Frame of Reference
In this section, the related economical and financial concepts and theories will be presented. The main parts concern Business Cycles, Supply and Demand for Gold, and the Modern Portfolio Theory. In addition some other important definitions and equations will be introduced.
Economical theories and concepts
The concepts of business cycles explain how the economy moves over time with more or less regular fluctuations. Business cycles are a part of macroeconomics that explains how the different components of GDP are affecting the market, and how the components themselves are affected by peaks and troughs in an economy. These fluctuations are not af-fected by seasonal changes or single identifiable events, but are spread over longer time span and follow a systematic regular pattern. (Ralf, 2000) The standard definition of a business cycle is presented by Burns and Mitchell (1946, p.56):
“Business cycles are a type of fluctuation found in the aggregate activity of na-tions that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, fol-lowed by similarly general recessions, contractions and revivals which merge in-to the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar charac-ter with amplitudes approximating their own.”
There are several kinds of business cycle theories trying to explain the occurrence of reces-sions and the ‘natural’ fluctuations. The truth of the matter is that recessions appear for many different reasons; intentionally (e.g. as a direct effect of Fed’s actions) and uninten-tionally (e.g. by natural disasters or terrorist attacks), expected and unexpected. However, until this point no theory has been able to fully explain, without undermining assumptions, why an economy suffers from an economic downturn. The different business cycle theo-ries give varying approaches to the problem from various points of views. These theories will not be presented in this study, however, Knoop (2004) has stated six general traits on business cycles in general.
Business cycles are not cyclical – looking back historically, the cycles have been any-thing else than cyclical. They have been unpredictable and irregular in both length and duration. The shortest recession in US history was in 1980 with only 6 months’ contraction, while the longest lasted 43 months between 1933 and 1937. In same fashion, the expansions in the economy have varied with the shortest expansion of 12 months to the longest of 121 months. With other words, the length or the depth and severity of a recession or expansion have in no ways given clues on how the next period would look like.
Business cycles are not symmetrical – in the US, a recession have lasted on average 14 months, while an expansion have lasted on average 43 months, more than three times the length of a recession. This clearly shows the asymmetry between ex-pansions and recession, and this asymmetry seems to be true internationally as well. Recessions tend to affect the industrial output more than expansion, and in general, there are shorter but sharper changes in GDP during a recession and a more gradual and slow changes during an expansion.
Business cycles have not changed dramatically over time – Experts often compare the economy by looking at the prewar period and postwar period. Up until ten years ago, economists believed that the postwar business cycles were shorter, less severe, and less frequent. However, with new data presented today, US economists instead mean that there only have been few moderations in the business cycles and the differences between prewar and postwar periods are smaller than earlier believed.
The Great Depression and the World War II expansion dominate all other recessions and expansions – Between 1929 and 1932, GDP fell by 50 % while unemployment rose to 25 % in 1933. To understand the sereneness of the Great Depression, a comparison with the second largest recession in 1973 – 1975 can be made, with a GDP reduction of 4.2 % and unemployment level of 9 %. In the same way, the expansion that started in 1938 continued during the World War II and be-tween 1941 and 1944, GDP increased with 64 %. This is obviously a result of intense mobility of resources and massive government purchases that took place during the war. No other expansions have even come close to the figures during this period.
The components of GDP exhibit much different behaviors than GDP itself – GDP is a measure of following components: consumption, investments, net exports, and government spending. Durable consumption (e.g. appliances and automobiles) and investments are both more volatile than nondurable consumption (e.g. food and clothing), government purchases and net exports. Durable consump-tion and investments changes more than output over the business cycle in total (Figure6).
Figure 6 shows the difference in how each of the components are affected by a fall in GDP, and also how much each component constitute in GDP. Nondu-rables and services both constitute a larger average proportion in GDP, than the average share of contribution when GDP is falling. This means that they are relatively more stable than the GDP as a whole, and are only mildly procyclical. Durables on the other hand are much more volatile than the GDP as a whole, strongly pro cyclical, and a decline in durables can be used as an immediate in-dicator of peaks and troughs in GDP.
Investments are heavily pro cyclical and more volatile than GDP in total. In a recession, the investments are responsible for 70 % of the changes. Govern-ment purchases have 20.6 % of the shares in GDP, but during a recession, the purchases are relatively acyclical meaning that they are only slightly affected by the downturn.
Finally, the net export is a negative balance because the US has had a trade def-icit since mid 1980s. This component is therefore not a reliable indicator of peaks and troughs.
Business cycles are associated with big changes in the labor market – Unemployment is a strongly countercyclical variable (moving in opposite direction) that changes significantly during a recession relatively to any other inputs for production. During recessions and expansions, unemployment counts for two thirds of the changes in GDP per capita, while production counts for remaining a third in GDP per capita. (Knoop, 2004).
3.2 Problem discussion
4 Frame of Reference
4.1 Economical theories and concepts
4.2 Financial theories
5 Historical Background
5.1 Dow Jones Industrial Average
6.1 Quantitative data collection
6.2 Deductive approach
6.3 Secondary data
6.4 Research process
6.5 Collection of data
6.6 Use of Data
6.7 Criticism and Delimitations
7 Results and Analysis
7.1 All time (1970 – 2008)
7.3 Comparison of gold with other assets
7.4 Conclusive analysis
8.1 Further studies
GET THE COMPLETE PROJECT
Gold During Recessions A study about how gold can improve the performance of a portfolio during recessions