Reading 15. Understanding Business Cycles
Learning Outcome Statements
a. describe the business cycle and its phases;
b. describe how resource use, housing sector activity, and external trade sector activity vary as an economy moves through the business cycle;
CFA Curriculum, 2020, Volume 2
Subject 1. The Business Cycle and its Phases
The business cycle is the fluctuations in the general level of economic activity as measured by such variables as the rate of unemployment and changes in real GDP. Periods of growth in real output and other aggregate measures of economic activity followed by periods of decline are distinguishing characteristics of business cycles. A complete business cycle is represented by A to G in the diagram below:
- Firms start to cut hours and freeze hiring, followed by outright layoffs.
- As final demand starts to fall off the downturn in investment spending usually occurs abruptly.
- Inventories accumulate involuntarily, and firms cut production below even reduced sales levels to let their inventories decline. This eventually accelerates the economic downturn.
- Hiring new workers is a costly process. Firms will wait until it's clear that the economy is in this phase. They will then start full-time rehiring as overtime hours rise.
- As inventories dwindle, businesses ultimately find themselves short of inventory. As a result, they start increasing inventory levels by producing output greater than sales, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate.
- Changes in sales can result in magnified percentage changes in investment expenditures. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates.