The Business Cycle

The purpose of the lesson is to help you become familiar with many of the terms you hear each day on the news and in the newspapers – terms like “inflation”, “unemployment”, and “The Fed”.    All of these things are related in a way that will help you understand what is going on at any time in the economy.  We will be referring to the chart below.

The Business Cycle, Inflation
And the Actions of “The Fed”

Companies borrow,

hire more workers,

expand operations.

Inventories at their lowest.

                                                                                             Production in full swing.

      Fed Lowers rates to “energize”                                   Workers making high incomes.

    sluggish economy.                                                    Inventories of finished goods

                                                                                     still lag Demand.

 
TOO FEW DOLLARS CHASING                                           TOO MANY DOLLARS    
TOO MANY GOODS.                                                           CHASING TOO FEW GOODS.
UNEMPLOYMENT HIGH.                                                       UNEMPLOYMENT LOW.
   INFLATION LOW.                                                                    INFLATION HIGH.

 Layoffs and fears of an       

economic slowdown cause                                            Fed raises rates to “cool”

   workers to spend less.                                                overheating economy.

                         Inventories still high.

   Companies cease expansion

   And borrowing.

   Layoffs of workers begin.

   Inventories reach highest levels.

The “Fed” is short for The Federal Reserve Banking System, which includes member banks and the governing body, the Federal Reserve Board.  In general use in the news, “The Fed” is usually referring to the actions of the Federal Reserve Board, currently headed by Chairman Alan Greenspan.

http://www.kc.frb.org/fed101/history/ This link tells you all about the Federal Reserve System.

It is the mission of the Federal Reserve System to balance the amount of money at work in our economy and the amount of goods and services available.  Think of it as a scale.

Goods and Services                              Supply of Money

How does this work?  Imagine we are in a robust economy – like about 5 years ago when the dot.coms were growing.  Workers were making lots of money, and feeling secure.  They wanted to buy stuff – washing machines, cars, etc.

Take a look at the very top entry in our chart – “Companies borrow, hire more workers, expand operations.”  That much you can understand, but what about “Inventories at their lowest”?   An important concept to remember is that production lags demand.  It takes time to produce stuff – you can’t just go out and build a washing machine or car tomorrow, you have to go mine the iron ore, make it into steel, and take the steel to the washing machine factory…  I think you get the idea.

Think of the scale – we are beginning to get heavier on the “money” side.

Moving to the right on our chart, we see that as time passes, production has begun to gear up to produce more goods and services, and in the process there are more workers, all making top dollar because businesses have to pay good wages to attract the more scarce workers.  But inventories are still lagging the demand – there just aren’t enough washing machines in Sears to fill the demand.

So what would happen on a nice Saturday morning if all of these workers showed up at the local Sears store wanting to buy a washing machine, and there was only one on the sales floor?  They might start bidding up the price in order to be the one who gets to purchase it.

This is a classic example of too many dollars chasing too few goods, which is the definition of inflation.

Inflation is happening when prices are rising in the economy, and it is BAD because inflation lowers the buying power of our dollars, not just here, but abroad as we try to buy needed raw materials and goods and services from other countries.  Too much inflation can cause businesses to fail, workers to lose their jobs, and for the economy to sink into recession, or worse, depression.

The paradox in this situation is as we see in the box on the right side of the chart – Unemployment is low, but economists are concerned because they fear inflation. 

The actions the “Fed” undertakes are what are known as “Monetary Policy” in that they deal with manipulating financial mechanisms to increase or decrease the supply of money.  In our simple model, the “Fed” raises interest rates charged by the Federal Reserve Bank to borrowing banks. (Newscasters usually say that the Fed is trying to “cool” the economy down so that the amount of money entering the economy begins to slow down so the supply of goods can catch up).    Since the cost of their money has gone up, banks raise their rates to borrowers.

At the bottom of the chart we see that because rates have risen, companies cease expansion – they decide to put off building that new plant because it’s too expensive to borrow money and they won’t be able to make a profit on the investment.

Companies begin to lay off workers.  At the same time, workers still on the job may decide to save more in case they, too, get laid off.  The supply of money in the economy begins to drop.

Remember how inventories of washing machines were lagging behind the demand?  Well now the train of inventory that has been in production all this time pulls in, and where Sears had one washing machine and a store full of buyers, there now is a room full of washing machines and nobody to buy them!

The scale has shifted entirely to the opposite side – we have lots of goods and services, but not much money out there.  What will stores do to attract the few buyers that are left?  SALE!!!  Prices begin to drop – DE-flation happens.

Now we have a situation where too FEW dollars are chasing too MANY goods.  Unemployment is high, but inflation is low.

So the Fed has achieved its goal of low inflation, but at what cost!! 

So to bring the scale back into balance, the Fed seeks to “energize” the sluggish economy by taking opposite actions to what was done earlier – rates are lowered to encourage investment.

Companies begin to think about building that new factory again, they begin hiring back workers, and production of washing machines begins again.

Of course, the inventory of finished washing machines has dropped during this time, and stores have not ordered more because they had no customers.  So we find ourselves back at the top, with workers beginning to make more money, but with inventories of finished goods lagging behind.

How long does this cycle take?

And here’s the trick – nobody knows.  The Fed is constantly trying to gauge where we are in the cycle because they fear inflation.  That’s why right now in September 2002, with the economy in the dumps, the Fed is cautious about lowering rates that are already at 30-year lows.

http://www.frbsf.org/publications/federalreserve/monetary/goals.html 

This link tells you about Monetary Policy, its goals, and the mechanisms that are used to affect the money supply.

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