the supply/demand elements affecting the price for one of the time periods also must have an effect on the prices inthe other time period.Time spreads can be very risky in some commodities and nearly riskless inothers. Those time spreads that would be near the low end of the risk spectrum wouldinvolve the completely storable, seasonally produced commodities, such as thegrains. Those at the other end of the spectrum would be highly perishable commodities, such as fat cattle or eggs. In the middle would be spreads in continuously produced, fully or semi-storable commodities that may have variable carryingcharges such as pork bellies or silver.For the seasonably produced, completely storable commodities, pricesbetween futures months are related to the cost of carrying the commodity in storage from one time period to the next. Such costs include storage, handling, insurance, shrinkage, interest on investment, and commissions. In a normal market,where the price system provides an incentive to producers who store products, thenearby months usually sell at a discount to the more distant months, the difference between the two representing the carrying costs. In a normal market, therefore, the price of May corn will usually be higher than the price of March corn.If the price differential between these two months exceeds the total cost of carry,smart commercial traders will buy a March contract and sell a May contract; and187
Chapter 19
then in March, if the differential has not returned to reflect carrying costs, they willtake delivery of the corn, store it for a month, and re-deliver it in May to cover theshort sale. The profit on the transaction would be the difference between the saleprice plus the sum of the carrying costs and the transaction costs, and the price ofthe March contract. Because traders will take advantage of such profit opportunities, the carrying costs usually limit the amount by which the price of the May corncontract will exceed that of the March corn contract.It is important to note, however, that there are no such carrying cost constraints on the amount that March can sell over May. In fact, this sometimes happens. When it does, it is referred to as an “inverted” market. An inverted marketresults from a shortage of immediately available supplies. It reflects an economic disincentive to storage and encourages storers to sell their grain. Since the farout months are selling at discounts, the market indicates it expects this near-termsupply/demand imbalance to correct itself in the short run.As indicated earlier, spreads in storable commodities are generally at thelow end of the risk spectrum because the prices of different months are related tocarrying costs, and usually these carrying costs establish a limit, albeit an imperfect one, on the forward premiums. However, in some storable commodities—such as silver—short-term interest rates constitute a major part of the carryingcosts. If short-term interest rates are quite volatile, carrying costs will fluctuateaccordingly.Such time spreads also work well for continuously produced, storable, orsemi-storable commodities, such as pork bellies. In such commodities, the normalspread relationship will change, however, between months as the in-to-storagemovement changes to out-of-storage. Remember that these discounts and premiums being paid in the market reflect essentially the strength of the incentive forholders to store or not store a product. It is for this reason that “normal” carryingcharges for the months when the product moves into storage will be different thanthose for such commodities when the product moves out of storage. This seasonality can be reflected in spread relationships and may offer special profit opportunities. The May-August spread tends to widen from the middle of March until thebeginning of May.
HOW PROFITABLE?Properly handled, spread trading can be very successful. Academic and industrystudies done over the years have regularly shown that spread trading, properlydone, often returns 15 percent to 20 percent on margin. The key to knowing the proper value of a spread is knowing how to calculate carrying costs. The simple equation for determining the total carrying costs in a market is:
188
Fact and Fiction About Spreads
Total Carrying Costs = X1 + (X2 × A) + (X3 × A)where:X1 = commission costs in cents per poundX2 = monthly interest on margin money in cents per pound(Note: This may be small or nonexistent if your broker pays interest on margin deposits.)X3 = insurance and storage costs per month in cents per poundA = number of months between the contracts included in the spread.Subtract the carrying costs from the price differential between two months.If that differential is large enough to provide a 20 percent return on margin, makethe trade. Of course, you have to be careful about interpreting results of trading teststhat were derived after the fact as being applicable in the future. Times change, markets change, and price relationships change.
