Basic, lesson 1 of 3
Growth and the business cycle
GDP is the scoreboard, the cycle is the pattern it follows, and leading indicators are how investors try to see the turn before the scoreboard shows it.
9 min, 3 checks
1What GDP adds up
Gross domestic product is the value of final goods and services an economy produces in a period. The spending approach splits it four ways: households, businesses, government, and net trade. In the US, consumption is by far the largest piece, which is why investors watch retail sales and jobs so closely.
GDP = C + I + G + (X - M)
Consumption, investment, government purchases, exports minus imports.
Worked example
A made up economy, in billions
- 1Consumption 14,000. Investment 3,500. Government 3,800.
- 2Exports 2,500. Imports 3,300, so net exports are -800.
- 3GDP: 14,000 + 3,500 + 3,800 - 800 = 20,500.
GDP is 20,500. Imports subtract because they are already counted inside consumption and investment but were produced abroad.
Check 1
Consumption is 70, investment 18, government purchases 17, exports 12, and imports 15. What is GDP?
2Nominal and real
Nominal GDP is measured at today's prices. Real GDP strips out price changes, so it tracks volume. Company revenues grow with nominal GDP, which is why a period of high inflation can show strong sales growth even as real output stalls.
Real growth = (1 + Nominal growth) / (1 + Inflation) - 1
Close to nominal growth minus inflation when both are small.
Check 2
Nominal GDP grows 5.5% and the GDP price deflator rises 2.5%. What is real growth, in percent, to two decimals?
3The cycle and the indicators
| Phase | Growth | Inflation and policy | What tends to lead |
|---|---|---|---|
| Early recovery | Rebounding from a low | Low; policy still easy | Small caps, cyclicals, credit |
| Mid cycle | Steady, near trend | Stable; policy neutral | Broad equities |
| Late cycle | Above trend, slowing | Rising; policy tightening | Energy, materials, short duration |
| Recession | Falling | Falling; policy easing | Long bonds, defensives, cash |
Indicators fall into three groups. Leading ones turn before the economy: building permits, new orders in manufacturing surveys, initial jobless claims, the yield curve, and credit spreads. Coincident ones move with it: payrolls, industrial production, real income. Lagging ones confirm after the fact: the unemployment rate, and core services inflation.
Check 3
Which of these is a leading indicator of the cycle?
Terms in this lesson: Gross domestic product, Duration, Yield curve, Credit spread.
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