Business Cycles
Learning Outcomes
After studying this unit, you would be able to
- Explain the Meaning of Business Cycles.
Describe the Different . ‘ of Business Cycles.
Explain the Features of Business Cycles.
Explain the General Causes behind these Cycles.
Elucidate the relevance of Business Cycles in Business Decision Making.
Introduction
Examples of business cycles include the rapid growth in the UK's GDP during the 1920s and China’s recent economic slowdown.
The UK's growth was driven by new technologies and production processes, such as the assembly line, leading to increased stock market values.
China’s slowdown has fostered a cycle of decline and panic across the world, escalating the risks of prolonged slumps and financial losses.
Business Cycles
We have seen in chapter 1 that Economics is concerned with fluctuations in economic activities.
The economic history of nearly all countries point towards the fact that they have gone through fluctuations in economic activities i.e. there have been periods of prosperity alternating with periods of economic downturns.
These rhythmic fluctuations in aggregate economic activity that an economy experiences over a period of time are called business cycles or trade cycles.
A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentage, altering with periods of bad trade characterised by falling prices and high unemployment percentages.
In other words, business cycle refers to alternate expansion and contraction of overall business activity as manifested in fluctuations in measures of aggregate economic activity, such as, gross national product, employment and income.
A noteworthy characteristic of these economic fluctuations is that they are recurrent and occur periodically.
That is, they occur again and again but not always at regular intervals, nor are they of the same length.
It has been observed that some business cycles have been long, lasting for several years while others have been short ending in two to three years.
Phases of Business Cycle
Business cycles reflect upward and downward movements in economic variables.
A typical business cycle has four distinct phases:
Expansion (Boom or Upswing)
Peak (Boom or Prosperity)
Contraction (Downswing or Recession)
Trough or Depression
The 'trend' line represents steady economic growth without business cycles.
The cycle starts at the trough, where economic activities are at their lowest.
Expansion follows as production and employment increase.
The economy starts contracting after reaching the peak.
The downturn continues until it hits the trough.
After remaining at the lowest point for some time, the economy revives, starting a new cycle.
Expansion
Characterized by increases in:
National output
Employment
Aggregate demand
Capital and consumer expenditure
Sales and profits
Rising stock prices and bank credit
Continues until full employment of resources and maximum possible production are achieved.
Involuntary unemployment is almost zero with only frictional or structural unemployment remaining.
Prices and costs tend to rise faster.
High standard of living due to:
High consumer spending
Business confidence
Production and Factor incomes
Profits and investment
The growth rate eventually slows down and reaches its peak.
Peak
The highest point of the business cycle.
Inputs become difficult to find and input prices increase due to shortages.
Output prices rise rapidly, increasing the cost of living and straining those on fixed incomes.
Consumers reduce spending on housing and durable goods.
Actual demand stagnates.
Marks the end of expansion when economic growth stabilizes briefly before reversing.
Contraction
The economy cannot grow endlessly; demand decreases in certain sectors after the peak.
Investment and employment levels fall.
Producers continue producing at existing levels, anticipating high demand, leading to
Mismatch between demand and supply, with supply exceeding demand.
This spreads from a few sectors to all, causing producers to halt future investments.
Orders for equipment and inputs are cancelled, impacting input markets.
Input prices fall, and wage earners' incomes decline, reducing demand for goods and services.
Producers lower prices to reduce inventories and meet financial obligations.
Consumers postpone purchases, expecting further price decreases, causing aggregate demand to fall and widening the demand-supply gap.
The process intensifies, leading to severe recession.
Investments, production, and employment decline, further reducing incomes, demand, and consumption.
Business firms become pessimistic, reducing investments due to lowered profit expectations.
Bank credit shrinks, investor confidence is low, and stock prices fall.
Unemployment increases despite falling wage rates.
The process of recession is complete when severe contraction pushes the economy into depression.
Trough and Depression
Depression is a severe form of recession with extremely sluggish economic activities.
Growth rate becomes negative, and national income and expenditure decline rapidly.
