Explain the link between the levels of unemployment, inventories and plant utilization during the expansion and recession phases of the business cycle. Inherent fluctuations in economic activity are what connote the business cycle in a broad term. Macroeconomics has a long tradition of measurements of business cycles and the founder of the National Bureau of Economic Research (NBER) Wesley Mitchell (1927) first provided a framework for the same. Both defined business cycle in terms of alterations between periods of recession and expansion, which are considered as two alternating phases of the cycle.
In other words, economic activity's transitory fluctuations from a “permanent trend” constitute these changes. In this cycle recessions lead to transitory fluctuations in output that are negative; although the fluctuations might differ in magnitudes and shapes depending on the type of cycle involved. An asymmetric shape is closely linked to unemployment, measure of economic slack and capacity utilization. This holds true even when univariate analysis pertaining to the gross domestic product is used to measure the cycle. In the macroeconomic parlance this is known as a model-averaged business cycle which involves univariate dynamics of the real GDP.
Level of capacity utilization and unemployment rate are considered as the two important variables of this cycle. These two variables are presumed to move as the business cycle moves but cannot be said to provide broad measures of real GDP's economic activity (Hamilton, 1989). Typically levels of unemployment, inventories and plant utilization move along with the four phases of the business cycle which are peak, recession, trough and expansion. The fluctuations entail economic shocks, decrease in employment and output, and sticky downward prices. Furthermore, unemployment creates a clutter in the types of efforts unemployed take, which include individuals who are either searching jobs or looking to take jobs soon; individuals who are struck by structural unemployment problems involving changes in the demand for workforce; and individuals who are struck by cyclical unemployment issues typified by the recession phase of the business cycle.
Those hurt by the fluctuations include fixed-income receivers, savers and creditors. Similarly inventory behaviours provide an insight into the business cycles even though they do not have a major role to play in the component of output.
This, however, should not go unnoticed that there has been considerable interest in inventory investment in macroeconomics on account of its significance that policy makers and macroeconomists find important. One reason for this could be a simple assumption that even if inventory investment relative to GDP is quite small, fluctuations in the same are not as small as the ones relative to GDP. In other words, inventory investment rate changes in a quarter are more than the changes encountered in GDP in the same quarter (Bils and Kahn, 1996).
There is a close association between the movements in output and movements in inventory levels, where inventories lead output slightly. That apart, on an average, changes in inventory holdings are 60 percent the changes in output on a quarterly basis. Blinder (1990, p. viii) has remarked that business cycles can be said to be inventory cycles to a surprisingly large degree. Inventories are said to play buffer-shock role in production if sales are stochastic. This is because of the inference that unexpected increases will be responded to by the firms by inventory holdings reduction and production increase.
The production increase will invariably be less than sales. If the production decision is taken by a firm before the sales shock is observed, then inventories will solely determine the increase in sales.