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Module 7 Introducing Economic Fluctuations & Its Impact on Economy

Module 7 Introducing Economic Fluctuations & Its Impact on Economy

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This educational video, introduces concepts related to the short run of the economy. The module discusses economics and business cycles both expansion and contraction, including leading and lagging indicators of the economic cycles, introduces concept of aggregate demand and supply enunciated with graphs, demand and supply shocks and a key example.

 

An economy goes through expansion and contraction phase and these economics fluctuations cause aggregate demand and supply to change over long term although in case of aggregate supply it might have long term impact.

“Leading Variable: Reaches peak or trough before the turning points of a business cycle. Lagging Variable: Turning points of these variables occur after the business cycle changes course. Co-Incident Variable: Reaches peaks and troughs at the same time. Procyclical economic variable moves in the same direction while countercyclical economic variables move in the opposite direction.”

Leading indicator

 

Yield is one of the few leading indicators discussed in depth. Inverse yield curve is one the most significant indicators of future recession especially in the US. Usually the 10Y and 2 Y yield spread is used to judge the probability of recession in the future.

Data from Credit Suisse going back to 1978 shows: Source CNBC

  • The last five 2-10 inversions have eventually led to recessions.
  • A recession occurs, on average, 22 months following a 2-10 inversion.
  • The S&P 500 is up, on average, 12% one year after a 2-10 inversion.
  • It’s not until about 18 months after an inversion when the stock market usually turns and posts negative returns.

Based on liquidity preference theory, bonds of higher duration will carry higher risk to increased risk due to volatility. This needs to be compensated with a higher annual coupon interest which implied that yields of 10Y sovereign notes will have higher yield compared to a 2Y sovereign note. However due to risk aversion there is an increased buying in the 10Y bond, the 10Y sovereign bond is the most liquid resulting in the yields falling down.

Refer to the Global Bond tutorial here.

Business confidence indices are often used as a leading indicator. University of Michigan Index of Consumer sentiment value is one of them. OECD publishes monthly a business confidence index. “This business confidence indicator provides information on future developments, based upon opinion surveys on developments in production, orders and stocks of finished goods in the industry sector. It can be used to monitor output growth and to anticipate turning points in economic activity. Numbers above 100 suggest an increased confidence in near future business performance, and numbers below 100 indicate pessimism towards future performance.” OECD

Further, Case Shiller 20 city home price index which is used as a laggard index is introduced herein. The module revisits short run and long run economy including the concept of classical dichotomy. In the long run, long run output is fixed by factors of production and level of technology while in the short run prices are sticky. The production function is revisited to understand in classical economics, the output is fixed.  Y= F (K,L) wherein in the long run the output and factors of production Capital and Labour are fixed.

Quantity Theory of Money 

M* V= P*Y   

M: Money supply; V: Velocity of the money supply considered to be stable; Y: Output; P: Price level

PY is nominal output

Based on this this theory, money supply determines the  nominal output of an economy while from the production function, it can be inferred that the productivity capacity of the economy determines the Real GDP.  Based on this theory, and considering the velocity of money to be stable the central banks controls the money supply and the rate of inflation. However, in recent times this theory does not stand true for advanced economies as seen both in the US and Japan.  The equation can be written in percentage form as the following.

                    % Change in Money + % Change in Velocity = % Change in Price + % Change in Output

In module 5, the equation  A Kα L1-α  where A is the level of technology was discussed. The level of technology defines the efficiency of utilizing factors of production. In the long run there is clear distinction between classical dichotomy i.e. nominal variables do not affect real variables. Nominal variables are effect of monetary supply, an increase in the money supply in the long term will result in increase in the price levels which leads to increase in wages etc. At the same time in the short run, increase in price levels impacts the output of the economy so there is no clear distinction between nominal and real variables. The aggregate supply is time dependent, horizontal in the short run as prices are sticky and vertical in the long run as the output is fixed. The aggregated demand curve is downward sloping. Refer to the inset video to know more.

Quantity theory helps to understand the purchasing power of stock of money to understand real variables.

MV=PY   M/P= Y/V =kY

Upcoming tutorials will look into stabilization policy using  change in money supply by central governments.

M/P called real money balances measures the amount of output money can buy. k is inverse of velocity of money and represents money held for units of money earned. Velocity is considered stable in this model however invention like online digital payment system, credit cards have  led to increase in the velocity of money. An example of how this affects the aggregate demand with an economy keeping money supply constant is mentioned below.

 

Concept of Aggregate Demand and Aggregate Supply

 

Aggregate Demand and Aggregate Supply are the total demand and supply for goods and services within an economy.  Demand and supply shocks are exogenous events which change the Aggregate Demand (AD) and Aggregate Supply (AS) within an economy.

Refer to the Module 4A here.

Change in money supply or velocity or both impact the movement of the AD curve while change in price will affect AS curve. Shift in the AD doesn’t impact output in the long run and therefore has no bearing on the employment rate which is at the natural level while in the short run shift in the AD impacts output and employment rate.  In the long run, shift in AD affects the price levels but not in the short run. Supply and demand shocks are exogenous events which change the AS and S curves within an economy. Example of shift in AD will be invention of digital payment system, credit cards which are favorable while adverse supply shocks include famine, increase in price of oil, taxation etc.

Above example of Digital Payment Methods

Digital payment and credit cards increase the velocity of the money supply. Keeping money supply constant, the increase in the velocity of money supply increases nominal spending and output.  In the short run, since the prices are sticky the supply curve is horizontal while in the long run its vertical.  Its causes the AD curve to shit outwards as the economy transits from point A to point B and then to point C. Since prices are sticky in the short run, the output increases, boosting employment, consumption and investment within an economy. This drives the price level up leading to increase in wages etc. The economy finally settles at point C in the long run as the output is fixed. This the economy again finally comes to the natural level of output but the quantity of output demanded reduces. Supply shocks impact cost of goods and services and can include taxation etc. which is used to also reduce negative externalities like carbon emissions, habit of smoking etc. So, one needs to look at the implied meaning of taxation. If the taxation is being used to increase the wellbeing of the society it should be viewed favorably. (I leave this to your judgement).

 


 

Textbook References

  • Macroeconomics Gregory Mankiw
  • Macroeconomics Mishkin

 

 

 

 

 

 

 

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