Demand decreases, prices decline rapidly, and firms shut down facilities.
Mounting unemployment results in very little disposable income for consumers.
Interest rates fall, but demand for credit declines due to low investor confidence.
Availability of credit also falls due to potential banking or financial crises.
Industries, especially capital and consumer durable goods, suffer from excess capacity.
Bankruptcies and liquidations reduce trade and commerce significantly.
All economic activities touch the bottom at the depth of depression, reaching a trough.
The Great Depression of 1929-33 is an example of enormous misery and human sufferings caused by depression.
Recovery
The economy cannot contract endlessly and starts recovering after reaching the trough.
Trough lasts for some time, marking the end of pessimism and the beginning of optimism.
The labor market initially feels the reversal process, where pervasive unemployment forces workers to accept lower wages.
Producers anticipate lower costs and a better business environment.
Business confidence improves, leading to renewed investments and inventory building.
The banking system starts expanding credit, and technological advancements spur investments in new machines and capital goods.
Employment increases, aggregate demand picks up, and prices gradually rise.
Price mechanism acts as a self-correcting process in a free enterprise economy.
Spurring of investment causes the economy to recover, marking a turning point from depression to expansion.
Increased spending causes increased aggregate demand, leading to more production of goods and services.
No economy follows a perfectly timed cycle, and business cycles are irregular, varying in intensity and length.
Difficult to predict turning points; economists use various activities as indicators.
Economic Indicators
Economists use changes in a variety of activities to measure the business cycle and to predict where the economy is headed towards. These are called indicators.
Leading Indicators
Definition: Measurable economic factors that change before the economy starts to follow a particular pattern or trend; variables that change before the real output changes.
Examples: Changes in stock prices, profit margins and profits, indices such as housing, interest rates and prices, value of new orders for consumer goods, new orders for plant and equipment, building permits for private houses, fraction of companies reporting slower deliveries, index of consumer confidence and money growth rate.
Limitations: Not always accurate; experts disagree on timing.
Even experts disagree on the timing of these so-called leading indicators. It may be weeks or months after a stock market crash before the economy begins to show signs of receding.
Nevertheless, it may never happen.
Lagging Indicators
Definition: Reflect the economy’s historical performance; changes are observable only after an economic trend or pattern has already occurred; variables that change after the real output changes.
Function: Confirm trends signaled by leading indicators.
Examples: Unemployment, corporate profits, labor cost per unit of output, interest rates, the consumer price index, and commercial lending activity.
Coincident Indicators
Definition: Coincide or occur simultaneously with business-cycle movements; describe the current state of the business cycle.
Function: Give information about the rate of change of expansion or contraction of an economy more or less at the same point of time it happens.
Examples: Gross Domestic Product, industrial production, inflation, personal income, retail sales and financial market trends such as stock market prices.
Examples of Business Cycles
Great Depression of 1930
The world economy suffered the longest, deepest, and the most widespread depression of the 20th century during 1930s. the global GDP fell by around between 1929 and 1932.
Started in the US and became worldwide.
Causes: Lower aggregate expenditures (Keynes), banking crisis and low money supply (monetarists), deflation, over-indebtedness, lower profits, and pessimism.
Impacts: Wide spread distress in the world as production, employment, income and expenditure fell.
Recovery: Increased money supply, huge international inflow of gold, increased governments’ spending due to World War II.
Information Technology bubble burst of 2000
Roughly covered the period 1997-2000.
The low interest rates in 1998–99 encouraged the start-up internet companies to borrow from the markets. Due to rapid growth of internet and seeing vast scope in this area, venture capitalists invested huge amount in these companies.
Description: Many new Internet–based companies (dot-com companies) were started; venture capitalists invested heavily; company stock prices increased by adding an "e-" prefix or ".com" suffix.
Unsustainable Practices: "Growth over profits" mentality led to lavish spending.
Collapse: Occurred during 1999–2001; dot-com companies ran out of capital and were acquired or liquidated; stock markets crashed.
