During periods of economic expansion, the economy is growing in real terms excluding inflation as the evidence unfolds. Indicators increase such as employment, production, sales, and personal incomes. The increase in production brings about the need for more employees. Because of this, firms hire more people thereby amounting to the availability of more money to spend. Businesses become more profitable and focus on growth. On the other hand, during recessions, the economy experiences contraction as it is measured on the basis of decreases in the above indicators (employment, production, sales, and personal incomes). When production slows down, fewer employees will be needed thereby amounting to less availability of money to spend. In turn, spending on growth by businesses reduces. In essence, a positive change rate in production and consumption refers to economic expansion while a negative change rate on production and consumption refers to economic contraction. Economies measure their expansion from the peak to the trough.
Table of Contents
- What is a business cycle?
- Business cycle phases (stages)
- Business cycle graph
- Example of how supply and demand impact the business cycle
- How fiscal and monetary policy influence the business cycle
- Types of business cycle
- Causes of the business cycle
- Business Cycle FAQs
What is a business cycle?
The business cycle in economics refers to the fluctuations in economic activities that an economy encounters over a period of time. It is sometimes referred to as the trade cycle or economic cycle. It is defined on the basis of expansion and contraction periods of the economy. This is a process that repeats itself over time and the primary measurement is on the rise and fall of GDP in an economy. Business cycles have to do with a series of economic stages as it expands or contracts.
They are universal to every nation that operates under capitalism. Such an economy will experience natural periods of economic growth and declines but not all at the same time. However, as globalization increases, business cycles seem to take place almost at the same time across different parts of the world more frequently than before. In essence, the business cycle describes the increase and decrease in economic activities over a period of time.
Business cycle phases (stages)
The following are the 5 phases of the business cycle;
Expansion is the first stage of the business cycle where positive indicators such as employment, production, wages, profits, consumption, demand, and supply of goods and services increase. During this period, debtors generally pay their debts on time because the supply of money is at a high rate. Also, investment increases/high in this period. This process continues for as long as these indicators remain favorable for expansion. This stage is considered normal or the most desirable state of an economy. It is an up period of the economy. There is a steady growth of businesses, especially in their production and profits. The unemployment rate is low. The stock market is not left out also, it performs very well. Consumers purchase more commodities and invest more funds. With the increase of demand for goods and services, prices begin to rise. At this point, if an economy fails to control price rise, inflation will become hyper. With the increase in investments opportunities, organizations and individuals utilize idle funds for different investment purposes. In such cases, the inflow of cash equals the outflow of cash of businesses.
Another name for a peak in the business cycle is a saturation point. Here, the growth in the expansion phase slows down and gets to its peak. This is the second stage of the business cycle. It is the maximum limit of growth that an economy attains. The economic indicators are at their highest and because of this, they do not grow further. Prices are at the peak during this period which marks the reversal point in the trend of economic growth. At this point, consumers begin to restructure their budgets and debts. Demand for various products gradually decreases as a result of the increase in the prices of input. At this point, no room for further economic growth is left.
After the peak phase, the next phase of the business cycle is the recession. As discussed earlier, the demand for various products begins to decrease gradually due to the increase in the prices of input. When this decline becomes rapid and steady, then the economy experiences the recession phase. This is the phase whereby all economic activities begin to decrease. In general terms, producers are not aware of the decrease in the demand for goods and services. Because of this, they continue with the production of goods and services. As time goes on, producers will realize that there is a surplus in the supply of their products when the manufacturing cost has exceeded the profit generated. Few industries will first of all, experience this and then it will spread slowly to all industries.
Firstly, firms and industries consider this situation as a small fluctuation in the market. However, as this continues to exist for a longer period of time, they begin to notice it. The result of this is that producers will start avoiding any further investment in factors of production such as labor and capital. This, in turn, brings about a reduction in the prices of these factors thereby resulting in the decline of the demand for inputs and output.
Just as the peak is the highest point of the business cycle, the trough is the low point. It comes about when the recession phase bottoms out and begins to rebound into an expansion phase. Here, the business cycle begins all over again. Usually, this rebound is not always quick. that is, it is not a straight line along the way towards economic recovery. During the trough phase, the economic growth rate becomes negative, that is, economic activities decline below the normal level. In addition to this, there is a rapid fall in a country’s national income and expenditure.
