CFA Level 1
Economics
Understanding Business cycles (Part 2)
Indicators of business cycles
A. Use of Resources
1. Inventory:
Inventory levels are good indicators of the stage of the business cycle. When expansion is nearing its peak, sales growth starts tapering out and firms are left holding excess inventory. This can be seen from the inventory to sales ratio which would be high in such a scenario. The GDP statistics however accounts for the increase in inventory as increase in economic output. Therefore looking at the GDP stats in isolation gives the picture of economic strength while the economy has actually already started to weaken.
The opposite is the case when contraction reaches a trough. In this case sales growth has started to accelerate but the firms are unable to cope with this having reduced their inventory levels to adjust to low demand. Therefore they find their inventory levels depleting quickly which is captured by the low inventory to sales ratio. Looking at the GDP stats in isolation in this case gives the picture of poor economic growth while in reality the economy has already started to turn around.
2. Labor:
Adding and laying off labor frequently with changes in the economic scenario is a costly option for firms. So they instead adjust the intensity of their use to produce more or less output as required or by reducing or increasing their work hours. Only when a phase of the business cycle is likely to persist do firms hire or lay off labor.
3. Plant and Machinery:
It is not possible for a firm to add or reduce plant and machinery in lockstep with the changing economic scenario. So firms generally adjust the intensity of use of this resource with changing times. Only when expansion looks likely to persist will a firm expand its operations by buying more plant and machinery. Also in a contraction a firm is more likely to adjust the capacity by delaying maintenance than outright selling equipment.
B. Housing sector
1. Low interest rate scenario (expansionary phase) induces increase in construction and sale of homes
2. When jobs are assured and incomes are rising more than the financing costs, construction and sale of homes tend to increase. Opposite is true when incomes are still rising towards the end of the expansionary phase but interest rates are rising more than it.
3. Money available at cheap interest rates during the expansionary phase tends to fuel the speculative demand for housing leading to bubbles which eventually break as interest rates rise and home buyers are not able to service their EMIs any more. This leads to an excess supply of housing causing a fall in prices.
For solved examples please refer to the Schweser CFA notes and Schweser Secret Sauce CFA level 1. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
You may also want to read:
Understanding business cycles (Part 1)
Aggregate output & economic growth(Part 5)
Aggregate output & economic growth(Part 4)
Aggregate output & economic growth(Part 3)
