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INTEREST RATES AND BUSINESS CYCLES.   Term Paper ID:30293 Click to get this paper

Essay Subject: Examines the role of interest rates within business cycles.... More...

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Paper Abstract: Examines the role of interest rates within business cycles. Centers on U.S. business environment. History of business cycles; lack of uniformity. Use of business cycles & practice of economic forecasting. Usefulnes of business cycles to companies. Analyzing economic measures & indicators. Fluctation of interest rates. Federal Funds Rate. 2 Charts. Paper Introduction: Introduction Business cycles have long been an area of interest because of the criticality of economic trends for the social and political welfare of the country. Numerous public and private organizations are devoted to the production of regular economic forecasts, and heavily funded research projects seek more accurate and reliable models on which to base these forecasts. While much attention is focused on the area of economic forecasting, and numerous computerized models have been developed to predict economic performance, there is also considerable interest in the role of interest rates within the business cycle. This research examines the business cycle and the role of interest rates within cycles. Background Until the 1970s, it w Text of the Paper: The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper. (2 , November). Background Until the 197 s, it was widely accepted that the American economypassed through business cycles. Internet address: http://www.bog.frb.fed.us/releases/H15/data/a/prime.txt. Internet address: http://www.bog.frb.fed.us/releases/H15/data/a/tbaa1y.txt. From 1854 to the mid-196 s, analysts generally consideredthat business cycles varied in length from between one and eight years,with the most common length being three years and the average length beingfour (Balasko & Ghiglino, 1995, p. This overlapping ofeconomists using the econometric models, and the overlap of the underlyingphilosophies and assumptions, has caused some critics to question whetherthe models do, in fact, offer distinct or independent judgments. Ascher, W. The following chart illustrates the rates associated with T-billsduring the latter part of the twentieth century. Research in this area is likely to continue because of the interest inthe implications of accurately being able to predict the national andinternational economies. Washington, DC: FederalReserve Board of Governors. Given theclose trading relationships between these two countries and the UnitedStates, it might be expected that a downturn in one trading partner'sfortunes would affect the others, as well (Balke & Wynne, 1995, p. Criticism of the econometric model has come from various sources. H., & Watson, M. Long-termforecasting enters into long-range corporate and governmental planning, andserves as a basis for the prediction of other trends. Federal funds rates. (1998, July 2 ). Introduction Business cycles have long been an area of interest because of thecriticality of economic trends for the social and political welfare of thecountry. Understanding the gap between theoryand practice. Washington, DC: Federal Reserve Board ofGovernors. Business Cycles and Interest Rates Interest rates fluctuate over the course of business cycles, but thereis some debate over whether such fluctuations are the result of thebusiness cycle, or one of the contributing factors to the cycle (whetherthe interest rates are leading or trailing economic indicators)(Alessandrini, 1999, p. Fasten your seat belts. The performance of short-term forecasting is analyzed withattention to the contributions of different methods, while long-termeconomic forecasting is evaluated with a greater emphasis on the overalllevels of accuracy. (2 ). Oneof the foremost criticisms is that many econometric models use a Keynesianapproach, with the result that there is a common family of models that usethe same variables in similar relationships. If thesesequences are regular, some events, such as increases or decreases ininventories, the number of new businesses formed, or changes in the moneysupply, will consistently signal future changes in trends in GNP,employment, inflation and other related economic events. Long-Term Forecasting Long-term economic forecasting differs from short-term forecasting inthat short-term trends depend on the capacity to understand the intricaciesand linkages of the current economic structure. The judgmental approach holds that individuals are the mostsensitive and comprehensive evaluator of the diverse evidence as to what islikely to occur in the future. Journal of Fixed Income, 9, pp. Recessions andrecoveries in real business cycle models. 25). 653). (2 ). In thisapproach, plausible relationships among various economic components, suchas prices, wages and investment levels, relate time-specific levels withone another in order to reproduce past patterns of economic progress. Instead,managers and executives need to incorporate the information related tobusiness cycles to their own environment and determine how their companywill perform in the current situation. Stock, J. The question that remains, then, is the effect that forecaststhemselves have on the future performance of an economy, and whether aforecast predicting a recession or a recovery may not be self-fulfillingbecause of the perceptions it creates, as well as the information it usesor accuracy it may represent. There are three commonly used short-term economic forecastingtechniques: judgmental approach, econometric modeling, and the indicatorapproach. 