Specifically, we’ll suppose that people suddenly learn that, three years hence, productivity in the tradable sector is going to start to fall (relative to base). To fix the numbers, we’ll scale the hit so as to produce a material decline in the fair value of the exchange rate – 10%, say. Given the other parameters in the model, this requires an anticipated and overall decline in labour productivity of around 8% in the tradable sector, 5% in the economy as a whole. The results of the 9  simulation are shown in Charts 9(a)-(h) . Because the foreign exchange market fully and correctly anticipates the productivity hit the depreciation occurs immediately and does nothing further when productivity actually falls (9(b)). In the interim, the weaker currency provides a big fillip to the tradable sector. Its sterling profits rise significantly and, for as long as productivity holds up, this encourages a significant expansion in investment, employment and output (the green lines in 9(c),(d) and (g)). This is the “sweet spot” I referred to in the talk I gave about sterling earlier this year. 10  I should emphasise that there’s nothing in this simple model that inhibits the response to this sweet spot. New investments are assumed to be costlessly reversible – firms can easily get out of them once productivity starts to decline – capital and labour can be easily moved from one sector to the other and there’s complete certainty about the timing and scale of that event.
Such interactions tend to amplify the amplitude of the bussiness cycle, thereby heightening the risk to financial stability. This description of procyclicality presupposes the existence of two cycles, namely the business cycle and the financial cycle, that interact and reinforce each other. However, economic and financial decisions underlying the two cycles are not independent. They are inherently linked by the risk-taking behaviour of economic agents: the behaviour which is prone to change in response to incentive, perception of risk, regulation, and new information. It is this change in risk-taking behaviour that explains large swings in investor sentiment, from a period of optimism when risk is disregarded to a period of pessimism when there is no willingness to  BIS Review 160/2009  1  take risk. And it is this change in risk-taking behaviour that underscores the abrupt change in financial behaviour, and in the direction and momentum of economic activities. It follows therefore that procyclicality is a mechanism that encompasses the interactions of at least three reinforcing cycles that move in tandem. They are the business cycle, the financial cycle, and the cycle of risk-taking beheviour represented by fluctuations in asset prices or the asset price cycle. The three cycles are self-reinforcing, and it is the ways the cycles interact with each others that define the amplitude and the momentum of the cyclical flunctuations, as well as risk of a financial crisis. Interactions of the three cycles can be illustrated with reference to a typical boom-bust cycle.