LM02 Understanding Business Cycles 2024 Level I Notes

LM02 Understanding Business Cycles

1. Introduction ...........................................................................................................................................................2
2. Overview of the Business Cycle......................................................................................................................2
Phases of the Business Cycle ..........................................................................................................................2
Leads and Lags in Business and Consumer Decision Making............................................................4
Market Conditions and Investor Behavior ................................................................................................4
3. Credit Cycles ..........................................................................................................................................................5
Applications of Credit Cycles ..........................................................................................................................5
Consequences for Policy ..................................................................................................................................5
4. Economic Indicators Over the Business Cycle..........................................................................................5
The Workforce and Company Costs ............................................................................................................5
Fluctuations in Capital Spending ..................................................................................................................6
Fluctuations in Inventory Levels ..................................................................................................................7
Economic Indicators ..........................................................................................................................................7
Summary................................................................................................................................................................... 10

This document should be read in conjunction with the corresponding reading in the 2024 Level I CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
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LM02 Understanding Business Cycles 2024 Level I Notes

1. Introduction
This learning module covers:
• What is a business cycle; what are the different phases in a business cycle?
• Credit cycles and their relationship to business cycles
• How resource use, capital spending, and inventory levels vary over the business cycle
• Economic indicators that are useful in predicting the future of an economy.
2. Overview of the Business Cycle
The curriculum defines business cycle as: “Business cycles are a type of fluctuation found in
the aggregate economic activity of nations that organize their work mainly in business
enterprises: a cycle consists of expansions occurring at about the same time in many
economic activities, followed by similarly general recessions, contractions, and revivals
which merge into the expansion phase of the next cycle; this sequence of events is recurrent
but not periodic; in duration, business cycles vary from more than one year to 10 or 12
years.”
Some important points to be noted from the definition:
• Business cycles occur in economies where there are a large number of private
companies, and not just agriculture economies.
• The economic activity shows a cyclical behavior between expansion and recession.
• They are pervasive, i.e., the cycle includes many economic activities and not just one
sector. And the phases of expansion or contraction occur at the same time throughout
the economy. For example, banking and real estate both may be in an expansion
stage.
• They are recurrent but not periodic, i.e., the cycles repeat. To say they are not
periodic means that the intensity and the duration differs. For instance, if an
economic boom lasted for five years from 2002-07, it does not mean that the
expansion phase will last for five years in the next cycle. Each cycle lasts about 1 to 12
years.
Phases of the Business Cycle
Types of Cycles
‘Classical cycle’ refers to fluctuations in the level of economic activity when measured by
GDP in volume terms. It is rarely used in practice, because it does not easily allow us to
distinguish between short-term fluctuations and long-term trends.
‘Growth cycle’ refers to fluctuations in economic activity around the long-term potential
trend growth level. The focus is on how much actual economic activity is below or above
trend growth in economic activity. The advantage of this method is that it divides economic
activity into a part reflecting long-term trends and a part reflecting short-term fluctuations.

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LM02 Understanding Business Cycles 2024 Level I Notes

‘Growth rate cycle’ refers to fluctuations in the growth rate of economic activity. A growth
rate above potential growth rate reflects upswings, while a growth rate below potential
growth rate reflects downswings. The advantage of this definition is that there is no need to
estimate a long-run growth path first. Also, peaks and troughs can be recognized earlier than
when using the other two definitions.
Four Phases of the Cycle
There are four phases of a business cycle:
1. Recovery: The economy is going through the trough of the cycle. Economic activity
(which includes consumer and business spending) is below potential but is starting to
increase.
2. Expansion: The recovery gathers momentum and economic activity rises above
potential. The economy enters the so-called ‘boom’ phase.
3. Slowdown: The economy is going through the peak of the cycle. Economic activity is
above potential but is starting to decrease.
4. Contraction: Economic activity falls below potential. The economy may experience a
recession.
The four stages are illustrated below (this exhibit is reproduced from the curriculum):
Schematic of Business Cycle Phases

Some of the important characteristics of each phase in a business cycle are presented in
Exhibit 5 from the curriculum.
Characteristics:

Phase Recovery Expansion Slowdown Contraction

Description Economy going Economy Economy going Economy weakens
through a trough. enjoying an through a and may go into a
upswing. peak. Positive recession.

