Week 5: Best Practices 4

Ch3 How to Anticipate Recessions and Downturns

Chapter Opening Questions

A manager needs to monitor:

• Crude material prices and volatility of their business

• The capacity and constraints in the production of that input

• Overall price conditions

• Federal policy changes on unemployment and inflation

The facts about inflation

• Volatility: CPI < PPI Finished Goods < PPI Intermediate Goods < PPI Crude Materials
• Price Growth: CPI > PPI Finished Goods > PPI Intermediate Goods > PPI Crude Materials
• There are thousands of specific indexes to choose from. So it is important to pick a correct price index for a specific business problem

Inflation and federal reserve policy

The Phillips Curve shows an inverse correlation between (unemployment) and (inflation) using data from 1861 - 1958. It implies the Fed could achieve low unemployment at the cost of high inflation.

The Phillips Curve broke down in the 1970s when Lyndon Johnson inaugurate Great Society social programs while the Fed kept interest rates low.

So is there a trade-off between inflation and unemployment? Milton Friedman and Edmund Phelps says:

• In the long run, there is no trade-off between unemployment and inflation.
• In the short run, there is a trade of between unemployment and unanticipated inflation.

Long-term growth and inflation

Countries with high inflation rates tend to have volatile rates. This volatility makes business planning difficult. There decisions accumulate when inflation is unstable, leading to a slower rate pf growth. Make sure to look for the Federal Reserve to continue its efforts to keep inflation low, so low that it is not a factor in business decisions.

Business decisions and profit squeezes

prices of inputs and outputs

It’s easier to pass on costs increases when the following is true:

1. Competitors are facing the same cost increases.
2. The industry has little excess capacity
3. Your customers can, in turn, pass the cost increases along to their customers.

Inflation clauses in long-term contracts

Long-term clauses often contain price adjustment clauses based in inflation measures. The long term agreement reduces risk to both the buyer and the seller, so as the inflation adjustment clause is well crafted. Union wages contracts often have a cost-of-living adjustment as well. Risks exist and must be allocated to both parties in the contract.

How accurate are our measures of inflation?

CPI doesn’t measure inflation, but there’s no reason to think that we see sharp swings in the error rate. Changes in inflation are due to actual economic condition, not measurement errors in CPI. The index is useful as an indicator of changes.

Summing up

A business for whom raw materials constitute a major cost should hedge against the risk of sharp increases in the price of raw materials by:

1. locking in purchase prices,
2. Have the contract price adjust to the cost of materials
3. and building an early warning system.

Economic terms

• Explain each of the following terms in your own words. The author explains the terms in the textbook. If necessary, you may also Google the term on the Web. Good resources include:

• The Economist

• Fun economic videos

Explain the terms in your own words briefly.

Inflation

• An overall increase in prices thus a fall in the purchasing power of money

Consumer Price Index (CPI)

• A measure of the overall change in consumer prices based on present goods and services.

Producer Price Index (PPI)

• A measure of the overall change in prices paid to the United States on goods and services.

The Phillips Curve

• An inverse relationship between unemployment and inflation rates.

Capacity Utilization

• Measures the percentage of possible output levels that is being met.

Stagflation

• When there is a combination of high inflation rates followed by high unemployment rates and the economy become stagnant.

Economic events

Describe the characteristics of the following events briefly.

The Phillips Curve in the 1970s

The author writes the Phillips Curve broke down in the 1970s. This is due stagflation where both inflation and employment are high. This broke the curve because it was no longer a curve it was a looping graph due to a stagnant economy.