Economic Analysis

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ECONOMIC ANALYSIS

Economic forces affect decisions made in personal business activities, as well as within business organizations, government entities, and nonprofit organizations. Changes in economic conditions affect and are affected by supply and demand, strength of buying power and the willingness to spend, and the intensity of competitive efforts. These changes propel fluctuations in the overall state of the economy and influence courses of action and the timeliness of actions. Nonprofit organizations, for example, may find that fund-raising efforts fueled by personal contributions are more successful during periods of economic prosperity. A first-time home buyer may be more inclined to purchase a house when interest rates are low and prices are likely to increase in future months. Since decision makers cannot control economic forces, a concerted effort should be made to monitor such forces. All business executives know that it is important to gain some idea of what general business conditions will be in the months or years ahead. Fortunately, certain economic indicators or indices enable decision makers to forecast oncoming changes in economic forces. Since both individuals and organizations operate in a dynamic economic environment, losing sight of what is going on can be disastrous for either.

THE BUSINESS CYCLE

Fluctuations in the economy tend to follow a general pattern that is commonly referred to as the business cycle. The business cycle, in the traditional view, consists of four stages—each of which may vary in terms of duration and intensity. The four stages are prosperity, recession, depression, and recovery.

Up-to-date charts, tabulations, and measures of relevant economic indicators are published by the Bureau of the Census in the monthly report, Business Cycle Developments. Economic indicators are predictors or gauges that signal cyclical movement of the economy within each stage of the business cycle or from one stage to another. A few examples of economic indicators include average workweek in manufacturing, new building permits for private housing, new orders for durable goods, and changes in consumer installment debt. While various government agencies collect and report monthly, quarterly, semi-annual, and annual measures of numerous economic indicators, economists representing various industries and other decision makers analyze and interpret the data.

Timing is everything when it comes to making good business cycle-sensitive decisions. Just as a truck driver starts braking before reaching an intersection with a flashing red light, decision makers need to make appropriate plans before the business cycle passes from one stage to the next. Prosperity, a period characterized by low unemployment and relatively high incomes, is followed by recession, a period during which unemployment rises and total buying power declines, leading to decreased spending by business firms and consumers. A production manager should make appropriate cutbacks prior to the onset of a recession. Failure to do so, in the face of decreasing sales, leads to bloated inventories and idle productive resources. On the other hand, when a period of recession (during which unemployment is extremely high and wages are very low), gives way to a period of recovery (characterized by increases in employment and income), a production manager should begin to plan for increased outputs. Just as the truck driver saw the red light and recognized it as a signal to start braking, decision makers must see changing economic conditions and make appropriate responses.

THE PROCESS OF CONDUCTING AN ECONOMIC ANALYSIS

Conducting an economic analysis requires the application of scientific methods to break down economic events into separate components that are easier to analyze. The remainder of this article discusses the steps included in this process.

Step 1—Identify Appropriate Economic Indicators

The first step in the process of conducting an economic analysis is to identify appropriate economic indicators for specific economic forecasts or trends. While various indicators may be selected, they are usually classified as indicators that lead, lag, and/or are coincident with economic conditions. Measures of data derived from economic indicators yield valuable information for the identification of economic trends and the preparation of specific economic forecasts.

Step 2—Collect Economic Data

Once the identification of indicators has been completed, the second step, which is the collection of economic data yielded by the indicators, can begin. Data collection is accomplished through observation and/or by reviewing measures of economic performance, such as unemployment rates, personal income and expenditures, interest rates, business inventories, gross product by industry, and numerous other economic indicators or indices. Such measures of economic performance may be found in secondary sources such as business, trade, government, and general-interest publications. The Bureau of Economic Analysis (BEA), contained in the U.S. Department of Commerce, provides economic information via news releases, publications, diskettes, CD-ROMs, and the Internet. The information may be accessed through the Bureau's Web site (http://www.bea.doc.gov), on recorded telephone messages, and in printed Bureau of Economic Analysis Reports. Such economic data are also available online through STAT-USA's Economic Bulletin Board.