Recent Example of Business Cycle: Global Economic Crisis (2008-09)
Origin: US financial markets.
Trigger: US Federal Reserve reduced interest rates to combat recession after the Information Technology bubble burst of 2000.
Effects of low interest rate: Led to large liquidity or money supply with the banks and credit became cheaper. the households, even with low creditworthiness, began to buy houses in increasing numbers
Housing bubble: Rising prices led to a belief prices would continue to rise leading to houses were built in excess during the boom period and due to their oversupply in the market, house prices began to decline in 2006.
Housing bubble got burst in the second half of 2007. With fall in prices of houses which were held as mortgage, the sub - prime households started defaulting on a large scale in paying off their instalments. This caused huge losses to the banks.
Impact: Losses in banks and financial institutions had a chain effect and soon the whole US economy and the world economy at large felt its impact.
Features of Business Cycles
Business cycles differ in duration and intensity, but commonly exhibit:
Periodicity: Occur periodically but without regularity; duration and intensity vary.
Distinct Phases: Expansion, peak, contraction, and trough phases lack smoothness and regularity.
Origin in Free Market Economies: Generally originate in free market economies and are pervasive.
Uneven Sector Impact: Some sectors like capital goods and durable consumer goods are disproportionately affected; industrial sector more prone than agricultural.
Complexity: Complex phenomena with varying characteristics and causes, making accurate prediction difficult.
Simultaneous Impact: Repercussions felt on output, employment, investment, consumption, interest, trade, and price levels.
Contagion: Contagious and international in character, spreading through trade relations.
Serious Consequences: Have serious consequences on the well-being of society.
Causes of Business Cycles
May occur due to external causes or internal causes or a combination of both.
Examples: The 2001 recession was preceded by an absolute mania in dot-com and technology stocks, while the 2007-09 recessions followed a period of unprecedented speculation in the U.S. housing market.
Internal Causes
Internal causes or endogenous factors which may lead to boom or bust are:
Fluctuations in Effective Demand: According to Keynes, fluctuations in economic activities are due to fluctuations in aggregate effective demand (Effective demand refers to the willingness and ability of consumers to purchase goods at different prices).
Higher aggregate demand leads to more output, income, and employment.
If aggregate demand outstrips aggregate supply, it causes inflation.
Low aggregate demand leads to lesser output, income, and employment.
The difference between exports and imports is the net foreign demand for goods and services. This is a component of the aggregate demand in the economy, and therefore variations in exports and imports can lead to business fluctuations as well.
Fluctuations in Investment: According to some economists, fluctuations in investments are the prime cause of business cycles.
Investment spending is the most volatile component of aggregate demand.
Investments fluctuate due to changes in profit expectations of entrepreneurs and the rate of interest.
Variations in Government Spending: Fluctuations in government spending with its impact on aggregate economic activity result in business fluctuations.
Government spending, especially during and after wars, has destabilizing effects on the economy.
Macroeconomic Policies: Macroeconomic policies (monetary and fiscal policies) also cause business cycles.
Expansionary policies boost aggregate demand, resulting in booms.
Softening of interest rates leads to inflationary effects and decline in unemployment rates.
Anti-inflationary measures cause a downward pressure on aggregate demand, slowing down the economy.
Money Supply: According to Hawtrey, trade cycle is a purely monetary phenomenon.
Unplanned changes in supply of money may cause business fluctuation in an economy.
An increase in the supply of money causes expansion in aggregate demand and in economic activities.
Excessive increase of credit and money also set off inflation in the economy.
On the other hand, decrease in the supply of money may reverse the process and initiate recession in the economy.
Psychological Factors: According to Pigou, modern business activities are based on the anticipations of business community and are affected by waves of optimism or pessimism.
Business fluctuations are the outcome of these psychological states of mind of businessmen.
External Causes
External causes or exogenous factors which may lead to boom or bust are:
Wars: During war times, production of war goods, like weapons and arms etc., increases and most of the resources of the country are diverted for their production.
