Business Cycles and Short-and Long-term Expectations

The business cycle refers to variations of economic productivity–often measured in terms of GDP–around its long-term trend rate. It is this long-term trend rate that serves as an anchor for forecasting business environments. This is because the economy cannot sustainably grow faster than its long-term trend rate and because the long-term trend rate means reverting. Since the movements around the trend rate are ultimately stochastic, the business cycle phases can often vary in intensity and length. Despite these fluctuations, a pattern emerges. The business cycle exhibits stochastic processes because it reflects economic decisions that:

• Are made on imperfect information.
• Require significant resources to implement.
• Are difficult or costly to reverse.

The output gap is the difference between the actual output of an economy and the maximum potential output of an economy expressed as a percentage of gross domestic product (GDP).

Actual Output – Maximum Potential Output = (+/-) Output Gap

This formula states that when actual output exceeds maximum output, a positive output gap exists since the economy is outperforming, i.e., overheating. A negative output gap is the opposite, the actual output below the maximum potential output.

Phases of the Business Cycle

Despite varying length and intensity, business cycles tend to follow a pattern. This pattern is encapsulated in the graphic below.

1. Initial recovery: This phase begins an uptick in economic activity, usually coinciding at the bottom of the trough. While the economy has been slow and weak, the initial recovery marks a turning point.
2. Early expansion: The economy continues to gain momentum in this stage. In addition, unemployment starts to decline, but the output gap remains negative.
3. Late expansion: This signifies that the output gap has closed, and the economy is increasingly in danger of overheating. A boom mentality is in the air; unemployment is low, business profits are strong, and wages and inflation are rising.
4. Slow down: During this stage, the economy approaches an eventual peak, usually in response to rising interest rates and inflation, availability of fewer viable investment projects, and debt accumulation. The economy is especially vulnerable to shock at this juncture as business confidence waivers.
5. Contraction: The last stage of the business cycle. A contraction is characterized by a steepening yield curve, firms cutting production, the central bank easing monetary policy, and profits dropping sharply. Recessions are often punctuated by major bankruptcies, incidents of uncovered fraud related to aggressive accounting practices, and/or a financial crisis. Unemployment can rise quickly, impairing household financial positions.

The Business Cycle and Market Expectations

The formulation of capital market expectations seems straightforward under the previous descriptions. If this is true, then making a few forecasts and earning abnormal returns should be easy. The truth is that it is quite a bit more complex than that. Evidence has shown that the business cycle exhibits the highest predictive power of one to three years.

Question

A situation in which actual output is below maximum potential output most likely reflects a:

1. Budget deficit.
2. Positive output gap.
3. Negative output gap.

Solution

The correct answer is C.

Use the following formula:

$$ \text{Actual output} – \text{Maximum potential output} = {(+/-) \text{ Output gap}} $$

This formula states that when actual output exceeds maximum output, a positive output gap exists as the economy is outperforming, i.e., overheating. A negative output gap is the opposite. The actual output is below the maximum potential output.

A is incorrect. A budget deficit occurs when government expenses exceed revenue, and it is not directly related to the actual output of an economy being below its maximum potential output.

B is incorrect. A positive output gap occurs when actual output exceeds potential output, meaning growth is inflationary and above the trend rate. In contrast, a situation where actual output is below maximum potential output reflects a negative output gap, with an economic downturn with unemployment and spare capacity.

Reading 1: Capital Market Expectations – Part 1 (Framework and Macro Considerations)

Los 1 (f) Discuss how business cycles affect short- and long-term expectations