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LM02 Understanding Business Cycles 2024 Level I Notes

Negative output gap Positive output output gap Negative output

starts to narrow. gap opens. starts to gap opens.
narrow.
Activity levels – Activity levels are Activity Activity Activity measures
consumers and below potential but measures measures are are below
businesses start to increase. show above- above average potential. Growth
average but is lower than
growth rates. decelerating. normal.
Moving to
below-average
rates of
growth.
Employment Layoffs slow. Businesses Businesses Businesses first
Businesses rely on move from continue hiring cut hours,
overtime before using overtime but at a slower eliminate
moving to hiring. and temporary pace. overtime, and
Unemployment employees to Unemployment freeze hiring,
remains higher than hiring. rate continues followed by
average. Unemployment to fall but at outright layoffs.
rate stabilizes decreasing Unemployment
and starts rates. rate starts to rise.
falling.
Inflation Inflation remains Inflation picks Inflation Inflation
moderate. up modestly further decelerates but
accelerates. with a lag.
Leads and Lags in Business and Consumer Decision Making
The behavior of businesses and households often leads or lags the turning points of the
business cycle. For example, at the start of an expansion phase, businesses rely on overtime
and wait to hire new employees until they are certain that the economy is truly growing.
Market Conditions and Investor Behavior
Recovery phase: When markets expect the end of a recession and the start of an expansion
phase, risky assets are repriced upwards. Investors start incorporating higher profit
expectations into the prices of stocks and bonds. Equity markets typically hit a trough about
3-6 months before the economy hits the trough.
Expansion phase: The boom phase tests the limits of the economy. For example, companies
may expand so much that they have difficulty finding qualified labor and will compete with
other companies by raising wages. Companies may also borrow a lot to fund capacity
expansions. The government may have to step in to prevent the economy from overheating.

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LM02 Understanding Business Cycles 2024 Level I Notes

Slowdown phase: During the boom, the riskiest assets will usually have significant price
increases. Whereas, safe assets such as government bonds may have lower prices and thus
higher yields.
Contraction phase: During contraction, investors prefer safer assets such as government
securities and defensive companies with stable positive cash flows.
3. Credit Cycles
Credit cycles describe the changing availability—and pricing—of credit. When the economy
is strong the willingness of lenders to extend credit on favorable terms is high. Whereas,
when the economy is weak lenders make credit less available and more expensive. This can
result in decline of asset values and cause further economic weakness and higher defaults.
Applications of Credit Cycles
Credit cycles should be studied due to the importance of credit in the financing of
construction and the purchase of property. The duration of recessions and recoveries are
often shaped by linkages between business and credit cycles. Recessions accompanied by
rapid fall in credit tend to be longer and deeper. Such situations can also lead to housing and
equity price busts. Recoveries accompanied by rapid growth in credit tend to be stronger.
They can also lead to a revival in house and equity prices.
Credit cycles are not always synchronized with the business cycle. They tend to be longer,
deeper, and sharper than the business cycle.
Consequences for Policy
Investors pay attention to the stage in the credit cycle because:
• it helps them understand developments in the housing and construction markets
• it helps them assess the extent of business cycle phases
• it helps them better anticipate policy makers’ actions
4. Economic Indicators Over the Business Cycle
The Workforce and Company Costs
Exhibit 7 from the curriculum depicts the pattern of hiring and employment through
different phases of the business cycle.
Phase Recovery Expansion Slowdown Contraction
Description of Economy starts at Economy enjoying Economy at peak. Economy goes into
activity levels trough and output an upswing, with Activity above a contraction,
below potential. activity measures average but (recession, if
Activity picks up, showing above- decelerating. The severe). Activity
and gap starts to average growth economy may measures are below
close. rates. experience potential. Growth is
shortages of factors lower than normal.
of production as

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LM02 Understanding Business Cycles 2024 Level I Notes

demand may exceed

supply.
Employment Layoffs slow. Businesses move Businesses continue Businesses first cut
Businesses rely on from using overtime hiring but at a hours, eliminate
overtime before and temporary slower pace. overtime, and
moving to hiring. employees to hiring. Unemployment rate freeze hiring,
Unemployment Unemployment rate continues to fall but followed by
remains higher than stabilizes and starts at slowly decreasing outright layoffs.
average. falling. rates. Unemployment rate
starts to rise.
Levels of employment lag the cycle