PERISHABLE SPREADSTime spreads in perishable commodities are high-risk transactions. Except underspecial circumstances, they are frequently more risky than an outright net positionin the commodity. This is the problem Joe Boswell had earlier. The reason is becausesupply/demand elements affecting the price of the commodity in one month mayhave very little effect on the price for another month. Take live hogs, for example.None of the hogs delivered in December are available for delivery in February.Further, if people eat less pork in December, they do not necessarily make up for itby increasing their consumption in February, nor do they necessarily continue theirreduced consumption in February. Because these supply/demand relationships areindependent, the two prices are independent. Their relationships change often andsometimes substantially, making the risk great on spread transactions in hogs.Nevertheless, from time to time a trader will find, after careful economicanalysis, that some contract months in commodities such as hogs or cattle areclearly overvalued and some months are clearly undervalued. In this instance, buying the undervalued contract and selling the overvalued contract can be profitable.An example is found in a recent preliminary report on price relationshipsbetween nearby and distant futures in cattle. A model that included the number ofcattle on feed, the average market weight of fat cattle, the steer/corn price ratio, plusa seasonable variable was successful in identifying profitable trading opportunities in cattle.However, you should be aware that such transactions are, in effect, two outright positions and not legitimate spreads, as there is very little natural economic
189
Chapter 19
connection between the two positions, and this is true whether your broker callsthem spreads or not.
INTER-SEASON SPREADSThe time spreads referred to above are all intra-season spreads. There are alsoprofit opportunities in spreading between seasons or crop years. For example, buying this year’s soybean crop and selling next year’s. These types of spreads dowork and are legitimate when the commodity is storable, so that one season’s supply can be carried over to the next season for delivery. This is possible in the grains,but not in pork bellies, where exchange rules prohibit it.Inter-season or inter-crop spreads are not restricted to crops that are grownin the soil. There is a seasonality to the production cycles in broilers, plywood,and other commodities, as well as periods of in-to-storage movement and out-ofstorage movement. It is important to note, however, when effecting transactions covering two distinct seasons, that an important event always occurs during this interim—namely, a new harvest or a turn in the cycle, which means major changes inproduction.
SPREADING LOCATION BASISThere are instances where the same commodity is traded on two different exchanges,and the contracts call for par delivery at two different locations. In this case, if allother elements of the contracts are equal, the difference in prices on the twoexchanges should be equal to the transportation cost between the two locations represented in the contracts. If, for whatever reason, the difference in prices betweenthe two contracts should exceed transportation costs, it will be profitable for commercial traders to buy the lower-priced contract on one exchange and sell the higherpriced contract on the other exchange, thus locking in a profit equal to the amountby which the price differential exceeds transportation costs. If these profit opportunities do not disappear by the time delivery can occur on the contracts, you needonly take delivery on the lower-priced market, transport the product to the par delivery point of the other market, and re-deliver in fulfillment of your short position.For example, if you were in a position to buy CBOT deliverable wheat inKansas City, ship it to Chicago, and re-sell it at a profit, you would do so. Hence,any time the contract in Kansas City sells below the contract in Chicago by morethan the transportation costs, some traders will be buying the contract in KansasCity and selling it in Chicago.
190
Fact and Fiction About Spreads
SPREADING QUALITY BASISJust as par locations differ between contracts for the same commodity listed underdifferent exchanges, quality specifications also sometimes differ. A smart trader willbe aware of what the normal price differential should be for the various gradesand qualities of a commodity. If the two contracts don’t sell at these normal differentials, the trader will buy one contract and sell the other. As the time for delivery approaches, the two prices should come to reflect the actual value in the spotmarket. To the extent those actual values reflect the normal differentials, the trader will have profited.
INTER-COMMODITY SPREADSAs noted above, there are physical relationships between certain commodities.Sometimes the supply and demand elements for two commodities are tied together because they are substitutes for each other, as corn is a substitute for milo or grainsorghum. Sometimes one commodity is derived from the other, such as soybeanmeal and soybean oil. Sometimes one commodity is the raw material used in theproduction of a finished product, as with feeder cattle and fat cattle.Because of these physical and economic relationships, the price fluctuationsin the two commodities are related. As a result, a price change in one commoditydirectly affects the price of another. This places constraints on the extent to whichprices in the two commodities can diverge. For example, as the price of corn risesrelative to the price of milo, livestock feeders will start substituting milo for corn.This reduces the demand for corn, thus slowing its price rise, while increasing thedemand for milo, encouraging it to rise in price.Likewise, reduction in the demand for soybean oil and soybean meal will bereflected in the demand for raw soybeans and thus limit that product’s price moves.Normally, the price differences between soybean oil, soybean meal, and soybeanswill reflect processing margins. If a trader expects the processing margins to widen,he should buy meal and oil and sell soybeans.
