Understanding the Phase of the Business Cycle
Understanding the relationship between economic variables and the phase of the business cycle where real gdp declines is essential to economic theory. Unfortunately, most of us are not familiar with this basic concept. We think that a country’s gross domestic product is the measure of how well the economy is performing compared to other countries.
The United States has consistently ranked high in international comparisons and a common question is what are the drivers of our consistent performance?
The short answer is complicated. Although it is easy to assume that the stock market is the sole influencing force behind the strength or weakness of the American economy, the truth is that there are many contributing factors. For example, the current trend in the stock market and the foreign exchange market is directly related to the condition of the American economy. Other external factors such as interest rates and unemployment are also important. But the stock market is not the only thing affecting the strength or weakness of the American economy. Understanding the balance of trade and the relationship between trade and GDP is the key to understanding the strength or weakness of the business cycle.
One of the key relationships in understanding the relationship between the stock market and the phase of the business cycle where real gDP declines is the relationship between risky assets and safe assets. If the United States is able to successfully manage its long-term liabilities (defaults) and its long-term investments (interest rate payments and deficits), the value of the dollar will be protected against changes in foreign currencies. Conversely, when the value of the dollar decreases or becomes negative (greatly leading to negative interest rates and deficit spending), riskier assets are more vulnerable to depreciation pressures. That is why the current trend in the foreign exchange market makes oil and other energy commodities like crude oil and copper highly sensitive to changes in the dollar value. The volatility and liquidity of the foreign exchange market also make precious metals like gold and silver highly attractive to investors.
On the other hand, if the United States does not manage its long-term liabilities (defenses) sufficiently or interest rates become too high, the value of the dollar will depreciate. As with the stock market, the value of the dollar is largely protected by long-term interest rates and the balance of trade. Therefore, the phase of the business cycle in which real gdp declines and the trade-weighted real GDP growth to slow down is characterized by a period of significant weakness in the market for both assets and labor, with the market providing little protection against further depreciation and the potential for the trade-weighted real GDP growth to decline even further.
Conversely, the period of time when the stock market experiences sustained growth is characterized by much greater volatility and the market providing substantial protection against further devaluation. This makes the phase of the business cycle where real gDP declines the most fragile. In a period of sustained economic growth, the stock market provides the means through which the national income can be spread around to more people. The stock market is also the platform on which the national economy is based.
Although the stock market is the best known and perhaps the most visible expression of the cyclical process through which the country’s economy operates, the actual process goes much deeper than that. It is possible to monitor the state of the nation’s economy using various other tools as well. For instance, the government can undertake regular studies on the state of the economy which it publishes online. This enables citizens to check in on how the economy is developing and whether it is on the path towards recovery or further slowdown. The availability of such data has made the availability of the phase of the business cycle where real gDP declines much easier to track. It is an essential tool for investors as it allows them to gauge the state of the nation’s economy.
