economics essay business cycle

Business Cycle in Economy Essay

Appearing in last Sunday’s edition of New York Times, the article “Living on Minimum Wage” illustrates a picture of an American economy which is in the recovery phase in the business cycle. This paper illuminates some of the main ideas contained in the article.

Business cycle, also referred to as economic cycle, is a term mainly used by economics scholars and business practitioners to demonstrate the fluctuating movements (increasing or decreasing) of levels of the gross domestic product (GDP) in an economy over a particular period of time that may vary from several months to a number of years (Ball, 2009).

The recurring and fluctuating levels of the GDP an economy experiences over a certain time frame are grouped into five phases for ease of analysis – growth (economic expansion), peak, recession (economic contraction), trough and recovery (McConnell, 2009; Romer, 1999).

From the article, it is clear that the United States economy suffered under the 2008 financial crisis and many economic pundits viewed the crisis as a major triggering force for the economic contraction that was witnessed in many economies of the developed world.

The author of the article acknowledges that “the recession took middle-class jobs, and the recovery has replaced them with low-income ones, a trend that has exacerbated income inequality” (Lowrey, 2013 para. 2). The shift from middle-class jobs to low-income jobs, according to Romer (1999) is a viable indicator of the economic fluctuations in the business cycle over time.

Another major theme in the article is President Obama’s concept of stimulating the federal minimum wage in his economic proposal by increasing the minimum wage from $7.25 an hour (current) to at least $9 to lift numerous American families above the poverty line (Lowrey, 2013).

As demonstrated in the relevant economics literature, the recovery phase in the business cycle is typified by improvement in customer’s optimism of the market, low bank lending rates, growth of companies due to capacity to finance projects, enhanced productivity due to better aggregate demand of the economy, increased production that allows organizations to start recruiting new workers, and increased income of consumers who can now manage to buy capital goods (Ball, 2009; McConnell, 2009; Romer, 1999).

Although the other variables have not been addressed in the article, the proposed increase in the minimum wage by President Obama demonstrates an economy that is in its recovery phase after the financial crisis.

As illustrated in the article, there has been opposing views about President Obama’s proposal to raise minimum wages, with some conformists and economics experts saying that raising the costs of recruiting new workers results in few workers whereas other pundits suggest that minimum wage increment does not necessarily result in companies shedding workers because it helps minimize turnover (Lowrey, 2013).

These are valid arguments that business people need to be aware of as they make critical organizational decisions since they reflect the uncertainties of the recovery phase. However, according to available literature, the profit margins of American companies will begin to rise, and the GDP will also start to expand during the recovery phase (McConnell, 2009), hence the need to reciprocate by raising the minimum wages of workers in the lowest echelons of the economy.

Ultimately, therefore, President Obama’s proposal to raise the minimum wages as demonstrated in the article may be somewhat rushed because the American economy was in bad shape and the uncertainties of the future are still hanging on the minds of business practitioners as they re-engineer their companies to start making profits. However, it is the right thing to do because the United States economy is slowly recovering from the effects of the recent global recession.

Ball, L. M. (2009). Money, Banking, and Financial Markets. New York: Worth Publishers.

Lowrey, A. (2013). Living on minimum wage. New York Times .

McConnell, C. R. (2009). Economics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin.

Romer, C.D. (1999). Changes in business cycles: Evidence and explanations. Journal of Economic Perspectives, 13( 2), 23-44. Web.

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All about the business cycle: where do recessions come from.

"Expansions don't die of old age." 

—Macroeconomic adage

It might be tempting to think the stages of the business cycle are like the cycles on your dishwasher—regular cycles that occur in predictable patterns: The rinse cycle always begins after the wash cycle has completed, and each rinse always lasts the same length of time. In fact, the way business cycles are often illustrated in textbooks and websites often support this thinking (Figure). But there is nothing "regular" about the business cycle.

So, what does a "typical" business cycle look like? Business cycles include the following four stages: 

1. The upward slope of the business cycle is called economic expan sion . This is a period when economic output increases. That is, more goods and services are being produced in the economy.

2. It would sure be nice if the economy expanded continuously, but all expansions come to an end. In economic terms, each one reaches a peak, which, like a roller coaster ride, is the point just before the downward movement begins.

3. The downward slope of the business cycle is called economic contraction . This is a period when economic output declines; it's measured as a decrease in real GDP. During this phase, the economy produces fewer goods and services than it did before. When fewer goods and services are produced, fewer resources are used by firms—including labor. As firms decrease their output, they will hire fewer new workers and often lay off some existing workers. As a result, when output falls, employment tends to fall as well. 

Economic contractions often become recessions , which result in economic hardship for many people and can have long-lasting effects. For example, losing a job due to recession can lead to high levels of debt or the loss of key assets such as a house or car. In addition, if people are unemployed for long periods of time, they might find it difficult to keep their work skills sharp, and they might find it difficult to find another job.

While an economic contraction is objective—that is, it's a measured decrease in real GDP—a recession is more subjective: The National Bureau of Economic Research (NBER) uses a variety of measures of economic activity, not just real GDP, to assess whether the US economy is in recession. We'll discuss this more later in the essay. 

4. Recessions are challenging, but fortunately they don't last forever. In economic terms, each one reaches a trough, which is the point just before the upward movement begins—like the low point on a roller coaster run, just before the track turns upward. 

What Causes Recessions?

If you watch the "talking heads" on financial news networks, you'll sometimes hear them say that an expansion is getting a little "long in the tooth," or that we are in the late stages of expansion. While they might have reasons for expecting the expansion to end, the phrasing can make it seem that expansions have a lifespan—that they end simply because they've been around for a while (like watching fruit start to go bad in your fridge and knowing you've got to throw it out soon).

That's not how economic expansions work, though. In fact, economic theory suggests there is no reason for economic cycles to occur at all, as the economy's natural state is expansion—positive growth. 1 The economy gets knocked off its natural growth trend only when an economic shock knocks it off track. And, as the word suggests, a shock is an unexpected event. 

These shocks can be positive (booms) or negative (recessions), and they come from a variety of sources. Economists suggest that shocks that cause recessions might include financial market disruptions, international disturbances, technology shocks, energy price shocks, and actions taken by monetary policymakers to restrain inflation. 2 Of course, we'd like to avoid recessions; they are costly because unemployed workers (and resources) lose income and economic opportunities, and the economy loses output that cannot be regained.

Is Two Quarters of Negative Growth in Real GDP a Recession? It Depends

People often have heated discussions about whether the economy is in recession. How can you tell?

Using the informal "rule of thumb" definition, a recession is two consecutive quarters of economic contraction (negative real GDP growth). However, that is not the definition the NBER Business Cycle Dating Committee uses. The NBER is a think tank with a very important role: It plays "referee" and decides when economic recessions occur in the United States.