Step 3—Prepare or Select an Economic Forecast

Of course, simply gathering information about economic indicators is not enough. Decision makers must use the data to identify trends and project forecasts. Decision makers know that it is important to gain some idea of what economic conditions will be in months or years ahead. As a result, they either use the collected data to prepare their own forecasts or they use economic forecasts that have been prepared by experts who monitor economic activity. Regardless of its origin, the forecast itself is essential if the decision maker is to recognize opportunities and threats posed by the economic environment. Thus, using economic data to predict the future is the third step in the process.

Economic forecasting can be and often is a complicated process. While accurate, relevant data are the basis for predictions, forecasters must be careful not to gather so much data that sheer volume makes analyzing impossible. Forecasts may be classified as short term (with spans or distances to the target period of up to one or two years), intermediate (two to five years), and long term (relating to more persistent developments and distant occurrences). Because of the possibility of unforeseen events occurring over a long interval, short-term forecasts are usually more accurate than long-range ones. There are four principal techniques used to forecast:

Judgmental forecasting is the oldest and still the most important method of forecasting the future. Judgmental forecasters often blend several forecasters' judgments together to produce a forecast. This may be a complicated process, since various "Delphic" methodologies are used to integrate inputs from people experienced in forecasting.
Indicator forecasts are nearly as old as judgmental forecasts. This technique requires that economic indicators be used to estimate the behavior of related variables. The index of leading indicators published by the Commerce Department is the best-known overall measure, but decision makers can use many other indicators for their own purposes.
Time-series techniques use trend projections of past economic activity to extend into the future. Projecting is done by plotting data for the past years on a chart and, from the latest data, extending a line into future time periods that follows the pattern of prior years.
Structural models of the economy try to capture the interrelationships among many variables, using statistical analysis to estimate the historic patterns. Large models of the U.S. economy, used by major forecasting firms and the government, may have up to a thousand interlinked equations. Simple models used by individual organizations, however, can have as few as one equation.

These four methods are not mutually exclusive. Combinations of methodologies are perhaps more commonly used in formulating forecasts today.

Step 4—Interpret the Economic Data

The fourth step requires decision makers to examine, assess, and interpret the economic data collected and the subsequent forecast generated from the economic data. Decision makers evaluate the data and forecast for accuracy, try to resolve inconsistencies in the information, and—if it is warranted—assign significance to the findings. By analyzing economic data and forecasts, decision makers should be able to recognize and identify potential opportunities and threats linked to economic changes and developments. As a result, they are better able to understand the influence that the economy is exerting and better prepared to make decisions and plan strategy. The process, however, should not be viewed in an oversimplified manner. Today's global economic links make economic forecasting and analysis especially complex.

Step 5—Monitor Intervening Forces

Then, too, intervening forces can and do influence economic activity. Such forces can shift or alter economic performance and trends and must be anticipated by decision makers. Thus, anticipating and monitoring the government's manipulation of two powerful sets of economic instruments, fiscal policy and monetary policy, becomes the fifth step in the process. Fiscal policy is the government's combined spending and taxation program, while monetary policy represents actions by the Federal Reserve System that affect the supply and availability of money and credit. The two arms of policy can work to supplement each other when powerful stimulus or restraint is sought. Or they can work in beneficial or damaging opposition, when one or the other is driven off-course into excessive stimulation or excessive restraint. Observers can often anticipate the government's implementation of fiscal and/or monetary policies based on prevailing economic conditions. The outcomes of such implementations must be considered by analysts.

Step 6—Use the Economic Analysis for Decision Making

Finally, decision makers use the results of an economic analysis for decision making. Astute decision makers recognize that economic forces are uncontrollable and that current strategies may need to be adjusted to cope with or overcome obstructing economic changes. They approach with caution opportunities and threats discovered as a result of economic scanning and analysis. They pursue a proactive approach, however, knowing that an economic analysis enables them to choose from alternative approaches how to employ scarce or uncommon resources and achieve objectives in the most efficient and cost effective manner.

see also Economics