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Lesson 3 : The Business Cycle & GDP

Module 1: Macro Fundamental Analysis

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Video Transcript

in this video we’re going to look at the business cycle and we’re also going to look at how it relates to gdp and we’re going to define gdp as well

so the business cycle or the economic cycle as it’s also known is a term used to describe the increase and the decrease of the production of goods and services in an economy over a given period of time

this is measured by the increase and the decrease of gross domestic product now this is an extremely important point to understand because the production of goods and services or more specifically all finished goods and services in an economy over a given period of time is the definition of gross domestic product so the business cycle and fluctuations in gdp are one and the same so to be predicting where we are heading in the business cycle is to be predicting where gdp is going is it going to increase is it going to decrease you have to understand that that is a very key principle because it underpins everything else that follows everything that we’ll be looking at in this course will be based around ascertaining whether we are actually going to see the business cycle expand or we are going to see it contract in other words if we are going to see an increase in gross domestic product or we’re going to see a decrease in gross domestic product in a given economy that is the key principle that underpins every single macro analysis so the business cycle can be broken down into two separate conditions the first of which is economic expansion now during times of economic expansion gdp will grow alongside corporate profits employment and individual wealth so all of these will increase in times of economic expansion the national bureau of economic research in the us estimates that since 1945 the average duration of an economic expansion is around 58 months and since 1990 it is around 95 months so as time has gone on economic expansions have increased in duration we can see the average period of economic expansion has increased as central bank intervention has become more common so the reason that economic expansions have increased in their duration in recent history is because central banks have become more and more active in actually perpetuating these economic expansions via monetary policy the second condition of the business cycle is an economic contraction or a recession they are not quite the same thing so during economic contractions or recessions gdp will fall alongside corporate profits employment and individual wealth so when gdp is declining this is actually reflective of a declining corporate profits a decline in employment a decline in individual wealth the national bureau of economic research in the u.s estimates that since 1945 the average duration of an economic contraction is around 11 months and since 1990 it is also around 11 months so what we can see here is that the average period of economic contraction has actually remained the same despite an increase in central bank intervention so the takeaway really from this is that central banks actually find it much much easier to perpetuate an economic expansion than they do to drag an economy out of an economic contraction or a recession so a technical recession is defined as two consecutive quarters of economic contraction so contraction in gdp that’s a definition that you need to know so next we’re going to look at the four phases of the business cycle and again this is extremely important because being able to predict the business cycle having an understanding of where we are currently in the business cycle where we are heading in the business cycle is to have an understanding of where and in which direction the next market moves will be so the first phase of the business cycle is sustained expansion

now during this stage of the business cycle there is sustained economic expansion where gdp tends to increase at a steady rate both consumer and business confidence tends to rise and as a result corporate sales and corporate profits increase companies will seek to cater for rising demand so output will increase they will produce more gdp goes up output is gdp and unemployment will decline as companies hire more workers so as more people enter employment both income and disposable income tends to rise and this in turn leads to greater consumption

so this increase in consumer demand consumption so greater consumption causes corporate sales and profits to increase as well and this creates an upward spiral you see so as the consumer becomes more bullish they will go out and spend one person’s expenditure is another person’s income as businesses generate more sales they will generate more profits and they will look to cater for increased demand they will do that by hiring more people they will employ more people and when they employ more people more people will actually have greater disposable income to go out and spend and consume so more people will go out and consume and this will just increase corporate sales and profits even more and so on and so on

so after a period of sustained economic expansion the rate of expansion starts to slow and eventually it peaks and it reverses so think of the business cycle as being like a tennis ball if you were to take that tennis ball in your hand and you were to throw it up in the air it would be at the fastest pace the moment it leaves your hand and the higher up into the air it goes it will actually start to slow at some point it will actually stop mid-air before reversing and falling back down to earth due to the gravitational forces that slowing and peaking of the business cycle is the second phase of the business cycle it is the end of the expansion the end of the upward spiral

so during this phase of the business cycle the economy reaches its maximum level of growth and gdp consumer and business confidence corporate sales and corporate profits also slow and peak at the top of the business cycle now this is important because if you are looking at stocks you would want to know whether corporate sales and profits are going to be increasing or decreasing as a result of this slowing and peaking levels of employment also slow in peak and this is due to slowing demand so levels of employment respond to the consumption and the demand if consumption is down employment will go down if consumption is up employment will go up and during this period incomes tend to stagnate when you have stagnating incomes people will consume less and this kicks off the downward spiral as people start to consume less corporate sales and profits also slow in peak therefore businesses will hire less people or may even start to cut some people from the wage bill and this is not just the end of the upward spiral it is actually the start of a downward spiral

so there may be a single quarter of negative gdp so an economic contraction in the slowing phase however this is not yet a recession as we discussed before you must have two consecutive negative prints of gdp for there to be a technical recession