According to the NBER, a recession is "a significant decline in economic activity that is spread across the economy and lasts more than a few months." And the decline must be characterized, at least to some degree, by each of the following characteristics: depth, diffusion, and duration. 3 Thus, emphasis is placed on a variety of measures of economic activity rather than on a single measure, such as GDP growth. In assessing the "decline in economic activity," the NBER includes data about real personal income, nonfarm payroll employment, household employment, consumer spending, wholesale-retail sales, and industrial production in their assessment (Table 1). 4  

Because the NBER considers several economic indicators, the change in real GDP might be relatively small while other data indicate a significant decline in economic activity, which is characteristic of recession. The NBER also focuses on monthly assessments of the business cycle, while real GDP is reported quarterly. So, while it's possible that the economy could experience two quarters of negative real GDP growth and not have a recession, history shows there is a lot of overlap. In each of the past 10 times the economy shrank for two consecutive quarters, a recession resulted. However, there have been recessions where the economy did not contract for two quarters; the 2020 COVID-19 recession lasted only two months, and real GDP declined in only one quarter during the 1980, 1991, and 2001 recessions (Table 2). 5

How do peaks and troughs line up with contractions and expansions? The first month of a recession is the month following a peak. Table 3 notes that the business cycle peaked in February 2020, which means the COVID-19 recession started in March 2020. That recession ended in April 2020, the date of the trough. 6 The next expansion began in May 2020.

You'll hear people arguing about whether we're in a recession because the NBER doesn't often declare a recession until well after it has begun: The NBER uses data that are backward looking, so it takes time for the NBER to analyze all the data and make a judgment. Sometimes it doesn't make the call until after a recession has already ended. For example, the recessions of 1991 and 2020 were both relatively short and had already ended by the time the NBER announced the beginning date of the recession. Likewise, the economy is often well into the next expansion by the time the NBER calls the end of the last recession. For example, the NBER made the announcement that the COVID-19 recession ended April 2020 on July 19, 2021 (Table 3).

The NBER notes that it has taken between 4 and 21 months after a recession started to declare the recession had started and that "there is no fixed timing rule. We wait long enough so that the existence of a peak or trough is not in doubt, and until we can assign an accurate peak or trough date." 7 Again, in the meantime, you'll hear lots of discussion about whether the next recession has started.

What Do Recessions Look Like?

While they all start with a shock, every recession is a little different, which makes us think that Mark Twain's quote that "history doesn't repeat itself, but it often rhymes" also refers to recessions.

So, what does a "typical" recession look like? Recessions usually include the following characteristics:

A. A negative shock such as a financial crisis occurs.

B. Firms reduce investment spending on machinery, equipment, new factories, and new office buildings (physical capital). In fact, typical recessions begin with reduced business investment spending, which is the most volatile component of GDP because businesses can postpone this type of spending.

C. As business investment falls, affecting employment and demand for inputs, consumers reduce spending on new houses and durable goods such as furniture, appliances, and automobiles.

D. As spending declines, firms that produce these products see declining sales and increasing inventories. They decide to cut production levels and lay off some workers.

E. Rising unemployment and falling profits lead to further declines in spending. 

F. Eventually, the declines will end as consumers and businesses reduce debt and increase their ability to spend and as producers lower their prices to reduce inventory. 

G. Lower interest rates and resource prices make investment and spending more attractive. 

H. Firms take advantage of low interest rates and resource prices by increasing investment spending on capital goods as they anticipate the next expansion.

I. Consumers take advantage of low interest rates by borrowing to spend on new houses and durable goods.

J. The increased demand for products and services increases employment and income, and consumer spending levels rise. 

K. As consumer spending increases, businesses increase production and employment.

L. Recession ends, beginning the next expansion.

Like a roller coaster, the business cycle has ups and downs. However, when it comes to the economy, most people prefer a smooth ride with very few dips. It would be much easier to plan and invest for the future if recessions were easy to predict, but they are not. Rather, they are unpredictable and irregular. The NBER Business Cycle Dating Committee acts as the official referee when it comes to business cycles. This group of expert macroeconomists use economic data and their understanding of the economy to determine when recessions start. (See boxed insert, "Which Specific Economic Indicators Does the NBER Use?") The process takes time, as the stakes are high, so it's important to get the "call" right.

1 Kliesen, Kevin L. "A Guide to Tracking the U.S. Economy." Federal Reserve Bank of St. Louis Review , First Quarter 2014, pp. 35-54; https://doi.org/10.20955/r.96.35-54 . 

2 Kliesen, Kevin L. "The 2001 Recession: How Was It Different and What Develop­ments May Have Caused It?" Federal Reserve Bank of St. Louis Review , September/October 2003, pp. 23-38; https://doi.org/10.20955/r.85.23-38 . 

3 Extreme conditions for one criterion may partially offset weaker indications from another.

4 Owyang, Michael T. and Stewart, Ashley H. "Is the U.S. in a Recession? What Key Economic Indicators Say." Federal Reserve Bank of St. Louis On the Economy Blog , September 2022; https://www.stlouisfed.org/on-the-economy/2022/sep/us-recession-what-key-economic-indicators-say .

5 National Bureau of Economic Research. "US Business Cycle Expansions and Contractions"; https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions . 

6 National Bureau of Economic Research. See footnote 5. 

7 National Bureau of Economic Research. "Business Cycle Dating Procedure: Frequently Asked Questions"; https://www.nber.org/research/business-cycle-dating/business-cycle-dating-procedure-frequently-asked-questions .

© 2023, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Business cycle: The fluctuating levels of economic activity in an economy over a period of time measured from the beginning of one recession to the beginning of the next.

Contraction: A period when real GDP declines; a period of economic decline.

Expansion: A period when real GDP increases; a period of economic growth.

Recession: A period of declining real income and rising unemployment. A significant decline in general economic activity extending over a period of time.

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What Is a Business Cycle?

Understanding the business cycle.

• Measuring and Dating
• Relationship With Stock Prices

The Bottom Line

Business cycle: what it is, how to measure it, the 4 phases.

Business cycles are a type of fluctuation found in the aggregate economic activity of a nation—a cycle that consists of expansions occurring at about the same time in many economic activities, followed by similarly general contractions. This sequence of changes is recurrent but not periodic.

The business cycle is also called the economic cycle .

Key Takeaways

• Business cycles are composed of concerted cyclical upswings and downswings in the broad measures of economic activity—output, employment, income, and sales.
• The alternating phases of the business cycle are expansions and contractions.
• Contractions often lead to recessions, but the entire phase isn't always a recession.
• Recessions often start at the peak of the business cycle—when an expansion ends—and end at the trough of the business cycle, when the next expansion begins.
• The severity of a recession is measured by the three Ds: depth, diffusion, and duration.

Madelyn Goodnight / Investopedia

In essence, business cycles are marked by the alternation of the phases of expansion and contraction in aggregate economic activity and the co-movement among economic variables in each phase of the cycle. Aggregate economic activity is represented by not only real (i.e., inflation-adjusted) GDP—a measure of aggregate output—but also the aggregate measures of industrial production, employment, income, and sales, which are the key coincident economic indicators used for the official determination of U.S. business cycle peak and trough dates.

Popular misconceptions are that the contractionary phase is a recession and that two consecutive quarters of decline in real GDP (an informal rule of thumb) means a recession. It's important to note that recessions occur during contractions but are not always the entire contractionary phase. Also, consecutive declines in real GDP are one of the indicators used by the NBER, but it is not the definition the organization uses to determine recessionary periods.

On the flip side, a business cycle recovery begins when that recessionary vicious cycle reverses and becomes a virtuous cycle, with rising output triggering job gains, rising incomes, and increasing sales that feedback into a further rise in output . The recovery can persist and result in a sustained economic expansion only if it becomes self-feeding, which is ensured by this domino effect driving the diffusion of the revival across the economy.

Of course, the stock market is not the economy. Therefore, the business cycle should not be confused with market cycles , which are measured using broad stock price indices.