SPOTTING SPREAD OPPORTUNITIESVisualizing the spread between months can be done in a number of different ways.One good way is to keep a daily price table noting the closing price on each sideof the spread and the difference between the two (see Table 19.1).Such a table allows you to tell at a glance how the price moves alter spreads.
191
Chapter 19
Table 19.1 SpreadsFebruaryPork Bellies48.9049.0048.00
MayPork Bellies50.0049.8049.50
Difference+ 1.10+ .80+ 1.50
ProfitBuy Feb.–Sell May+ 30– .70
It is also a good idea to obtain a history of several previous years’ priceactions. However, you don’t want to become too dependent on past history. Disease,droughts, monetary problems, governmental programs, and other factors willchange price patterns from year to year.
SUGGESTED RULESWhen putting in spread orders, the buy side, or the long side, is always mentionedfirst. The sell, or the short side, is second, and the premiums state either buy or sell.For example, if you wanted to execute a December/June hog spread at +125, the ordershould read: “buy one December live hog, sell one June live hog, 125 premium.”Many profitable trading strategies can be employed using spreads. Spreads,however, are unique. They require a different approach than simply trading longor short positions. One of the biggest problems in trading spreads is exiting them.Most beginning traders are reluctant to exit a spread, even as it goes against them,because they find it difficult to be sure that the fundamental factors are workingagainst them rather than moving simply in a short-term random blip. Hence, theytend to hold on too long and suffer larger losses than expected. Experienced traderswill tell beginning traders to first look for strong seasonal tendencies in price patterns, be selective entering a spread, and be very patient. Use exit benchmarks thatare based on money or time. In other words, risk a predetermined amount of moneyon a spread and exit it once that money is gone or a certain time period has passed.If the spread is still within the time benchmark of your seasonal play, look for anew entry point at a better price. Most successful spread traders I know trade twopositions—one is a core spread position with established entry and exit points,and the other a second-level position where one side or the other of the spread istraded on a short-term basis. This is called lifting a leg. It is risky, but if done selectively and in moderation, it can always keep you in the market to benefit (or lose)from seasonal tendencies, and provide reasonably good returns on the marginmoney posted.192
Fact and Fiction About Spreads
OPTIONS SPREADS AND TREND CHANGERSMost new traders search diligently for a market timing signal designed to get themin at the top of a market and out at the bottom. If it was easy to do, everybody wouldbe doing it and, of course, then it would not be very profitable. Combining the concept of options and spread trading, however, with a little patience, yields a tradingstrategy that helps one get properly positioned to take advantage of tops and bottoms.This technique is called the option back-spread (buying more options than you sell).To illustrate, assume you believe that bond futures prices are about to peak, but youdo not want to take a naked short position, and you do not want to simply buy a put,which, if prices continued to rise, would result in a complete loss of your premium.An alternative would be to do a put ratio back-spread. The trader would sella put of one strike and buy two puts at a lower strike. If the market continues torise, moderately, you will end up with a small gain or loss depending upon theexact prices and premiums paid or gained from the legs in the spread. If pricesbegin to fall, the long put options generate profits, and the more they fall, the moreyou gain. Clearly, if futures fail just a little bit, or remain stable, you will end witha loss equal to the difference in the cost of the two puts and the money obtainedfrom the sale of the put at the higher strike. For example, if December bond futuresare at 105, and you sell a 106 put at 1–45, and buy two 104 puts at 0–60, you willhave an initial net cash outflow of $171.88. If the final December settlement priceis 104, you will have a net maximum loss of $469—$297 from the loss that wouldoccur on the 106 put if the price settles at 104–00, plus the $172 differential in thevalue of the option sold versus those bought. The 104 puts will be worth zero.This will give you a break-even price of 103–17 (see Table 19.2).Clearly, you would not want to use this strategy if you expected only a minorcorrection to the major trend. While this strategy is risk limiting, it can still resultin substantial losses. In order for it to pay off, you need a substantial reversal in prices.Nevertheless, it is loss limiting and, when used with moderation and with capitalconservation principles in place, keeps you capable of being wrong and still available to continue participating in the market when that major change in trend occurs.This strategy works equally well on the long side and for any commodity. Thatwould be called a call ratio back-spread. You would be shorting one call at a particular strike and buying two calls at a higher strike.