This affects the production of other goods - capital and consumer goods. Fall in production causes fall in income, profits and employment.
Post War Reconstruction: After war, the country begins to reconstruct itself. Houses, roads, bridges etc. are built and economic activity begins to pick up.
All these activities push up effective demand due to which output, employment and income go up.
Technology Shocks: Growing technology enables production of new and better products and services. These products generally require huge investments for new technology adoption.
This leads to expansion of employment, income and profits etc. and give a boost to the economy.
Natural Factors: Weather cycles cause fluctuations in agricultural output which in turn cause instability in the economies, especially those economies which are mainly agrarian.
In the years when there are draughts or excessive floods, agricultural output is badly affected.
Population Growth: If the growth rate of population is higher than the rate of economic growth, there will be lesser savings in the economy.
Fewer saving will reduce investment and as a result, income and employment will also be less.
Relevance of Business Cycles in Business Decision Making
Understanding the business cycle is important for businesses of all types as they affect the demand for their products and in turn their profits which ultimately determines whether a business is successful or not.
Knowledge regarding business cycles and their inherent characteristics is important for a businessman to frame appropriate policies.
Business cycles have tremendous influence on business decisions. The stage of the business cycle is crucial while making managerial decisions regarding expansion or down-sizing.
Businesses have to advantageously respond to the need to alter production levels relative to demand. Different phases of the cycle require fluctuating levels of input use, especially labour input.
Firms should exercise the capability to expand or rationalize production operations so as to suit the stage of the business cycle.
Business managers need to work effectively to arrive at sound strategic decisions in complex times across the whole business cycle, managing through boom, downturn, recession and recovery.
Businesses whose fortunes are closely linked to the rate of economic growth are referred to as "cyclical" businesses. These include fashion retailers, electrical goods, house-builders, restaurants, advertising, overseas tour operators, construction and other infrastructure firms.
During a boom, such businesses see a strong demand for their products but during a slump, they usually suffer a sharp drop in demand.
Understanding what phase of the business cycle an economy is in and what implications the current economic conditions have for their current and future business activity, helps businesses to better anticipate the market and to respond with greater alertness.
Summary
The rhythmic fluctuations in aggregate economic activity that an economy experiences over a period of time are called business cycles or trade cycles and are manifested in fluctuations in measures of aggregate economic activity such as gross national product, employment and income.
A typical business cycle has four distinct phases namely,
Expansion (also called boom or upswing) characterized by increase in national output and all other economic variables.
Peak of boom or prosperity refers to the top or the highest point of the business cycle.
Contraction (also called downs-wing or recession) when there is fall in the levels of investment, employment.
Trough or depression occurs when the process of recession is complete and there is severe contraction in the economic activities.
Economists use changes in a variety of activities to measure the business cycle and to predict where the economy is headed towards. These are called indicators.
A leading indicator is a measurable economic factor that changes before the economy starts to follow a particular pattern or trend. i.e. they change before the real output changes.
Variables that change after real output changes are called ‘Lagging indicators’.
Coincident economic indicators, also called concurrent indicators, coincide or occur simultaneously with the business-cycle movements.
According to Keynes, fluctuations in economic activities are due to fluctuations in aggregate effective demand.
According to some economists, fluctuations in investments are the prime cause of business cycles. Investment spending is considered to be the most volatile component of the aggregate demand.
Fluctuations in government spending with its impact on aggregate economic activity result in business fluctuations.
Macroeconomic policies, (monetary and fiscal policies) also cause business cycles.
According to Hawtrey, trade cycle is a purely monetary phenomenon. Unplanned changes in the supply of money may cause business fluctuation in an economy.
According to Pigou, modern business activities are based on the anticipations of business community and are affected by waves of optimism or pessimism.
According to Schumpeter, trade cycles occur as a result of innovations which take place in the system from time to time.
Understanding what phase of the business cycle an economy is in and what implications the current economic conditions have for their current and future business activity, helps businesses to better anticipate the market and to respond with greater alertness.