Measuring and Dating Business Cycles

The severity of a recession is measured by the three D's: depth, diffusion, and duration. A recession's depth is determined by the magnitude of the peak-to-trough decline in the broad measures of output, employment, income, and sales. Its diffusion is measured by the extent of its spread across economic activities, industries, and geographical regions. Its duration is determined by the time interval between the peak and the trough.

An expansion begins at the trough (or bottom) of a business cycle and continues until the next peak, while a recession starts at that peak and continues until the following trough.

The National Bureau of Economic Research (NBER) determines the business cycle chronology—the start and end dates of recessions and expansions for the United States. Accordingly, its Business Cycle Dating Committee considers a recession to be "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."

The Dating Committee typically determines recession start and end dates long after the fact. For instance, after the end of the 2007–09 recession, it "waited to make its decision until revisions in the National Income and Product Accounts [were] released on July 30 and Aug. 27, 2010," and announced the June 2009 recession end date on Sept. 20, 2010.

The average length of recessions in the U.S. since World War II has been around 11 months. The Great Recession was the longest one during this period, reaching 18 months.

U.S. expansions have typically lasted longer than U.S. contractions. From 1854–1899, they were almost equal in length, with contractions lasting about 25 months and expansions lasting about 29 months, on average. The average contraction duration then fell to 18 months in the 1900–1945 period and 11 months in the post-World War II period. Meanwhile, the average duration of expansions increased progressively, from 29 months in 1854–1899 to 30 months in 1900–1945, 43 months in 1945–1982, and 70 months in 1982–2009.

Stock Prices and the Business Cycle

The biggest stock price downturns tend to occur—but not always—around business cycle downturns (e.g., contractions and recessions). For example, the Dow Jones Industrial Average and the S&P 500 took steep dives during the Great Recession. The Dow fell 51.1%, and the S&P 500 fell 56.8% between Oct. 9, 2007 to March 9, 2009.

There are many reasons for this, but primarily, it is because businesses assume defensive measures and investor confidence falls during contractionary periods. Many events occur before those in an economy are aware they are in a contraction, but the stock market trails what is going on in the economy.

So, if there is speculation or rumors about a recession, mass layoffs, rising unemployment, decreasing output, or other indications, businesses and investors begin to fear a recession and act accordingly. Businesses assume defensive tactics, reducing their workforces and budgeting for an environment of falling revenues.

Investors flee to investments "known" to preserve capital, demand for expansionary investments falls, and stock prices drop.

It's important to remember that while stock prices tend to fall during economic contractions, the phase does not cause stock prices to fall—fear of a recession causes them to fall.

What Are the Stages of the Business Cycle?

In general, the business cycle consists of four distinct phases: expansion, peak, contraction, and trough.

How Long Does the Business Cycle Last?

According to U.S. government research, the business cycle in America takes, on average, around 6.33 years.

What Was the Longest Economic Expansion?

The 2009-2020 expansion was the longest on record at 128 months.

The business cycle is the time is takes the economy to go through all four phases of the cycle: expansion, peak, contraction, and trough. Expansions are times of increasing profits for businesses, rising economic output, and are the phase the U.S. economy spends the most time in. Contractions are times of decreasing profits and lower output, and is the phase the least amount of time is spent in.

St. Louis Federal Reserve. " All About the Business Cycle: Where Do Recessions Come From? "

The National Bureau of Economic Research. " Business Cycle Dating ."

National Bureau of Economic Research. “ Business Cycle Dating Procedure: Frequently Asked Questions. What is a Recession? What is an Expansion? ”

National Bureau of Economic Research. " The NBER's Recession Dating Procedure ."

National Bureau of Economic Research. " Business Cycle Dating Committee, National Bureau of Economic Research ."

National Bureau of Economic Research. " US Business Cycle Expansions and Contractions ."

Federal Reserve Bank of Atlanta. " Stock Prices in the Financial Crisis ."

Congressional Research Service. " Introduction to U.S. Economy: The Business Cycle and Growth ," Page 2.

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All About the Business Cycle: Where Do Recessions Come From?

What constitutes a recession? Two quarters of negative real GDP growth? Well, most of the time that “rule of thumb” definition works, but not always. The NBER Business Cycle Dating Committee has a more nuanced way of determining what a recession is. This essay discusses where recessions come from, how they are determined, and how they end.

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Development of rational expectations models of the business cycle has been the central issue on the macroeconomic research agenda since the influential analyses of Robert Lucas (1972a, b). In this essay, we review these developments, focusing on the extent to which the rational expectations perspective has generated a new understanding of economic fluctuations.

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Economy analysis: Business Cycle and Economic Trends

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Latest Update 20 Jan, 2024

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Table of content

Phases of the business cycle

How is the business cycle measured, how economists view business cycles, investors, markets and the business cycle.

Entrepreneurs   and their businesses run the financial world. This means they determine the face of development and general human well-being. There is a time when production, trade, and general economic activities are high, and there is a time when they are low. On several occasions, there is what we can call, a balance-out, where it is neither low nor high. And this is the general behavior of business and economy. It is defined by the term “business cycle” or economic cycle or boom-bust cycle.

When defined using a conceptual perspective approach, we can say the business cycle is the upward and upward movement of the GDP. Think of it like any other form of fluctuation, in say internet connectivity or something. It is all about the period of expansions and contractions in the level of economic actions over a long term growth behavior. The subject of the business cycle is one of the most important things to look at when taking economic studies. It does prepare students not only to know how the business world operates but to discover the best ways to adjust when they start running businesses. It gives them the mind to forecast how things will be and prepare adequately.

Different factors influence the growth and success of a business. One of the biggest influencers is a change in demand and supply. As you may have already guessed, when demand surges, businesses grow if they can supply more. And when there is no demand, companies go down because they will not be making enough to meet the production costs and make a profit. Because of this, there comes a time when a business will be booming high, and another period when things will be down low.

Studying economic cycles can help a country adjust their way of dealing with GDP and GNP. When businesses are not doing well, a country stands to lose on the GDP. And the citizens don’t have jobs and cannot spend as desired; there is a problem too because then, someone has to be accountable for the situation.

All these are scenarios that define fluctuations in business. And the process is inevitable; so is its impact on the general economy of a nation. And since we cannot stop it, the best thing is to understand how to handle different situations when and how they happen. This is because human beings depend on such growth, and getting things right can be the difference between growth and failure. We can all agree that business institutions have everything to do with the growth and development of a society. Hence, economic fluctuations not only impact those directly involved in the production, but it goes down to the consumers who depend on those products. When prices surge, you will be compelled to pay more for common products, which may require one to work extra hard.

The best way to understand the economic cycle is by a clear look into phases that define it. There are four main phases: expansion, peak, contraction, and trough. Around the world, there are bodies that control the outcomes of business fluctuations so that producers and consumers get what they deserve. In the United States of America, for instance, the body that is generally accepted for this job is the National Bureau of Economic Research (NBER). And like the name, suggests they are the final arbiter of the dates of highs and lows in the business cycle.

Expansion is often taken as the first stage of the business cycle. It could be because the business cycle is something that happens over a long time. Hence, expansion is taken as an arbitrary starting point. When it happens, there are all positive things in the GDP. The level, so employment rises, there is decent income, production, and sales all go out. And this means people will pay taxes and debts on time.   Financial institutions   will grow faster as they will be able to serve more people at all times. In general, the economy has a steady flow of money supply. Also, there is high growth in the investment graph. People enjoy it when the economy is growing well, and they will do everything to ensure they keep things that way. Every process becomes a success, and there is nothing that seems impossible.

