4 - How can investors forecast the behaviour of financial markets?: The role of business cycles

Abstract

Business activity historically goes through waves of expansion followed by waves of contraction. At one stage of the cycle production, employment, and profits rise, followed by another phase when profits, prices, and outputs fall, resulting in rising unemployment. Then the entire cycle repeats itself again. Two characteristics of the cyclical behavior of macroeconomic variables are important for the discussion of the business cycle facts. The first is the direction in which a macroeconomic variable moves, relative to the direction of aggregate economic activity. The second characteristic of this macroeconomic behavior is the timing of the variable's turning points (peaks and troughs) relative to the turning points of the business cycle. An economic variable is a leading variable if it tends to move in advance of aggregate economic activity. In other words, the peaks and troughs in a leading variable occur before the corresponding peaks and troughs in the business cycle. A coincident variable is one whose peaks and troughs occur at about the same time as the corresponding business cycle peaks and troughs. Finally, a lagging variable is one whose peaks and troughs tend to occur later than the corresponding peaks and troughs in the business cycle.