In this phase, it becomes difficult for debtors to repay their debts. This brings about a decrease in interest rates and in turn, banks will not prefer to lend money to borrowers. Consequently, the cash balances of banks increase. Furthermore, the output level of the economy becomes low while unemployment becomes high. Also, investors tend not to invest in the stock market. In the trough phase, many organizations that are weak opt out of the industry or rather dissolve. This becomes the lowest level at which the economy shrinks.
Above, it was explained that an economy reaches its lowest level of shrinking in the trough phase. This is the limit to which an economy can shrink. As soon as the economy gets to its trough level, the negative state of the economy marks an end and begins to go back to its positive state. This then brings about the reversal process of the business cycle. In this case, organizations and individuals begin to develop a positive attitude towards different economic factors such as production, investment, and employment. Demand will begin to pick up due to low prices thereby bringing about an increase in supply. The reversal process begins in the labor market.
At this point, organizations will not continue to lay off individuals, they will start hiring people but in a limited number. The wages that organizations provide to individuals become less when compared to their skills and abilities. This marks the beginning of the recovery phase of the economy.
It is at this point also that banks begin to utilize their cash balances by declining the lending rate as they increase investments in various bonds and securities. Investors similarly adopt a positive approach as they also start investing in the stock market. As a result of this, the prices of security increase while the interest rate decreases.
In the recovery phase of an economy, price mechanism plays a vital role. We discussed that during the recession, the falling rate of the price of factors of production is greater than the reduction rate of the prices of final products.
At the trough phase, producers will be able to generate a certain amount of profit. In the recovery phase, the increase in profit continues. Aside from this, producers replace some of the depreciated assets/capital goods and maintain some. This results in an increase in employment and investment by organizations. As this process continues, the economy gains entrance into the expansion phase thereby completing the business cycle.
Business cycle graph
The phases of the business cycle can be explained in a diagram below;
Example of how supply and demand impact the business cycle
In the beginning
Economic expansion results because of the confidence that consumers have in the economy. They believe in their hearts that employment is steady and there is a guarantee of income. Because of this, they spend more which brings about an increase in demand. This causes firms to hire more people to work and increase capital expenditure to meet up the demand. Investors allocate more capital to assets thereby bringing about an increase in stock prices.
The economy gets to its peak of expansion when the demand exceeds the supply. In this case, businesses take additional risks to meet up to the increase in demand as well as remain competitive in the market.
Inflation increases too fast when interest rates rise quickly, or financial crisis in the economy, the economy begins to contract. The confidence that stimulated the economic growth evaporates quickly, replacing it with diminishing consumer confidence. Rather than spending money, individuals save thereby reducing demand. On the other hand, businesses cut down production and lay off workers as their sales dry up. In order to avoid a drop in the value of portfolios, investors sell their stocks.
At the trough phase, demand and production reach their lowest point. However, there is a need for these factors to reassert themselves. Gradually, consumers begin to gain confidence as improvement begins all over again in economic activities as government policies and actions spur this. Here, consumers begin to buy and invest as the economy enters a new phase of expansion.
How fiscal and monetary policy influence the business cycle
Although the business cycle moves in a natural phase, it can be influenced. Countries usually try managing the different stages of slowing down business cycles as well as speeding them up through the use of fiscal policy and monetary policy. While the government carries out fiscal policy, the central bank of a nation carries out monetary policy. For example, during contraction particularly in a recession, governments make use of expansionary fiscal policies which comprises the increase in expenditure of projects, cutting down taxes, or both. These measures bring about an increase in the levels of disposable income that consumers can either spend, save, or invest. In turn, this stimulates economic growth. On the other hand, during a rapid economic expansion, the government can make use of contractionary fiscal policies which has to do with reducing government expenditure on projects, increasing taxes, or both. In turn, this helps to slow down the economy when it is growing too fast in order to control inflation.
In the same vein, the central bank will use an expansionary monetary policy to bring an end to the economic recession by reducing interest rates thereby making borrowing money to be cheaper. In turn, this stimulates spending and the economy eventually. On the other hand, the central bank will employ a contractionary fiscal policy if the economy is growing too fast. This has to do with increasing interest rates thereby making borrowing more expensive. This in turn makes the act of spending money less attractive.
