Cycles, Leading variables, lagging variables

Procyclical, Acyclical and Countercyclical Variables

A data series is made by taking an indicator and saving it at regular intervals of time

When we look at the GDP growth rate, we notice that it reaches maximum and minimum points (peaks and troughs) with a certain regularity. Generally, after a boom, there is a slowdown. One cycle of the economy is defined as 'the period between two peaks'. A question we want to ask is, "Where are we in the current cycle?" Some element of an answer can be given by looking at other indicator series.

The economy is described by a series of documenting movements in variables that are related in some way to output (GDP, GNP, growth, employment, unemployment, prices, job creation, interest rates, housing, consumption, etc.) Some variables follow a cycle similar to GDP; when GDP is growing faster, they are also growing faster, and vice versa. These variables are said to be procyclical. Other variables go in the opposite direction, and are said to be countercyclical. Finally some variables are acyclical, meaning they are not moving in a way that is linked somewhat systematically to GDP.

Volatility

Another important concept is that of volatility. By volatility, we mean how big is the deviation from the mean. This is usually measured by the standard deviation. A variable is more volatile if the swings from a peak to a trough are big. GDP is relatively volatile: it does swing around. Later on, we will want to explain why it does so. By looking at the variables that compose GDP, and comparing the share of GDP they are accountable for, as well as their relative volatility, we can form an idea of which of them influences the changes in GDP the most. Consumption of non durables and services accounts for roughly 60% of our measure of GDP, with broad investment and government consumption accounting for 20% each.

Consumption it's self is not very volatile: the average swing is less than half that of GDP. Government consumption is as volatile as GDP, but, as we see in the chart above, acyclical. Investment, on the other hand, is much more volatile than GDP, so, although it doesn't account for much of the measure, it seems to be an important factor in explaining the swings in output.

The bottom line: understanding the link between investment and output will be crucial to understanding business cycles.

Leading and Lagging variables

If we want to answer the question in hand ("Where are we in the current cycle?") it is interesting to look at procyclical variables and ask whether these variables reach a peak at the same time, or before or after, the GDP. Variables that reach a peak before GDP are called leading indicators. Variables that are behind in the schedule are called lagging indicators. Those that reach a peak at the same time are called coincident indicators.