Fluctuations in Capital Spending

Exhibit 8 from the curriculum depicts the fluctuations in capital spending through different
phases of the business cycle.
Phase Recovery Expansion Slowdown Contraction
Business Excess capacity Companies enjoy Business conditions Companies
conditions and during trough, low favorable conditions. at peak, with healthy experience fall in
expectations utilization, little Capacity utilization cash flow. demand, profits,
need for capacity increases from low Interest rates tend and cash flows.
expansion. levels. Over time, to be higher—aimed
Interest rates tend productive capacity at reducing
to be low— may begin to limit overheating and
supporting ability to respond to encouraging
investment. demand. investment
Growth in earnings slowdown.
and cash flow gives
businesses the
financial ability to
increase investment
spending.
Capital spending Low but increasing Customer orders and New orders New orders
as companies start capacity utilization intended to increase halted, and some
to enjoy better increase. Companies capacity may be an existing orders
conditions. Capex start to focus on early indicator of the canceled (no
focus on efficiency capacity expansion. late stage of the need to expand).
rather than The composition of expansion phase. Initial cutbacks
capacity. the economy’s Companies continue may be sharp and
Upturn most capacity may not be to place new orders exaggerate the
pronounced in optimal for the as they operate at or economy’s
orders for light current structure of near capacity. downturn. As the
producer demand, general cyclical
equipment. necessitating bust matures,
Typically, the spending on new cutbacks in
orders initially types of equipment. spending on
reinstated are for Orders precede heavy equipment
equipment with a actual shipments, so further intensify
high rate of orders for capital the contraction.
obsolescence, such equipment are a Maintenance
as software, widely watched scaled back.

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LM02 Understanding Business Cycles 2024 Level I Notes

systems, and indicator of the

technological future direction of
hardware. capital spending.
Examples Software, systems, Heavy and complex Fiber-optic Technology and
and hardware (high equipment, overinvestment in light equipment
rates of warehouses, and late 1990s that with short lead
obsolescence) factories. peaked with the times get cut first.
orders placed or re- A company may need “technology, media, Cuts in
instated first. warehouse space in telecoms bubble.” construction and
locations different heavy equipment
from where existing follow.
facilities are.

Fluctuations in Inventory Levels

Increase and decrease in inventory happens very rapidly, and has a major effect on economic
Inventory
growth despite the small size. (I/S) ratio is an important indicator. Final sales
Sales
numbers better reveal the reality of the economic situation than inventory numbers because
the inventory may accumulate or companies may want to dispose obsolete inventory before
starting production; it depends on the stage of the business cycle. Inventories tend to rise
when the I/S ratio is low. During recovery, inventory will be less than sales and companies
start production to increase inventory.
Exhibit 9 from the curriculum shows how production, sales, and inventories typically move
through different phases of the business cycle.
Phase Recovery Expansion Slowdown Contraction
Sales and Sales decline slows. Sales increase. Sales slow faster Businesses produce
production Sales subsequently Production rises than production; at rates below the
recover. Production fast to keep up inventories sales volumes
upturn follows but with sales growth increase. necessary to
lags behind sales and to replenish Economic dispose of
growth. inventories of slowdown leads to unwanted
Over time, finished products. production inventories.
production This increases the cutbacks and
approaches normal demand for order
levels as excess intermediate cancellations.
inventories from the products.
downturn are “Inventory
cleared. rebuilding or
restocking stage.”
Inventory–sales Begins to fall as Ratio stable. Ratio increases. Ratio begins to fall
ratio sales recovery Signals weakening back to normal.
outpaces economy.
production.

Economic Indicators
Economic indicators are variables that are used to assess the state of the overall economy
and for providing insights into future economic activity.

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LM02 Understanding Business Cycles 2024 Level I Notes

Types of Indicators
Economic indicators can be classified based on whether they lag, lead, or coincide with
changes in an economy’s growth.
• Leading indicators have turning points that tend to precede those of the business
cycle. They help in forecasting the economy in the near term.
o Ex: Weekly hours in manufacturing, S&P 500 return, private building permits.
• Coincident indicators have turning points that tend to coincide with those of the
business cycle and are used to indicate the current phase of the business cycle.
o Ex: Manufacturing activity, personal income, number of non-agricultural
employees.
• Lagging indicators have turning points that tend to occur after those of the business
cycle.
o Ex: Bank prime lending rate, inventory-to-sales ratio, average duration of
unemployment.
Composite Indicators
Composite indicators consist of a composite of different variables that all tend to move
together. Different countries will have different composite indices. These indicators are
based on empirical observations of an economy.
Leading Indicators
In the U.S., the composite leading indicator is called the Index of Leading Economic
Indicators (LEI) that consists of 10 component parts. Exhibit 11 presents the 10 components
used in the LEI.
1. Average weekly hours, manufacturing: Firms cut on overtime before a downturn and
increase the overtime before hiring full-time workers during a recovery.
2. Average weekly initial claims for unemployment insurance.
3. Manufacturers’ new orders for consumer goods and materials.
4. ISM new order index: The Institute of Supply Management (ISM)polls its members to
build indexes of manufacturing orders, output, employment, pricing, and comparable
gauges for services.
5. Manufacturers’ new orders for non-defense capital goods excluding aircraft
6. Building permits for new private housing units.
7. S&P 500 stock index.
8. Leading credit index: Aggregates the information from six leading financial indicators,
which reflect the strength of the financial system to endure stress.
9. Interest rate spread between 10-year Treasury yields and overnight borrowing rates:
Spread is the difference between long-term yields and short-term yields. If the curve
is upward sloping (a wider spread), then we expect short-term rates in the future to
be high and more economic growth.