566). However, economic behavior is based not only onempirical information, but also on the perception of how the economy isgoing to perform. Balasko, Y., & Ghiglino, C. The task here is toproject productivity, which is assumed to increase at a predictable rate.The other approaches focuses on the demand side of the equation, and toforecast GNP as a consumption function, projecting the demand for goods andservices. Washington, DC: Federal ReserveBoard of Governors. In one method, thefocus is on the capacity of the economic system to supply the goods andservices that make up the gross national product. 1). Although econometricmodels can be used for both long and short-term forecasting, thetraditional approaches to predicting economic behavior varies depending onthe time frame. 6 ). Numerous public and private organizations are devoted to theproduction of regular economic forecasts, and heavily funded researchprojects seek more accurate and reliable models on which to base theseforecasts. During the depression ofthe 193 s, 26 percent of the corporations in one group analyzed by theNational Bureau of Economic Research had rising profits (Richman, 1995, p.6 ). Since World War II, long-term forecasting has focused on twoapproaches, both of which use component breakdowns. Highly organizedcountries were likely to have highly organized business cycles, with cyclesoccurring at like times in Western Europe and the United States. For example, if the economy enters a recovery phaseafter being in a recession, the Fed may be expected to raise interest ratesto keep inflation down. (1993, Spring). (1999, April 17). 65). Business professionals may also makedecisions about whether or not to invest in new equipment and facilities(which can pose interest rate risk) based on their expectations aboutupcoming business cycles. 6 ). (1993). 85). The indicators approach to forecasting is based on the premise thatinteraction among different aspects of economic activity are consistentenough to establish regular sequences of economic events. 48). (1995, December). In long-term forecasting,these short-term fluctuations need not be accounted for to the same levelof detail. Despite the observations that business cycles are not universal and donot occur with uniformity throughout a single economy, let alone theinternational market, they are convenient measures of economic activitywhich remain popular because of their simplicity (Ascher, 1978, p. (1999, September). Therelationships can be complex and convoluted, and the advent of the computerhas made their computations much easier and less time consuming than wheneconometric models were first introduced (Ascher, 1978, p. These innovations notwithstanding, however, economic forecastingremains a controversial subject that has yet to settle on a single methodfor either short-term or long-term forecasting. 95-153. During a period of expansion, not all time series componentsexpand; during a recessionary period, not all time series componentscontract. Fundamentally, it is difficult for such observers to determine whethermovements up or down (in small increments) represent a temporary situation,or whether these movements are the beginning of a more significant trend.Lacking predictive capabilities, even experts such as Alan Greenspan (headof the Federal Reserve) can only base their own actions on the bestforecasting tools they have available). This is particularly true since some companies can do well when theeconomy suffers a downturn (for example, outplacement firms) and somecompanies are able to thrive regardless of the business cycle. For example, the results of the operation of some companies runcounter to the main stream of profits or losses. S. S., & Wynne, M. Boston: Johns Hopkins UniversityPress. Balke, N. Labor market analysis became popular and was used during World WarII to predict the postwar economy, but it too was abandoned when thedepression it predicted in the post-war years did not happen. Washington, DC: Federal Reserve Board ofGovernors. 42). One year rates. As expected, the T-billsclosely mirror the performance of the federal funds rates and prime rateduring periods of recession (the 197 s and 198 s) as well as during timesof expansion ("Three-Month," 2 , p. 147). For example, the Harvard ABC curve, which was a precursorof today's leading indicator approach, failed to predict the 1929 stockmarket crash and ensuing depression, and so was abandoned as a widely usedtool. 42-55. W. There are two types of economic forecasts that are generallydeveloped: short-term (less than two years) and long-term (more than twoyears) (Matthews, 1998, p. The most significant drawback to the judgmental approach is thatthere is no real way to determine what has gone wrong if the method fails,and thus it is difficult to come up with remedial steps that can be takento make the method work better in the future. A procedure for predictingrecessions with leading indicators. Journal of Business Forecasting, 12, 26-28. During periodsof recession, the prime rate is relatively high (as during the 198 s) whereduring expansionary business cycles, the prime rate is relatively low (asduring the 196 s). (1995, August 7). [pic] Another key interest rate associated with business cycles is the ratespaid by the government on its indebtedness. Canada andJapan shared downturns in their economies often at the same time as theUnited States, although the downturns were not as pronounced. Chicago: University ofChicago Press, pp. The Fed has recently increased rates in anattempt to keep the economy from growing too rapidly, but this posesproblems for business professionals, investors and others who watchinterest rates for signs of changes in the business cycle. However, as various models areimplemented and executed, they are sometimes abandoned if they fail topredict an event which has a strong effect on the economy. Chase, C. As evidenceof this, some companies survived the Great Depression of the 193 s whileother companies were driven out of business by the severe economicdownturn. The Economist (UK), pp.S4 -S41. (1978). 