But the process cannot continue forever. Think of it like pulling and elastic belt. It will reach a point where its elasticity cannot stretch any further. The same happens with economic growth. When it goes high, it comes a time when the economy cannot grow any further. Hence, the next stage of the business cycle is a peak. Here, the economy hits a snag after reaching the maximum level of growth. Prices hit the highest point while economic indicators stop growing. Here, many business owners start to restructure everything they do. They have to anticipate what might happen next. In most cases, they will take advantage of the situation and sell as much as possible. But production will not be as high, because economic growth starts reversing.

This leads to the next stage of the business cycle - recessions. This is the reverse of the first stage, where business begins to contract. An economy can never be stagnant after reaching the peak. There are very many factors that control economic growth and recession is just a result of these indications. Recession comes with many negative impacts, including a rise in unemployment levels, slow production, sales begin dropping as demand declines, and income becomes stagnant or reduces. It is a time when many businesses will begin laying off some workers and decreasing salaries. Luckily, smart business owners have a way of anticipating such situations, and they will make proper plans for it. A company may, for instance, take advantage of the peak and reap maximum profits to take them through the recession period. However, the worst is yet to come.

Depression comes but not always after depression. But when it happens, economic growth continues further downtrends. Whatever is happening, the recession becomes worse. There is no growth in the economy, whereas the level of unemployment rises significantly. Consumers and businesses face hard times recurring credit, as financial institutions try to weight their options. This is the period when trade goes down with many bankruptcies being reported. Consumers don’t have any confidence as investment opportunities become scarce. And you can imagine what impact such a trend has on the country’s GDP. It is a time of great depression and struggles for sustenance on the socio-economic activities. More negative implications may include a rise in the crime rate as citizens struggle to make ends meet.

The next stage it trough. It is the opposite of a peak, where the economy cannot go further down. In other words, a trough marks the end of the depression, paving the way for the next stage.

A trough marks the start of recovery. And this term is used to literally mean a situation where the economy begins to turn around. Because prices are low, consumer demand more, leading to an increase in production. And this means companies will require more workers, which translates to increased employment. Lenders open up their credit, giving business and consumers more opportunities to grow. This stage marks the end of the business cycle.

Business cycles are measured from every stage. For instance, expansion is determined based on the bottom line of the previous business cycles. And this means when one cycle ends, another begins. The next cycle is, therefore, measured from the trough to the peak of the current cycle. Recession is considered based on the peak down to the rough. It is an vise versa kind-of process.

NBER determines when a business cycle begins and ends in the USA. It is responsible for recording this data and sharing for business preparedness. As stated above, a business owner and the government need to be ready for what comes after every stage. The committee measures the real GDP together with other indicators like real income, employment, industrial production, and wholesale-retail growth. These measures and combined with debt and market parameters to determine what causes expansions and how long they are likely to last. NBER recorded that an average expansion lasted for fifty-eight months while contraction went for eleven-month from 1954. After this, NBER has recorded an increase in expansions from the 1990s, rising to 94 months on average, whereas the contraction level remains the same.

Following the 2008 economic recession, a trough was witnesses in June 2009, which the most difficult time for the NBER committee. They looked at the data and discovered ten measures hit the trough between June and December the same year. This means recession when for 18 months starting from December 2007, which was the lowest level since World War II. The USA has also witnessed the longest recessions after the war that came between 1973 to 1975 and 1981 to 1981, both going for more than sixteen months.

Business cycles have a great impact on a country’s economy. Because of this, economists always have something to say about the situation. For instance, John Keynes states that economic cycles happen because of highs and lows in the aggregate demand. This process brings the economy to short-term equilibriums that differ from full-employment equanimity. He comes up with Keynesian theories that don’t necessarily indicate the periodic business cycles, but they show cyclical responses to socks using multipliers. In this case, the level of investment determines how far the fluctuations will go, which comes from the level of aggregate input.

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Other economists, including Finn E. Kydland and Edward C. Prescott from the Chicago School of Economics, come with contradicting ideas challenging the Keynesian Model. In this case, they look at fluctuations in terms of economic growth from technology and innovation point of view, as opposed to monetary shocks.

Some economists feel that the business cycle must happen naturally within the economy, whereas others think it is controlled indirectly by the central banks that intervene in monetary policy. During a fast expansion, the central banks will step in to hold on money supply and raise interest rates, reducing the speed of money supply. And when there is a fast recession, they lower the rates and increase the money supply. These critics hold that economic cycles will cease when these interventions stop.

This is where investors have to very keen. It comes a time when they can make a huge profit from the market when they choose the right investment at the right time. For instance, an investor can choose commodity and technology stocks during a trough. At this time, the sticks may be cheap, and the economy is entering a recovery period. Hence, they can make a profit by selling them early during expansion. But when the market is overheating and at the peak, and investors can wisely put their bets on utilities, consumer staples, and healthcare. These sectors tend to work better during recessions. It is all about understanding what works best during which periods and tapping into the advantages.

Recessions can have a significant toll on the stock markets. In most cases, the main equity indexes globally endured a decline of more than 18 months during the economic recession of 2008. It was the worst depressions since the 1930s. At this period, global equities were not left behind as they went through major changes at the start of 2001. Companies like Nasdaq Composite were the most hit as indicators dropped by close to 80% from 2001 peak to the 2002 trough. Note also, that recessions resulting from credit bubbles bursting can hit income and consumption far worse than anything else.

The business cycle has become more like natural occurrences today. And different factors cause these fluctuations, apart from possible interventions from central banks. For instance, global pandemics like the 2019/2020 COVID-19 outbreak, which paralyzed major economic processes. Such things can have unexpected results leading to harder times. But the economy always rises stronger after.

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Business Cycle: Definition, Characteristics and Phases (With Diagram)

1. Definition of Business Cycle:

A capitalistic economy experiences fluctua­tions in the level of economic activity. And fluctuations in economic activity mean fluctuations in macroeconomic variables.

At times, consumption, investment, employment, output, etc., rise and at other times these macroeconomic variables fall.

Such fluctua­tions in macroeconomic variables are known as business cycles. A capitalistic economy exhibits alternating periods of prosperity or boom and depression. Such movements are similar to wave-like movements or see saw movements. Thus, the cyclical fluctuations are rather regular and steady but not random.

Since GNP is the comprehensive measure of the overall economic activity, we refer to business cycles as the short term cyclical movements in GNP. In the words of Keynes : “A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentages, alternating with periods of bad trade characterised by falling prices and high unemployment percentages.”

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In brief, a business cycle is the periodic but irregular up-and-down movements in economic activity. Since their timing changes rather unpredictably, business cycles are not regular or repeating cycles like the phases of the moon.

2. Characteristics of Business Cycles:

Following are the main features of trade cycles:

(i) Industrialised capitalistic economies witness cyclical movements in economic activities. A socialist economy is free from such disturbances.

(ii) It exhibits a wave-like movement having a regularity and recognised patterns. That is to say, it is repetitive in character.

(iii) Almost all sectors of the economy are affected by the cyclical movements. Most of the sectors move together in the same direction. During prosperity, most of the sectors or industries experience an increase in output and during recession they experience a fall in output.

(iv) Not all the industries are affected uniformly. Some are hit badly during depression while others are not affected seriously.

Investment goods industries fluctuate more than the consumer goods industries. Further, industries producing consumer durable goods generally experience greater fluctuations than sectors producing non­durable goods. Further, fluctuations in the service sector are insignificant in comparison with both capital goods and consumer goods industries.