MORE ON SPREADSOne interesting and unique spread trading idea is using futures to synthesize aphysical production or processing activity. Three examples come to mind: the soybean crush, the paper feedlot, and the oil “crack” spread.193
Chapter 19
Table 19.2 Put Ratio Back-SpreadBond Futures Price 105–00Sell 1 Bond 106 Puts @ 1 45/64= $1,703Buy 2 Bond 104 Puts @ 60/64 = 937.50 × 2= 1,875Net Cash Outflow=172Futures Price @ Maturity = 106106 Put Value = 0Net = +$1,703104 Put Value = 0Net = –$1,875Net–$172Futures Price @ Maturity = 104106 Put Value = 2,000 – 1,703= –$297104 Put Value = 00Initial Net Cash Outlay= –$172Net Loss = –$469
The CrushThe crush refers to a three-way spread involving the purchase of soybeans and thesale of soybean oil and soybean meal in the same ratio as those two products arerepresented when one crushes soybeans.Assume you calculate the economic cost of buying soybeans, crushing them(processing them through a soybean mill), and selling the two resultant outputs, soybean oil and soybean meal, and find that given today’s interest rates and profitmargins, etc., the cost is 36 cents per unit. Assume also that the futures show adifferential of 42 cents. If your calculations are correct, then economic forces willeventually cause the futures differential to fall back toward 36 cents, because people will buy soybean futures and sell the meal and oil futures, then take deliveryof the beans, crush them, and deliver the oil and meal in satisfaction of the futures.As this happens, the differential between 42 cents and 36 cents will narrow.
The Paper FeedlotThe paper feedlot refers to a complex spread that balances the major factors of acattle feeding operation. Feedlot operators buy feeder calves and they buy feedwhich is consumed by the cattle, and, five months later, they sell fat cattle. Duringthat period, a 600-pound calf grows into a 1,000- to 1,100-pound steer, after consuming roughly 45 bushels of grain. This spread would involve the purchase of194
Fact and Fiction About Spreads
four feeder cattle contracts and three corn contracts, and the sale of seven livecattle contracts.The June live cattle/May feeder cattle spread is an example of a seasonalmarket tendency. Historically, this spread works well from early March to the endof April, but as one might expect, actual trading situations tend to differ from yearto year; hence, what worked in 1987 doesn’t necessarily repeat itself in 1992. Toidentify these seasonal tendencies, one should analyze at least 10 years of data inorder to get an idea of the expected probability that those tendencies will repeat,identify the time of the year in which they tend to repeat, and establish the time toenter into the position. Using the moving averages, try to enter slightly before thetime you actually expect the ideal entry time to occur. Once that process is complete, you need to fine-tune the timing for entry. One successful spread trader I knowuses simple five- or seven-day moving averages lagged by several days to filter outwhipsaw.One could use the same simple moving average systems for exiting the strategy. Money-limit stops also should be used to exit in advance of the time when youexpect the seasonal move to end. As with all these things, one needs to watch andstudy patterns, evaluate the history, and then develop various spread-specific indicators that are useful to the trader and with which the trader is comfortable.
The “Crack”The “crack” involves the purchase of three crude oil contracts and the sale of twogasoline contracts and one heating oil contract. It is roughly equivalent to runningan oil refinery. You buy crude oil, refine it, and get fuel oil and gasoline. Traditionallythis is called the 3-2-1 spread (see Figure 19.1). This can be stepped up to a moreappropriate ratio called the 5-3-2, capturing the reality of refining relationshipsmore closely.Traders have to realize that despite the conventional wisdom of spreads,these are neither risk-free nor loss-proof. Lower margins for these spreads do notobscure their speculative nature. A major risk in these trades comes from execution risk. It is not always possible to execute these transactions simultaneously atthe appropriate prices or in the desired quantities. That’s especially true in cattle.In the case of soybean and energy spreads, traders can specify in advance that theyare trading a 5-3-2 or 3-2-1 and trade the spread directly. In the case of cattle, however, traders must work into three or four positions at two different exchanges.That leaves considerable room for slippage and risk.
