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CFA® Level I · Economics · free lesson
Understanding Business Cycles
Earnings, credit spreads, bond yields and sector leadership all move with the business cycle, so knowing where an economy stands is central to asset allocation and security analysis. This module explains the phases of the cycle, the credit cycle that amplifies it, how spending, inventories, housing and trade behave along the way, how to read leading, coincident and lagging indicators, and how unemployment and inflation are measured and interpreted.
What you will learn
1. Describe the phases of the business cycle and explain how the output gap, employment, inflation and asset prices typically behave in each phase.
- A business cycle is an irregular fluctuation around trend, with peaks and troughs as turning points.
- Four phases: recovery, expansion, slowdown, contraction, defined by growth versus trend and the output gap.
- Output gap = (actual GDP - potential GDP) / potential GDP.
- Inflation tends to peak late in the cycle; unemployment peaks after the trough.
- Asset prices are forward-looking and usually turn before the economy does.
2. Describe credit cycles and explain how they interact with and amplify business cycles.
- Credit cycles are swings in the availability and cost of credit, closely linked to property prices.
- Easy credit raises asset prices and collateral values, which supports more lending: credit is procyclical.
- Credit cycles are usually longer and deeper than business cycles.
- Recessions combined with credit busts or financial crises are deeper and recoveries slower.
- Warning signs: credit growing faster than GDP, property prices outpacing incomes, looser lending standards.
3. Explain how resource use, consumer spending, business investment and inventories, housing activity and external trade vary as an economy moves through the business cycle.
- Firms adjust hours and capacity use before hiring or firing.
- Investment is volatile: short-lived equipment first in recovery, structures later.
- A rising inventory-to-sales ratio late in an expansion signals production cuts ahead.
- Durable goods spending is highly cyclical; services and non-durables are stable.
- Housing is rate-sensitive and tends to lead; exports follow foreign growth, imports follow domestic income.
4. Classify economic indicators as leading, coincident or lagging, and interpret a set of indicators while recognizing their uses and limitations.
- Leading indicators (new orders, permits, yield spread, stock prices, initial claims) turn before the economy.
- Coincident indicators (industrial production, payrolls, real income, sales) describe the current state.
- Lagging indicators (duration of unemployment, inventory-to-sales ratio, unit labour costs, prime rate) confirm turning points.
- Composite and diffusion indexes reduce noise from single series.
- Limitations: variable lead times, false signals, data revisions and structural change.
5. Describe frictional, structural and cyclical unemployment, and calculate and compare measures of labour market activity, including the unemployment rate and the participation rate.
- Labour force = employed + unemployed (actively seeking work); discouraged workers are excluded.
- Unemployment rate = unemployed / labour force; participation rate = labour force / working-age population.
- Frictional (job search), structural (skills mismatch), cyclical (weak demand).
- The natural rate (NAIRU) includes frictional and structural, but not cyclical, unemployment.
- Employment lags the cycle: hours change before headcount.
6. Distinguish inflation, disinflation, deflation and hyperinflation, calculate price indexes using the Laspeyres, Paasche and Fisher methods, and contrast cost-push with demand-pull inflation.
- Disinflation = slower but positive inflation; deflation = falling price level; hyperinflation = extremely rapid inflation.
- Laspeyres uses base-period quantities and overstates inflation (substitution bias); Paasche uses current quantities.
- Fisher index = geometric mean of Laspeyres and Paasche.
- Core inflation excludes food and energy to reveal the underlying trend.
- Cost-push: supply shock, prices up and output down. Demand-pull: excess demand, prices and output up.
Module at a glance
- Four phases: recovery, expansion, slowdown, contraction, read from growth versus trend and the output gap.
- Asset prices are forward-looking and turn before the economy; unemployment turns after it.
- Credit cycles are longer and deeper than business cycles and make downturns after credit booms more severe.
- A rising inventory-to-sales ratio late in an expansion signals production cuts ahead.
- Leading indicators turn first, coincident ones show the present, lagging ones confirm turning points.
- Unemployment rate = unemployed / labour force; discouraged workers leave the labour force.
- Laspeyres overstates inflation (substitution bias), Paasche understates it, Fisher sits between.
- Cost-push inflation raises prices as output falls; demand-pull raises both prices and output.
This free module has 6 lessons, 14 practice questions with full explanations.