(v) One also observes the tendency for consumer goods output to lead investment goods output in the cycle. During recovery, increase in output of consumer goods usually precedes that of investment goods. Thus, the recovery of consumer goods industries from recessionary tendencies is quicker than that of investment goods industries.

(vi) Just as outputs move together in the same direction, so do the prices of various goods and services, though prices lag behind output. Fluctuations in the prices of agricultural products are more marked than those of prices of manufactured articles.

(vii) Profits tend to be highly variable and pro-cyclical. Usually, profits decline in recession and rise in boom. On the other hand, wages are more or less sticky though they tend to rise during boom.

(viii) Trade cycles are ‘international’ in character in the sense that fluctuations in one country get transmitted to other countries. This is because, in this age of globalisation, dependence of one country on other countries is great.

(ix) Periodicity of a trade cycle is not uniform, though fluctuations are something in the range of five to ten years from peak to peak. Every cycle exhibits similarities in its nature and direction though no two cycles are exactly the same. In the words of Samuelson: “No two business cycles are quite the same. Yet they have much in common. Though not identical twins, they are recognisable as belonging to the same family.”

(x) Every cycle has four distinct phases: (a) depression, (b) revival, (c) prosperity or boom, and (d) recession.

3. Phases of a Business Cycle:

A typical business cycle has two phases ex­pansion phase or upswing or peak and con­traction phase or downswing or trough. The upswing or expansion phase exhibits a more rapid growth of GNP than the long run trend growth rate. At some point, GNP reaches its upper turning point and the downswing of the cycle begins. In the contraction phase, GNP declines.

At some time, GNP reaches its lower turning point and expansion begins. Starting from a lower turning point, a cycle experiences the phase of recovery and after some time it reaches the upper turning point the peak. But, continuous prosperity can never occur and the process of downhill starts. In this con­traction phase, a cycle exhibits first a reces­sion and then finally reaches the bottom—the depression.

Thus, a trade cycle has four phases:

(i) depression,

(ii) revival,

(iii) boom, and

(iv) recession.

These phases of a trade cy­cle are illustrated in Fig. 2.7. In this figure, the secular growth path or trend growth rate of GNP has been labelled as EG. Now we briefly describe the essential characteristics of these phases of an idealised cycle.

1. Depression or Trough:

The depression or trough is the bottom of a cycle where eco­nomic activity remains at a highly low level. Income, employment, output, price level, etc. go down. A depression is generally character­ised by high unemployment of labour and capital and a low level of consumer demand in relation to the economy’s capacity to pro­duce. This deficiency in demand forces firms to cut back production and lay-off workers.

Thus, there develops a substantial amount of unused productive capacity in the economy. Even by lowering down the interest rates, fi­nancial institutions do not find enough bor­rowers. Profits may even become negative. Firms become hesitant in making fresh invest­ments. Thus, an air of pessimism engulfs the entire economy and the economy lands into the phase of depression. However, the seeds of recovery of the economy lie dormant in this phase.

2. Recovery:

Since trough is not a permanent phenomenon, a capitalistic economy experiences expansion and, therefore, the process of recovery starts.

During depression some machines wear out completely and ultimately become useless. For their survival, businessmen replace old and worn-out machinery. Thus, spending spree starts, of course, hesitantly. This gives an optimistic signal to the economy. Industries begin to rise and expectations tend to become more favourable. Pessimism that once prevailed in the economy now makes room for optimism. Investment becomes no longer risky. Additional and fresh investment leads to a rise in production.

Increased production leads to an increase in demand for inputs. Employment of more labour and capital causes GNP to rise. Further, low interest rates charged by banks in the early years of recovery phase act as an incentive to producers to borrow money. Thus, investment rises. Now plants get utilised in a better way. General price level starts rising. The recovery phase, however, gets gradually cumulative and income, employment, profit, price, etc., start increasing.

3. Prosperity:

Once the forces of revival get strengthened the level of economic activity tends to reach the highest point—the peak. A peak is the top .of a cycle. The peak is characterised by an allround optimism in the economy—income, employment, output, and price level tend to rise. Meanwhile, a rise in aggregate demand and cost leads to a rise in both investment and price level. But once the economy reaches the level of full employment, additional investment will not cause GNP to rise.

On the other hand, demand, price level, and cost of production will rise. During prosperity, existing capacity of plants is overutilised. Labour and raw material shortages develop. Scarcity of resources leads to rising cost. Aggregate demand now outstrips aggregate supply. Businessmen now come to learn that they have overstepped the limit. High optimism now gives birth to pessimism. This ultimately slows down the economic expansion and paves the way for contraction.

4. Recession:

Like depression, prosperity or pea, can never be long-lasting. Actually speaking, the bubble of prosperity gradually dies down. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough or depression. Between trough and peak, the economy grows or expands. A recession is a significant decline in economic activity spread across the economy lasting more then a few months, normally visible in production, employment, real income and other indications.

During this phase, the demand of firms and households for goods and services start to fall. No new industries are set up. Sometimes, existing industries are wound up. Unsold goods pile up because of low household demand. Profits of business firms dwindle. Output and employment levels are reduced. Eventually, this contracting economy hits the slump again. A recession that is deep and long-lasting is called a depression and, thus, the whole process restarts.

The four-phased trade cycle has the following attributes:

(i) Depression lasts longer than prosperity,

(ii) The process of revival starts gradually,

(iii) Prosperity phase is characterised by extreme activity in the business world,

(iv) The phase of prosperity comes to an end abruptly.

The period of a cycle, i.e., the length of time required for the completion of one complete cycle, is measured from peak to peak (P to P’) and from trough to trough (from D to D’). The shortest of the cycle is called ‘seasonal cycle’.

Related Articles:

• 5 Phases of a Business Cycle (With Diagram)
• Business Cycles: Definition and Concept
• Business or Trade Cycles in an Economy: Meaning, Definition and Types
• Real GNP and Business Cycle (With Diagram)

What is Business Cycles? Phases, Types, Theory, Nature

• Post last modified: 1 August 2021
• Reading time: 40 mins read
• Post category: Economics

What is the Business Cycle?

Business Cycle , also known as the  economic cycle  or  trade cycle , is the fluctuations in economic activities or rise and fall movement of gross domestic product (GDP) around its long-term growth trend.

No era can stay forever. The economy too does not enjoy same periods all the time. Due to its dynamic nature, it moves through various phases.

Table of Content

• 1 What is the Business Cycle?
• 2 Business Cycle Definition
• 3.1 Expansion
• 3.3 Contraction
• 4.1 Cyclical nature
• 4.2 General nature
• 5 Types of Business Cycle
• 6.1 Hawtrey Monetary Theory
• 6.2 Innovation Theory
• 6.3 Keynesian Theory
• 6.4 Hicks Theory
• 6.5 Samuelson theory
• 7 Business Economics Tutorial

The change in business activities due to fluctuations in economic activities over a period of time is known as a business cycle . Business cycle are also called trade cycle or economic cycle. Business Cycle  can also help you make better financial decisions. 

The economic activities of a country include total output, income level, prices of products and services, employment, and rate of consumption. All these activities are interrelated; if one activity changes, the rest of them also change.

Also Read: What is Economics?

Business Cycle Definition

Arthur F. Burns and Wesley C. Mitchel defined business cycle definition as

Business cycle are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration, business cycle vary from more than one year to ten or twelve years; they are not divisible into shorter cycle of similar characteristics with amplitudes approximating their own. Arthur F. Burns & Wesley C. Mitchel

Also Read: What is Demand in Economics

Phases of Business Cycle

4 Phases of Business Cycle are:

Contraction

Let us discuss 4 phases of business cycle in detail:

Expansion is the first phase of a business cycle . It is often referred to as the growth phase .