SPREADING AND TAXESThe Tax and Revenue Act of 1981 specifies that:195
Chapter 19
Figure 19.1 2:1:1 Crack and 3:2:1 Crack Spreads (weekly data)
a. Futures transactions have no required holding period.b. Any gain or loss in futures contracts be treated as 60 percent long-term capital gain or loss and 40 percent short-term capital gain or loss. This ratioapplies irrespective of the length of time the futures position is held.c. Futures losses can be carried back three years against futures gains or carried forward against securities gains.The tax act marks all commodity futures contracts to market at year-end andtreats all of these “unrealized” gains and losses as if 60 percent of the capital gainsand losses on them were long-term and 40 percent were short-term “realized”gains or losses; i.e., each futures contract is repriced daily to reflect the market’sofficial closing price. The profit or loss resulting from this repricing is realized onthat day in the equity of the investor’s account.The tax rules, therefore, require gains and losses to be taken into accountnot only when futures positions are closed out, but also on all open positions onthe last business day of each taxable year.
CARRYBACK AND CARRYFORWARD OF LOSSESIf a taxpayer, other than a corporation, has a net commodity futures loss for a taxyear, the amount of loss may be carried back to each of three taxable years preceding196
Fact and Fiction About Spreads
the loss year against market-to-market gains. Of the amount carried back, 60 percent will be treated as long-term capital loss and 40 percent will be treated as shortterm capital loss. The loss is carried first to the earliest of the three prior years.However, the loss may be carried back only to the extent that it does not exceedthe “net commodity futures gain” for that year—defined as the lesser of regulated futures gains or the net capital gain for that year—and that the carryback doesnot increase or produce a net operating loss for that year.Losses not used up by the carryback may be carried forward. They are considered as 60 percent long-term and 40 percent short-term capital losses and arecarried forward under existing rules related to capital losses generally. Carrybackof losses may not be available for investors in stocks, bonds, options, and other alternative investments. It is another advantage that exists for investing in commodityand financial futures. Check with your tax advisor on all the rules and regulations.They change.
SUMMARYIn conclusion, then, several points are worth reiterating:1. Certain normal price relationships exist between futures contracts for thesame commodity, based on time, quality, and location differences betweenthe contracts. Because these natural economic factors tie pieces together,the premiums and discounts between futures have approximate naturallimits placed on them. Spread transactions that take advantage of these natural relationships can be relatively low-risk yet profitable transactions.2. Unless the price differences between two contracts are related to naturaleconomic bonds, the risks in spread transactions may be very high. Thesenatural bonds are extremely weak in perishable commodities. Hence, it iswise to study commodity futures price relationships with respect to time,location, and quality differences before instituting a spreading program.This necessitates reviewing past price transactions and studying marketing patterns for the physical commodity.3. In nearly all spread transactions, commercial traders have a distinct advantage over public speculators. Commercial traders have easy access to theactual commodity and the facilities necessary for storage, processing, anddisposal should they decide to actually give or receive delivery in orderto realize their profit from the spread. It is generally a wise practice, therefore, for speculators to liquidate futures positions prior to delivery, unlessthey have made specific arrangements to accept delivery and hold theproduct for re-delivery later.197
Chapter 19
4. Spreading is far from riskless. The low margins required for spread transactions can result in small gains or losses in absolute terms, but can havethe same proportionate impact on the value of the margin investment asa larger swing in an outright position that requires higher margins.5. When spreading, try to spread approximately the same dollar amounts oneach side of the transaction. Frequently, the contracts will not be of equalvalue, particularly in inter-commodity spreads. If they aren’t of approximately equal value, you may end up in the unfortunate position of having a gain on the small side and a loss on the larger side, which nets outto a pretty good-sized loss. You’ll be right, but you’ll lose money. You’llwin the battle but lose the war.6. Do not yield to the temptation of establishing a spread in an attempt torecover from a losing outright position. Such tactics virtually always backfire. The spread transaction will not offset the loss, but will only initiatea new position that could work to compound the loss.7. Consult first and often with your tax advisor. Spreading can be profitableand should be considered as a possible part of every trader’s strategy andtrading plan. It can hold relatively low risk in certain circumstances. Forthe beginning trader, spreads in low-risk situations are one of the bestways to learn about the market without being subject to the possibility ofsharp market losses.
