Business cycles comprise upturns and downturns in aggregate measures of economic activity. In TrackingAsia, business-cycle fluctuations are measured in terms of the growth rate of real GDP around a long-term trend, called the growth gap.
A business cycle is characterized by four phases, depending on whether the growth rate is one of the following:
The duration of one cycle is the number of quarters from a peak to the next peak. A slowdown is a period from a peak to the next trough; an expansion is a period from a trough to the next peak. The height of the cycle from the peak or trough to the zero-trend line is called the amplitude.
Using historical quarterly real GDP per capita, the growth gap cycle is extracted and turning points—peaks and troughs—are identified. Based on historical patterns in this data, the average duration of a cycle, expansions, slowdowns, and amplitude are computed. The position on the cycle in the latest quarter can be compared with the summary statistics to gauge how many quarters expansions and slowdowns typically last, and how far an economy is from turning direction.
The EAI is a weighted average of multiple indicators of economic activity, where the weights capture the indicator’s relative importance to historical fluctuations. These weights are estimated using principal components analysis, applied individually to each economy. Indicators, which may differ by economy, are selected from the six categories and sectors of data—consumption, investment, trade, government, finance, and the external sector. This data are available at a monthly frequency and are detailed in Resources.
The following is the methodology used to compute the EAI:
In the first stage, monthly data that feed into the construction of the index are compiled from various sources for available years and transformed, using these steps:
Generating the EAI
Principal components analysis is applied to the monthly indicators selected in the first stage to identify common movements. The first principal components are used to create the index. They are first transformed into weights by taking the absolute value and dividing it by the sum of all the estimated components. The rescaled components are then multiplied with the monthly indicators and summed to generate the EAI. The index is a weighted average of the underlying indicators, where the weights capture the relative importance of historical fluctuations that arise in different categories and sectors of the data. To track periods of economic expansion and slowdown, represented by the business cycle, the EAI is projected onto GDP gap cycles.
In the second stage, and to improve the accuracy of the EAI in tracking economic cycles, statistical techniques are used to fine tune the selection of indicators that feed into the construction of the index.
Variable selection for constructing the EAI
To identify the relevant indicators for inclusion in the EAI using the principal components analysis method outlined earlier, three alternative selection methods are used. The first is a correlation method, where the correlation of each indicator with the GDP growth rate is computed using Pearson’s correlation. Indicators with less than 50% correlation are removed. The other two methods belong to model averaging techniques—Bayesian model averaging and weighted-average least squares.
Among the automatic variable selection processes to construct the EAI, the method which best tracks GDP gap cycles is identified. To improve the fit, an ad hoc examination—using economy-specific knowledge—of the existing set of indicators is conducted.
Click here for a graphic representation of the sequence of steps used in the indicator selection process for constructing an Economic Activity Index.
Interpreting the EAI
A value of zero reflects economic activity at its long-term trend. Positive values indicate above-average economic activity and negative values indicate below-average activity. The scale is in standard deviations from a trend rate of growth. The sector/category-specific indexes are interpreted similarly.