In the expansion phase, there is an increase in various economic factors, such as production, employment, output, wages, profits, demand and supply of products, and sales. During this phase, the focus of organisations remains on increasing the demand for their products/services in the market.

The expansion phase is characterised by:

• Increase in demand
• Growth in income
• Rise in competition
• Rise in advertising
• Creation of new policies
• Development of brand loyalty

In this phase, debtors are generally in a good financial condition to repay their debts; therefore, creditors lend money at higher interest rates. This leads to an increase in the flow of money.

In the expansion phase, due to increase in investment opportunities, idle funds of organisations or individuals are utilised for various investment purposes. The expansion phase continues till economic conditions are favourable.

Peak is the next phase after expansion. In this phase, a business reaches at the highest level and the profits are stable. Moreover, organisations make plans for further expansion.

Peak phase is marked by the following features:

• High demand and supply
• High revenue and market share
• Reduced advertising
• Strong brand image

In the peak phase, the economic factors, such as production, profit, sales, and employment, are higher but do not increase further.

An organisation after being at the peak for a period of time begins to decline and enters the phase of contraction. This phase is also known as a recession .

An organisation can be in this phase due to various reasons, such as a change in government policies, rise in the level of competition, unfavourable economic conditions, and labour problems. Due to these problems, the organisation begins to experience a loss of market share.

The important features of the contraction phase are:

• Reduced demand
• Loss in sales and revenue
• Reduced market share
• Increased competition

In Trough phase, an organisation suffers heavy losses and falls at the lowest point. At this stage, both profits and demand reduce. The organisation also loses its competitive position.

The main features of this phase are:

• Lowest income
• Loss of customers
• Adoption of measures for cost-cutting and reduction
• Heavy fall in market share

In this phase, the growth rate of an economy becomes negative. In addition, in trough phase, there is a rapid decline in national income and expenditure.

After studying the business cycle , it is important to study the nature of business cycle .

Read: Difference Between Micro and Macro Economics

Nature of Business Cycle

The nature of business cycle helps the organisation to be prepared for facing uncertainties of the business environment.

Cyclical nature

General nature.

Let us discuss the nature of business cycle in detail.

This is the periodic nature of a business cycle. Periodicity signifies the occurrence of business cycle at regular intervals of time. However, periods of intervals are different for different business cycle . There is a general consensus that a normal business cycle can take 7 to 10 years to complete.

The general nature of a business cycle states that any change in an organisation affects all other organisations too in the industry. Thus, general nature regards the business world as a single economic unit.

For example, depression moves from one organisation to the other and spread throughout the industry. The general nature is also known as synchronism.

Read: What is Business Economics?

Types of Business Cycle

Following the writings of Prof .James Arthur and Schumpeter, we can classify business cycle into three types based on the underlying time period of existence of the cycle as follows:

• Short Kitchin Cycle
• Longer Juglar cycle
• Very long Kondratieff Wave

Short Kitchin Cycle (very short or minor period of the cycle, approximately 40 months duration)

Longer Juglar cycle (major cycles, composed of three minor cycles and of the duration of 10 years or so)

Very long Kondratieff Wave (very long waves of cycle, made up of six major cycles and takes more than 60 years to run its course of duration)

Also Read: Scope of Economics

Business Cycle Theory

A business cycle is a complex phenomenon which is common to every economic system. Several theories of business cycle have been propounded from time to time to explain the causes of business cycle.

Business Cycle Theory are:

Hawtrey Monetary Theory

Innovation theory.

• Keynesian theory

Hicks Theory

Samuelson theory.

Hawtray was of opinion that in depression monetary factors play a critical role. The main factor affecting the flow of money and money supply is the credit position by the bank. He made the classical quantity theory of money as the basis of his trade cycle theory .

According to him, both monetary and non-monetary factors also affect trade. His theory is basically the product of the supply of money and expansion of credit. This expansion of credit and other money supply instrument create a cumulative process of expansion which in return increase aggregate demand.

According to this theory the only cause of fluctuations in business is due to instability of bank credit. So it can be concluded that Hawtray’s theory of business cycle is basically depend upon the money supply, bank credits and rate of interests.

Criticism of this Business Cycle theory

• Hawtray neglected the role of non-monetary factors like prosperous agriculture, inventions, rate of profit and stock of capital.
• It only concentrates on the supply of money.
• Increase in interest rates is not only due to economic prosperity but also due to other factors.
• Over-emphasis on the role of wholesalers.
• Too much confidence in monetary policy. vi. Neglect the role of expectations. vii. Incomplete theory of trade cycles.

The innovation theory of business cycle is invented by an American Economist Joseph Schumpeter. According to this theory, the main causes of business cycle are over-innovations.

He takes the meaning of innovation as the introduction and application of such techniques which can help in increasing production by exploiting the existing resources, not by discoveries or inventions. Innovations are always inspired by profits. Whenever innovations are introduced it results into profitability then shared by other producers and result in a decline in profitability.

• Innovation fails to explain the period of boom and depression.
• Innovation may be major factor of investment and economic activities but not the complete process of trade cycle.
• This theory is based on the assumption that every new innovation is financed by the banks and other credit institutions but this cannot be taken as granted because banks finance only short term loans and investments.

Keynesian Theory

The theory suggests that fluctuations in business cycle can be explained by the perceptions on expected rate of profit of the investors. In other words, the downswing in business cycle is caused by the collapse in the marginal efficiency of capital, while revival of the economy is attributed to the optimistic perceptions on the expected rate of profit.

Moreover, Keynesian multiplier theory establishes linkages between change in investment and change in income and employment. However, the theory fails to explain the cumulative character both in the upswing and downswing phases of business cycle and cyclical fluctuations in economic activity with the passage of time.

Hicks extended the earlier multiplier-accelerator interaction theory by considering real world situation. In reality, income and output do not tend to explode; rather they are located at a range specified by the upper ceiling and lower floor determined by the autonomous investment.

In the theory, it is assumed that autonomous investment tends to grow at a constant percentage rate over the long run, the acceleration co-efficient and multiplier co-efficient remain constant throughout the different phases of the trade cycle, saving and investment co-efficient are such that upward movements take away from equilibrium.

The actual output fails to adjust with the equilibrium growth path overtime. In fact it has a tendency to run above it and then below it, and thereby, constitute cyclical fluctuations overtime. This basic intuition can be shown with the help of the following figure.

• Wrong assumption of constant multiplier and acceleration co-efficient.
• Highly mechanical and mathematical device.
• Wrong assumption of no-excess capacity.
• Full-employment ceiling is not independent

According to this theory process of multiplier starts working when autonomous investment takes place in the economy. With the autonomous investment income of the people rises and there is increase in the demand of consumer goods. It directly affected the marginal propensity to consume.

If there is no excess production capacity in the existing industry then existing stock of capital would not be adequate to produce consumer goods to meet the rising demand. Now in order to meet the consumer’s requirements, producers will make new investment which is derived investment and the process of acceleration principle comes into operation.

Then there is rise in income again which in the same manner continue the process of income propagation. So in this way multiplier and acceleration interact and make the income grow at faster rate than expected. After reaching its peak, income comes down to bottom and again start rising.