198
Chapter 20
Financial Futures—An Introduction
We are all familiar with the dollar bill. We recognize and accept it as payment for debts.These dollar bills are simply pieces of paper manufactured by our federal government and declared by it to be legal tender for the payment of taxes and other debts.In the commodity futures world, money has always been important as a medium of exchange. In recent years, however, it has taken on even more importanceas a tradable “commodity.”The opening of foreign currency and interest rate futures in Chicago madeevery commodity trader realize that money is also a commodity and that it, too, hasa price just like everything else. Money’s price is quoted in two ways: (1) a foreign exchange rate, reflecting the purchasing power of one country’s money relative to another country’s and (2) an interest rate price, reflecting the value of moneyas an income-producing asset, and any price quoted at any time will reflect someelements of both.Just as the value of a bushel of wheat fluctuates relative to the value of abushel of corn, so too does the value of the U.S. dollar fluctuate relative to thevalue of the French franc. This price for money is called an exchange rate and represents a sort of external price other countries are willing to pay for our money.199Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 20
Just as wheat may be used to produce flour, money may be used to earnincome by lending it to people who, say, build houses. The price of money here isthe interest rate cost of borrowing it. This interest rate price for money reflects thevalue sellers (lenders) and buyers (borrowers) place on the use of money for a certain period of time. In both cases—the exchange rate price and the interest rateprice—supply, demand, and political events determine the level of price.Money is the ultimate commodity, and no commodity trader’s education iscomplete without an understanding of the futures market for money. Indeed, themoney futures markets are the most fascinating and largest of all. The next few chapters will provide you with a very basic introduction to these markets. This chapter will give an introduction to the role of money in the general economy. An understanding of that role is essential to evaluate the price movements for money.Subsequent chapters will discuss foreign currency trading, Treasury bond and notefutures, Eurodollar futures, and stock index futures.
MONEYIf we did not have money, goods would be exchanged through barter, an inefficientand time-consuming process. If a person wanted to trade his output with someoneelse, he would first have to search among other willing sellers until he found anopposite party with a product he wanted. Second, the two parties would then haveto agree on a price representing equivalent values. Even if they agreed that threechickens and two hogs were equivalent to one cow in value, one party might endup with two hogs more than he wanted.Humankind, in its wisdom, realized at some point in its development thatan intermediate good, which everybody could readily recognize and accept inexchange for all other goods, might make for a lot fewer headaches in bargainingand doing business. Thus, money was born. Producers could sell their output inexchange for the intermediate good (money) to anyone who wanted to buy. Theywould not need to waste time looking for someone who had a product they actually wanted. Prices of all goods could be expressed in terms of the intermediate goodand the amount of payment could be matched to the price. No longer would people get more hogs than they really wanted. They could take the intermediate goodand buy precisely the number of hogs and chickens they desired.Money, as shown above, performs several functions. It serves as a medium ofexchange; everybody accepts it as payment. It serves as a store of value; it can beused to buy things. It serves as a unit of measurement—$2,000 will buy one horse.Through the years, many different things, ranging from cigarettes to gold, haveserved as money. At times, more than one intermediate good has been used asmoney by various countries of the world. But this reduced the efficiency of transactions because producers had to quote the price for each product in terms of each200
Financial Futures—An Introduction
of the monies. Since it was virtually impossible to maintain a stable relationshipbetween the various monies, most countries reverted back to the use of a single intermediate good as money. Today, all countries of the world use paper money.Although all countries use paper money, each country tends to use a different name for its money (e.g., dollar, peso, franc, etc.), and because of differencesin political stabilities, natural resources, levels of workers’ productivity, opportunities for foreign investment, etc., some countries’ money commands a higherprice relative to the U.S. dollar than other countries’ money.
MONEY IN THE ECONOMYMoney is the grease that makes an economy run smoothly. Imagine the economyof a country as one big machine. This machine represents all the mills, factories,farms, offices, and shops that turn out the goods and services consumed in the society. Everyone with a job works on this big machine. Some are repairpeople, someare operators, but all of them are producing goods and services the people use.Naturally, all of the workers are paid and these workers use their money tobuy things produced by the machine. Thus, a nice, smooth circle is completed ofpeople working on the machine, being paid by the machine, and buying their goodsand services from the machine.If the people buy all that is produced, then everything is in balance and theeconomy for this country is healthy and stable. Sometimes, however, imbalancesappear and interrupt the smooth flow of labor, money, and goods and services.When this happens, prices change and we get increases or decreases in economicactivity.These imbalances may arise because of leakages in flows of spending by themachine or by the people. For example, people may decide not to spend all of theirmoney on goods and services, but may decide instead to save (hoard) some oftheir income. Thus, they do not buy as many cars and television sets. Because theflow of money back to the machine is reduced, the machine slows down its production. Fewer people are needed to run the machine, and total income and totalbuying power are reduced. Economists refer to this set of