now during the slowing of the economic expansion leading economic indicators lei’s they start to slow or even reverse beforehand we will be looking at leading economic indicators in more depth later on in this course it is the leading economic indicators that will tell you in advance when an economic expansion is coming to an end

so the third phase of the business cycle is sustained contraction so a recession or possibly even a depression depending on how bad the economic data is

so in the third phase the economic expansion has slowed peaked and real gdp contracts for two consecutive quarters so phase one throwing the tennis ball in the air phase two the tennis ball starts to slow peaks and starts to fall and three the tennis ball is in free fall it’s in decline and gravity is now pulling it all the way down to the ground this is the third phase of the business cycle the economy is in a state of sustained economic contraction and now can be defined as being in a recession so two negative quarters of gdp

during this phase of the business cycle corporate sales and profits decline due to the lack of demand and both consumers and businesses find it harder to obtain credit now this becomes a big problem because credit is a lubricant for any economy and much of the investment and consumption in any economy which you choose is as a result of credit so people or businesses taking out loans so as credits dries up consumption and investment also drops drops further and also trade declines now trade really is just cross border consumption and investment so you can think consumption and investment in terms of a closed economy so just inside the economy in and of itself and then trade is simply an open economy so the consumption and investment across borders with another economy and this is why if one country goes into a recession other countries will fall into a recession and there will be a knock-on effect this domino effect comes from that cross-border consumption and investment dropping

so continuing on in the third phase unemployment rises as companies start to reduce their wage costs and as anybody who’s operated a business will know wage costs are usually the biggest cost for any business and when companies start to reduce their wage bill they fire people people lose their jobs companies will also start to reduce their prices to try and stimulate demand so this is important because this affects the value of the currency this is deflationary prices start to come down debt obligations become impossible to meet and businesses become insolvent so this is also why people struggle to find credit and these businesses will go out of business and individuals will actually lose their houses as they’re unable to meet their mortgage repayments

and finally the fourth phase of the business cycle is the contraction slowing and what’s known as troughing so the rate of economic contraction slows and the economy reaches maximum economic contraction conditions begin to improve slightly after the trough and there are signs of an increase in economic activity so going back to the analogy of the tennis ball imagine that you have started out with a tennis ball as i said you’ve thrown it in the air as it is going up this is phase one it starts to slow it hangs in the air and it starts to reverse that’s phase two so the peaking and the reversing it then comes all the way back down towards the ground and that is phase three so that drop is phase three phase four now just imagine is that it has fallen from a great height into some water and initially it will go under the water and as it goes down into the water it will at some point start to slow as it moves through the water and then it will begin to actually bounce back up to the surface of the water again that is the fourth phase it’s that slowing at the bottom and then reversing

so during this period consumer and business confidence may begin to improve leading to signs of a recovery and finally we come to the recovery and sustained economic expansion so back into that first phase and it just goes round and round in a cycle so demand is returning due to lower prices and the bargain mentality starts to prevail this increase in demand means business sales and business profits also increase and companies begin to employ more workers to meet the increase in demand so output also increases to meet that demand output gdp gdp also increases

individual wealth begins to increase and credit becomes easier to obtain as more people are now in employment so banks are prepared to lend to them of course then a period of sustained economic expansion follows just as we looked at in the first slide of phase one now it’s also important to note as this relates to the Forex market during the first phase of the business cycle this is inflationary this is an inflationary time so the general level of prices of goods and services in an economy over a given period of time increases why because demand has returned due to the bargain mentality business sales and profits have increased output therefore increases and as output increases businesses hire more people as they hire more people into employment people become more wealthy and therefore they go out and spend more so what happens is as demand is increasing prices for goods and services in that economy gets bid up so they actually start to increase so something very important that you need to remember is consumer and business sentiment leads the business cycle if you’re looking at a closed economy so economy just in and of itself not linked to any other economy without trade you have making up that economy consumers businesses and the government those are the three major pillars of any economy anywhere in the world so if we take for example economy a economy a is made up by the interactions between government consumer and business and this can be considered a closed economy so gdp as you will see later on in the course when we go through the gdp module is made up between the interactions of government consumers and business closed economy and when economy a decides to interact to trade to import and export with economy b that is when you can consider it an open economy and that trade with economy b becomes the fourth factor in overall gdp so the fourth factor in the overall economy

so consumer and business optimism or pessimism will generally become a self-fulfilling prophecy so if the consumer or if businesses become optimistic the economy will tend to do well purely because consumers will go out and spend more because of their optimism and businesses will start to employ more people because of their optimism conversely if the consumer becomes pessimistic for any reason even if the economy in let’s say a year or two’s time would be fine if the consumer or businesses start to believe that it will not be fine they may start to tighten their belts consumers won’t spend businesses won’t spend as much in terms of investment and they may start laying people off and because of this pessimism a future downturn in the economy will become a self-fulfilling prophecy we are going to be analyzing consumer and business indicators later on in the course as well as many other things so if you’ve heard terms such as inflation and you want to know more about it you’re not too sure don’t worry everything is going to be explained fully in the course