The Impact of the Business Cycle

Key economic variables change throughout the business cycle.

Unemployment increases during business cycle recessions and decreases during business cycle expansions (recoveries). However, employment levels follow the cycle with a delay as companies initially use overtime before hiring after the onset of recovery and then reduce overtime before reducing employment as the economy passes its peak and enters contraction.

Capital spending is highly sensitive to changes in economic activity, and fluctuates with the business cycle.

The size of inventory is small relative to the size of the economy, but inventories can fluctuate dramatically over the business cycle. Inventory-sales ratio measures the inventory available for sale to the level of sales. Analysts pay attention to inventories to gauge the position of the economy in the cycle.

Consumer spending, the largest component of output, follows cyclical patterns as workers make decisions based their levels of income, income growth, and employment outlook. For example, an increase in durable spending may be an early indication of economic recovery. Consumer spending is however less cyclical than investment spending though.

The housing sector is very sensitive to interest rates. It is also affected by the rate of family formation and expectation of housing price increases.

Imports respond to the domestic cycle. It will increase if the domestic economy is in the expansion stage, and decline in the contraction stage. Exports depend more on cycles of foreign economies. The currency exchange rate plays an important role in this sector.

Economic Indicators

Economic indicators are statistics on macroeconomic variables that help in understanding which stage of the business cycle an economy is in. Economic indicators can be leading, lagging, or coincident, which indicates the timing of their changes relative to how the economy as a whole changes.

• Leading: Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and improves before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.

• Lagging: A lagging economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagging economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.

• Coincident: A coincident economic indicator is one that simply moves at the same time the economy does. The Gross Domestic Product is a coincident indicator.

No single indicator is able to forecast accurately the future direction of the economy. In the U.S., economists often refer to the Conference Board's diffusion index when judging the moves in the leading index. The diffusion index can measure the breadth of a move in any BCI index, showing how many of an index's components are moving together with the overall index. The index generally turns down prior to a recession and turn up before the beginning of a business expansion.

However, there are two problems with the index.

• There has been significant variability in the lead time of the index. For example, a downturn in the index is not always an accurate indicator of the future.
• The index has often given false alarms. For example, a recession forecasted by a decline in the index does not materialize.

While we cannot predict the future perfectly, economic indicators help us understand where we are and where we are going.