Autonomous investment is incurred by the government with the objective of social welfare. It is also called public investment. The autonomous investment is the investment which is done for the sake of new inventions in techniques of production.

Derived investment is the investment undertaken in capital equipment which is induced by increase in consumption.

• This model only concentrates on the impact of the multiplier and acceleration and it ignored the role of producer’s expectations, changing business requirements and consumers preferences etc.
• It is not practically possible to compute the fact of multiplier and acceleration principle.
• It has wrong assumption of constant capital output ratio.

Also Read: What is Law of Supply?

• D N Dwivedi, Managerial Economics , 8th ed, Vikas Publishing House
• Petersen, Lewis & Jain, Managerial Economics , 4e, Pearson Education India
• Brigham, & Pappas, (1972). Managerial economics , 13ed. Hinsdale, Ill.: Dryden Press.
• Dean, J. (1951). Managerial economics (1st ed.). New York: Prentice-Hall.

Business Economics Tutorial

( Click on Topic to Read )

• What is Economics?

Scope of Economics

• Nature of Economics
• What is Business Economics?
• Micro vs Macro Economics
• Laws of Economics
• Economic Statics and Dynamics
• Gross National Product (GNP)
• What is Business Cycle?
• W hat is Inflation?
• What is Demand?
• Types of Demand
• Determinants of Demand 
• Law of Demand
• What is Demand Schedule?
• What is Demand Curve?
• What is Demand Function?
• Demand Curve Shifts
• What is Supply?

Determinants of Supply

• Law of Supply
• What is Supply Schedule?
• What is Supply Curve?

Supply Curve Shifts

• What is Market Equilibrium?

Consumer Demand Analysis

• Consumer Demand
• Utility in Economics
• Law of Diminishing Marginal Utility
• Cardinal and Ordinal Utility
• Indifference Curve
• Marginal Rate of Substitution
• Budget Line
• Consumer Equilibrium
• Revealed Preference Theory

Elasticity of Demand & Supply

• Elasticity of Demand
• Price Elasticity of Demand
• Types of Price Elasticity of Demand
• Factors Affecting Price Elasticity of Demand
• Importance of Price Elasticity of Demand
• Income Elasticity of Demand
• Cross Elasticity of Demand
• Advertisement Elasticity of Demand
• Elasticity of Supply

Cost & Production Analysis

• Production in Economics
• Production Possibility Curve
• Production Function
• Types of Production Functions
• Production in the Short Run
• Law of Diminishing Returns
• Isoquant Curve
• Producer Equilibrium
• Returns to Scale

Cost and Revenue Analysis

• Types of Cost
• Short Run Cost
• Long Run Cost
• Economies and Diseconomies of Scale
• What is Revenue?

Market Structure

• Types of Market Structures
• Profit Maximization
• What is Market Power?
• Demand Forecasting
• Methods of Demand Forecasting
• Criteria for Good Demand Forecasting

Market Failure

• What Market Failure?
• Price Ceiling and Price Floor

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Did we miss something in Business Economics Tutorial? Come on! Tell us what you think about our article on Business Cycle | Business Economics in the comments section.

• What is Inflation?
• Determinants of Demand

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BUSINESS CYCLES AND FORECASTING GRADE 12 NOTES - ECONOMICS STUDY GUIDES

• Key concepts
• The composition and features of business cycles
• Explanations
• Government policy
• The new economic paradigm
• Features underpinning forecasting with regard to business cycles

Business cycles refer to fluctuations in economic activity or production over several months or years. They seem to indicate a long-term trend, typically involving shifts over time between periods of rapid economic growth (expansion or boom), and periods of stagnation or decline (contraction or recession). Forecasting relates to the economic indicators used to forecast the trends in the business cycle. Overview

2.1 Key concepts

These definitions will help you understand the meaning of key Economics concepts that are used in this study guide.

2.2 The composition and features of business cycles

2.2.1 Nature of business cycles

• Changes in economic activity are recurring but never exactly the same or of the same magnitude.
• Different circumstances and expectations cause consumers and producers to respond differently to initiating forces.
• The duration and amplitude of every business cycle will be different.
• Two periods namely contraction and expansion;
• Two turning points namely trough and peak;
• Four phases, namely recovery, prosperity, recession and depression.
• Economic activity is shown by the upward and downward movements of the curve.
• A period where there is a general increase in economic activity is known as an upswing.
• A period of general decline in economic activity is called a downswing.
• The business cycle oscillates between the upper (peak) and lower (trough) turning points along a trend line.
• The length of the business cycle is measured from peak to peak or from trough to trough.
• The entire period from the peak to the trough is known as the downswing.
• The entire period from the trough to the peak is known as the upswing.
• The period immediately before and through the upper turning point of the cycle is called the boom.
• The period immediately before and through the lower turning point is known as the slump.
• The trend line is the long-term average position or pattern.

2.2.3 Real (actual) business cycle

• An actual business cycle is obtained when the effects of irregular events, seasons and long-term growth trend are removed from the time series data.
• Figure 2.2 shows the real GDP of South Africa over a 12 year period displayed in a jagged diagram.
• The length or duration of the cycle is measured from trough to trough or peak to peak.
• The percentage point difference of successive peaks and troughs can be calculated e.g. a + b (3 + 5 = 8) compared to b + c (5 + 1.5 = 6.5).

Exogenous includes, amongst many others, the monetarist view. Endogenous focuses mainly, but not only, on the Keynesian approach

2.3 Explanations

There are numerous theories as to the causes of business cycles. Among these are the monetarist approach and the Keynesian approach. The government uses monetary instruments such as interest rates to mediate these business cycles. 2.3.1 The exogenous explanation Exogenous variables are those independent factors that can influence business cycles and originate outside the economy. Some economists believe that business cycles are caused by exogenous factors such as those described below:

• The monetarists believe markets are inherently stable and disequilibrium is caused by incorrect use of policies, e.g monetary policy.
• Weather conditions and market shocks cause upswings and downswings.
• Governments should not intervene in the market.
• Sunspot theory based on the belief that increased solar radiation causes changes in weather conditions.
• Technological changes.
• This is often called the Keynesian view.
• The Keynesian approach holds the view that markets are inherently unstable and therefore government intervention may be required.
• The price mechanism fails to co-ordinate demand and supply in markets and this gives rise to upswings and downswings.
• Prices are not flexible enough (e.g. wages).
• A business cycle is an inherent feature of a market economy.
• Indirect links or mismatches between demand and supply are normal features of the economy.
• Kitchen cycles: last between 3 to 5 years caused by adapting inventory levels in businesses.
• Jugler cycles: last from 7 to 11 years and are caused by changes in net investments by government and businesses.
• Kuznets cycles: last between 15 to 20 years, caused by changes in activity in the building and construction industry.
• Kondratieff cycles: last longer than 50 years, caused by technological innovations, wars and discoveries of new deposits of resources e.g. gold.

2.4 Government policy

Government can use monetary and/or fiscal instruments to help stabilise business cycles, also called “fine tuning” the economy. 2.4.1 Policy instruments MONETARY POLICY – can be defined as policies used by monetary authorities (SARB and MPC) to change the quantity of money in circulation as well as the interest rates, with the aim to stabilise prices, reach full employment and achieve high economic growth. The size of the M3-money stock is an important determinant of the quantity of money. The following TWO theories explain changes in the quantity of money and its impact on the economy:

• The quantity theory of money shows how an increase in the stock of money can lead to an increase in the inflation rate and a decrease in the buying power of money. Quantity theory-equation: MV = PT Where: M = Total stock of money V = Velocity of money P = Prices of goods and services T = Quantity goods and services When the stock of money (M) increases, prices (P) will rise and because production (T) cannot be increased immediately it will lead to INFLATION, assuming velocity (v) remains constant.
• The second theory links the change in deposits and the cash reserve requirement. If the amount of new deposits increase, the money multiplier kicks in: Tm = ΔD × 1/rd Where: Tm = Total stock of money at the end of the process ΔD = The initial inflow of new money to the banks/new deposits Rd = Minimum cash reserve percentage kept by banks.