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LM02 Understanding Business Cycles 2024 Level I Notes

10. Average consumer expectations for business conditions

Using Economic Indicators
Leading indicators are particularly useful as they can help predict where the economy is
likely to be in the near future. Coincident and lagging indicators can help confirm what the
leading indicators are telling us.
Other Composite Leading Indicators
Apart from the LEI used in the US, there are several other composite leading indicators that
are used across different countries.
Surveys
Composite indicators often make use of economic surveys. These surveys are usually
conducted by central banks, research institutes, statistical offices, and trade associations on
a monthly or quarterly basis. The surveys are conducted among either businesses,
consumers, or experts. For example, among the 10 components of the LEI, the following
three components are survey based:
• ISM new order index
• Manufacturers’ new orders for non-defense capital goods excluding aircraft
• Average consumer expectations for business conditions
The Use of Big Data in Economic Indicators
In recent years, due to the vast increase in the amount of information and the number of
variables that go into composite indicators, statistical techniques such as ‘principal
component analysis’ are frequently used while constructing indexes using economic
indicators.
Nowcasting
Policy makers and market practitioners have started monitoring economic and financial
variables such as internet searches and electronic payment data in real-time. This allows
them to continuously assess current conditions and produce a nowcast.
Nowcasting produces an estimate of the current state of the economy. The advantage of this
method is that it helps overcome delays associated with the release of actual measures. For
example, measures such as GDP are only published with delay, after the end of the time
period under consideration.
GDPNow
GDPNow is a nowcast published by the Federal Reserve Bank of Atlanta. According to the
Atlanta Fed, “GDPNow” is “best viewed as a running estimate of real GDP growth based on
available data for the current measured quarter.”

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LM02 Understanding Business Cycles 2024 Level I Notes

Summary
LO: Describe the business cycle and its phases.
There are four phases of a business cycle:
1. Recovery: The economy is going through the trough of the cycle. Economic activity
(which includes consumer and business spending) is below potential but is starting to
increase.
2. Expansion: The recovery gathers momentum and economic activity rises above
potential. The economy enters the so-called ‘boom’ phase.
3. Slowdown: The economy is going through the peak of the cycle. Economic activity is
above potential but is starting to decrease.
4. Contraction: Economic activity falls below potential. The economy may experience a
recession.
LO: Describe credit cycles.
Credit cycles describe the changing availability—and pricing—of credit. When the economy
is strong the willingness of lenders to extend credit on favorable terms is high. Whereas,
when the economy is weak lenders make credit less available and more expensive. This can
result in decline of asset values and cause further economic weakness and higher defaults.

LO: Describe how resource use, consumer and business activity, housing sector
activity, and external trade sector activity vary over the business cycle and describe
their measurement using economic indicators.

Recovery:
• GDP growth rate changes from negative to positive.
• High unemployment rate and a moderate or declining inflation.
• Increasing production to meet the pickup in sales with more flexible methods like
overtime or increasing utilization levels.
Expansion:
• GDP growth rate increases.
• Reduction in unemployment rate as hiring rises.
• Inflation may begin to rise.
• Increasing production needs are met with investments and labor force additions.
Slowdown:
• GDP growth rate decreases.
• Unemployment rate decreases, but firms cut back on hiring.
• Business and consumer confidence declines, slowing the growth rates in investments
and consumer spending.
• Inflation rate increases.
Contraction:

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LM02 Understanding Business Cycles 2024 Level I Notes

• GDP growth rate is declining.

• Unemployment rate increases as firms cut back on production.
• Inflation decreases with a lag.
• Decline in consumer and business confidence lowers the investment and consumer
spending.
The three types of indicators are:
• Leading indicators:
o Indicators that change direction before the peaks and troughs of business cycles.
o Examples: Stock prices, index of consumer expectations etc.
• Coincident indicators:
o Indicators that change direction at roughly the same time as the peaks and
troughs of business cycles.
o Examples: Industrial production, manufacturing and trade sales etc.
• Lagging indicators:
o Indicators that do not change direction until the expansions and contractions are
already in progress.
o Examples: inventory-sales ratio, unemployment rate, labor cost per unit of
output, etc.

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