1; "Prime,"2 , p. Forecasting. Internet address: http://www.bog.frb.fed.us/releases/H15/data/a/tbaa3m.txt. H., & Watson, M. However, business planning should not be based solely on theanticipation of a downturn (or upturn) in a business cycle. Managing through a downturn.Fortune, pp. These errorscan be dramatic. Such cycles were characterized byexpansion and contraction phases, and conventional wisdom held that suchcycles differed in the length of the cycle, but not in the existence of thecycle overall. 25. Business Cycles and Forecasts The use and prevalence of business cycles has given rise to thepractice of economic forecasting, which attempts to predict the businesscycles and significant economic events. 64 -663. Usefulness of Business Cycles Although business cycles are not universally accepted, the Americaneconomy uses economic indicators and business cycles as forecasting tools.Because of this, analyzing economic measures and indicators can helpcompanies gain a competitive edge in that they can anticipate changes inthe market. However, interest rates exhibited differentbehavior during the 199 s than during the 197 s and 198 s in that they haveremained relatively stable. A. Evidence of slowdown piles up.American Banker, p. W., eds.Business Cycles, Indicators and Forecasting. Minorcycles did not share this commonality, and the United States was consideredto have had more business cycles than Europe overall, and it was notuncommon for some countries to enter recovery while others remained inrecessionary states. In the meantime, most investorsare aware of the risks that interest rates pose for the investmentsdirectly as well as the companies behind those investments, andconsiderable effort continues to be put into improving the forecasting ofbusiness cycles and their effects (Alessandrini, 1999, p. References Alessandrini, F. TheKeynesian models emphasize fiscal policy in the form of governmentexpenditures to establish demand, production, employment and othercategories of economic activity, and put monetary expansion to the side inconsideration of its effect on economic forces ("Fasten Your," 1999, p.S4 ). [pic] Conclusion The advent of computers and the availability of large amounts ofcomputing power has made it possible for economic forecasters to developcomplex models designed to accurately predict future economic events andbehavior. 1; "One-Year," 2 , p. In some studies, time series do nothave regular cyclical movements while others were found to reach their peakevery month. (1995, October). 566-577. Richman, L. If this does notoccur, the indicators may herald a significant economic change, but beunable to predict when the change is due to occur. Changes inleading indicators must also precede these shifts in other trends byuniform intervals from one business cycle to another. Stock, J. Economic Inquiry, pp. Credit risk, interest rate riskand the business cycle. In anticipation of this, investors and managersare likely to change their behavior, all because of perceptions, longbefore any actual action takes place. The success offorecasting with leading indicators depends on the uniformity of thedynamics of business cycles from one point in time to another (Stock &Watson, 1993, p. 59-61. W. Financialinstitutions use the federal funds rate to make their pricing decisions,and the prime rate (the rate that banks and other institutions charge theirbest customers) typically mirrors the federal funds rate. What is critical for long-term forecasting is the anticipationof changes in the overall economic structure (Ascher, 1978, p. While much attention is focused on the area of economicforecasting, and numerous computerized models have been developed topredict economic performance, there is also considerable interest in therole of interest rates within the business cycle. Business cycles, according to traditional thinking, affected allcountries that were based on free-market principles. Three month rates. 1). This research examinesthe business cycle and the role of interest rates within cycles. Short-term forecasting is used extensivelyto making immediate business and economic policy decisions. Econometric modeling emerged during 195 s from earlier attempts todescribe the entire economy as a set of mathematical equations. Internet address:http://www.bog.frb.fed.us/releases/H15/data/a/fedfund.txt. Journal of Economic Theory, pp. Treasury bills provide both ashort-term and long-term (three month and one year) view, with investorsmore likely to turn to the relative safety of T-bills during uncertaintimes. On the existence ofendogenous cycles. Prime rates. Even the business cycle concept with regard to the United States isnot considered an all-pervasive event. The limitation of this method is that notall conclusions that are reached can be based on pure logic, but insteadinvolve (as its name implies) the judgment of the individual making theanalysis. (2 , November). Matthews, G. This lack of uniformity in international businesscycles continued after World War II, with the United States experiencingmore and deeper recessions than its European counterparts. The following chart illustrates the relationshipbetween the federal funds rate and the prime rate for more than 4 years(annualized on an average basis) ("Federal Funds," 2 , p. The federal funds rate is the rate that financial institutions pay toborrow immediately available funds, primarily for one day. Econometricmodeling, which has gained recent favor, is experiencing strong criticismbecause it failed to predict the economic downturns of the 197 s (Ascher,1978, p. If this paper is not what you are looking for, you can search again: Search for: or Click here to request an essay written just for you.