Investment (level) = Consumption = Employment = inflation = Output or income