It can be seen that a relatively small deposit of R1 000 with a relatively small cash reserve requirement of 5% (0,05) may lead to a relatively large increase in the total stock of money. Tm = 1 000 × 1/0,05 = 1 000 × 20 = R20 000

• Keeping the TWO theories in mind, the central bank can use the following instruments separately or jointly from its arsenal of monetary and related policy instruments in a selective or discretionary manner:
• Open market transactions The SARB can directly increase/decrease the supply of money by buying/selling government securities in the open market.
• Interest rates If banks experience a shortage of funds in the money market, they are accommodated by the SARB, when they are allowed to borrow money through the Repo system (Repurchase tender system) at a rate known as the repo rate. By increasing this rate, money becomes more expensive for commercial banks, who pass on the increase to their clients by increasing interest rates on loans. Loans become more expensive to the consumer and so the demand for money will decrease.
• Cash reserve requirements The SARB is permitted by the Banks Act to occasionally change the minimum cash balances the banks are required to maintain in order to manipulate the money creation activities of the banks. See the money multiplier equation. Change the 5% to 10% and see what the effect would be on the creation of credit/money in the economy.

SARB buys bonds from ABSA → more money flows into the economy so money supply increases. SARB sells bonds to ABSA → money flows out of the economy and money supply decreases.

FISCAL POLICY – Fiscal policy = Is the process of using taxation and public expenditure to even out the swings of the business cycle. Governments, through their fiscal policy have a powerful weapon for stabilising/ironing out/smoothing of cycles, to stop peaks from ending in high inflation and troughs in too high levels of unemployment.

The original equilibrium situation: Accepts that all economic activities are stable and all markets in equilibrium. Assumes the beginning of the following undesired conditions/problems:

• Raising government spending (G) with borrowed money (Budget Deficit). Aggregate expenditure increases and so does demand. The economy is stimulated and employment is likely to increase.
• Decreasing taxes . Consumers and producers have a larger part of their incomes available to spend on goods and services. Aggregate expenditure increases. The economy is stimulated and employment is likely to increase.
• Raising government spending and simultaneously decreasing taxes . This will have a double effect. Government spending increases and consumers and producers also have more to spend. Demand increases substantially. Employment increases.
• Cut down on government spending (G). The unspent money is preserved. Aggregate expenditure is less and demand drops. Inflation is likely to decrease.
• Increasing taxes (T ). Workers pay more tax and this results in consumers having less income to spend and demand dropping. Inflation is likely to decrease.
• Reducing government spending (G) and simultaneously increasing taxes (T) . This will have a double effect. Government spending decreases and consumers and producers also have less to spend. Demand drops substantially. Inflation decreases.

A COMBINATION OF MONETARY AND FISCAL POLICY: The strongest effects are obtained when a government uses these policies in combination with one another to manipulate aggregate demand.

Restrictive policies make the economy slow down. Expansionary policies make the economy go faster (grow).

2.5 The new economic paradigm

The “new economic paradigm” discourages policy makers from using monetary and fiscal policies to fine-tune the economy, but rather encourages achieving stability through sound long-term policy decisions relating to demand and supply in an economy.

2.5.1 Demand-side policies Demand-side policies focus on aggregate demand in the economy. When households, firms and government spend more, demand in the economy increases. This makes the economy grow but can lead to inflation.

• Aggregate demand increases more quickly than aggregate supply and this causes prices to increase.
• If the supply does not react to the increase in demand, prices will increase.
• This will lead to inflation (a sustained and considerable increase in the general price level).
• Demand-side policies are effective in stimulating economic growth.
• Economic growth can lead to an increase in the demand for labour. As a result more people will be employed and unemployment will decrease.
• As unemployment decreases inflation is likely to increase. This relationship between unemployment and inflation is illustrated using the Phillips curve.

2.5.2 Supply-side policies Supply-side policies include:

• Infrastructural services
• Administrative costs
• Cash incentives
• Capital consumption
• Human resources development
• Free advisory services
• Deregulation
• Competition
• Levelling the playing field

2.6 Features underpinning forecasting with regard to business cycles

There are many economic indicators that can be used to forecast business cycles. Some of these are: 2.6.1 Leading indicators

• Leading indicators give consumers, businesses and the state a glimpse of the direction in which the economy might be heading.
• When these indicators rise, the level of economic activities will also rise a few months later.
• Examples of leading indicators are job advertising space; inventory; and sales.

2.6.2 Co-incident indicators

• Co-incident indicators move at the same time as the economy.
• They indicate the actual state of the economy.
• Examples of these indicators are value of retail sales and real GDP.

2.6.3 Lagging indicators

• Lagging indicators won’t change direction until after the business cycle has changed its direction.
• Examples of these indicators are hours worked in construction and total of commercial vehicles sold.

2.6.4 Composite indicators

• It is a grouping of various indicators of the same type into a single value.
• The single figure forms the norm for a country’s economic performance.

2.6.5 Trend

• The trend is the general direction of the economy.
• The trend line that rises gradually will be positively sloped in the long run. This rising line indicates a growing economy.

2.6.6 Length

• Length is measured from peak to peak or from trough to trough.
• Longer cycles show strength and shorter cycles show weakness with regard to economic activities.

2.6.7 Amplitude

• Amplitude refers to the vertical (height) difference between a trough and the next peak of a cycle.
• The larger the amplitude, the more extreme the changes that occur.

2.6.8 Extrapolation

• Extrapolation means to estimate something unknown from facts that are known. For example, extrapolations from known facts are used to predict future share prices.

2.6.9 Moving averages

• Moving avarages are used to analyse the changes in a series of data over a certain period of time.

Leading indicators show us where we’re heading ♪ Lagging indicators won’t change direction Co-incident indicators, moving together

What’s the trend? Show me the way What’s the length? Weak or strong today

Pump up the amplitude to see the difference I need to extrapolate to make my predictions♫

(Create a song to help you remember these seven forecasting features. Singing the words to a catchy tune over and over again will help you.)

• Define the term business cycle. (3)
• Indicate which indicator is represented by T. (2)
• What is measured by the horizontal axis? (2)
• At which point did the economy reach a peak and a trough? (4)
• Identify the four phases into which the business cycle is divided in the above illustration. (8)
• How is the length measured in the above business cycle? (2)
• Explain lagging and coincident indicators used in the forecasting of business cycles. (2 × 4) (8) [29]
• What is the message behind the cartoon? (2)
• Why do you think that unemployment will not lead to an economic lift off? (2)
• To which forecasting indicator does unemployment refer? (2)
• How would you describe the recovery phase of a typical business cycle? (2) [8]

Activity 3 Discuss the monetarist approach as a cause of business cycles. [8]

Activity 4 Discuss the trend line in the forecasting of business cycles. [8]

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Economics Gr. 10 T1 W7 Lesson: Macroeconomics - Business cycles

Economics Grade 10 Term 1 Wk7  Lesson: Macroeconomics - Business cycles

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