The aim of fiscal and monetary policies is to keep the economic growth at a sustainable rate as well as create adequate job opportunities for those seeking it, and make the growth slow enough not to increase
Types of business cycle
According to Prof James Arthur and Schumpeter, the business cycle can be classified into three major types. This classification is on the basis of the underlying time period in which the business cycle exists. They are;
- Short kitchen cycle
- Longer jugular cycle
- Very long Kondratieff wave
A short kitchen cycle refers to a very short or minor period of the business cycle with an approximation of 40 months duration. The longer jugular cycle refers to a major cycle that comprises three minor cycles with a duration of approximately 10 years. Lastly, the very long Kondratieff wave has to do with very long waves of the business cycle and this comprises six major cycles which take more than 60 years to run their course.
Causes of the business cycle
The business cycle occurs as a result of many factors in combination. This can be categorized into;
- Internal factors
- External factors
The internal factors that bring about a change in the phases of an economy are;
- Changes in demand
- Investment fluctuations
- Macroeconomic policies
- Money supply
- Psychological factors
Changes in demand
Keynesian economists believe that changes in demand bring about a change in economic activities. The firms in an economy begin to produce more goods as demand increases. This brings about more output, employment, income, and higher profits. In turn, there will be an economic boom. However, there will be inflationary pressures if demand exceeds supply. On the other hand, a fall in demand below the level of supply brings about a decrease in economic activities. This will bring about a contraction in the economy and if it persists, depression may unfold.
Just the way demand fluctuates, investment does. This is a major cause of business cycles. There are many factors that bring about fluctuations in investment such as interest rate in the economy, profit expectation, and entrepreneurial interest. Economic activities increase correspondingly with an increase in investment. So also, the economy contracts with a decrease in investment.
The fiscal and monetary policies of a nation bring about changes in the phases of business cycles. If these policies are geared towards expanding economic activities as well as promoting investment, then there will be an economic boom. On the other hand, an increase in interest rates and taxes will bring about a contraction or a recession in the economy.
Supply of money
A belief exists that business cycles are purely monetary factors. Therefore, changes in the supply of money will bring about business cycles. While an increase in the supply of money will bring about economic expansion and growth, a decrease in the supply of money contracts the economy. However, if the supply of money is too much in the economy, there will be inflation which can be adverse to the economy.
Pigou pointed out that business cycles appear as a result of the optimistic and pessimistic moods of the entrepreneur. Investments will increase when they are optimistic about the future conditions of the market. This in turn expands the phase of the business cycle which will ultimately result in an economic boom. on the other hand, investments reduce when entrepreneurs are pessimistic thereby shifting investment, production, and employment. This turns down the trend in economic activities which brings about recession and even depression.
The external factors that bring about the business cycle are;
- Post-war period
- Technological development
- Natural factors
- Population expansion
In periods of war and unrest, a country puts economic resources to make goods such as weapons, arms, and other commodities for war. This situation shifts the focus of the government from consumer goods and capital goods. This then brings about a fall in personal income, employment, and economic activities. The effect that war has on an economy is that the economy faces a downturn. In other words, economic activities contract.
During the post-war period, the focus of the nation will be on rebuilding as there will be a need to reconstruct infrastructural facilities such as houses, roads, and bridges. With progress with regard to this, the economy will be able to pick up again. As economic activities keep on moving upward, demand will increase. In essence, the level of consumption and investment increases as well bringing about an effective increase in economic indicators such as income and employment.
Technological development is oftentimes a factor that boosts the economy. New technology implies new investment, an increase in employment, and then higher income and profits follow subsequently. An example is the invention of improved mobile phones which brings about a boost in the telecommunication industry. Technological development is a factor that has a great effect on the business cycle. This requires a great or huge amount of investment to manufacture these products. This in turn will bring about an increase in employment, profit, and income.
Natural factors such as droughts, floods, hurricanes, etc can destroy agricultural products. This in turn is a great loss to the agricultural sector. When there is a shortage of food, there will be an upward shift in the prices of commodities thereby bringing about a high rate of inflation. This will also bring about a decrease in the demand for capital goods. On the other hand, the favorable weather condition is a thing of joy to the agricultural sector. Output goes up thereby increasing the demand for capital goods.
Uncontrolled growth in population can bring about a problem to the economy. That is, the economic savings begin to shrink when the growth in the population exceeds the economic growth. Investments will also reduce thereby lowing down the economy even to a state of depression.
Business Cycle FAQs
What are the 5 phases of the business cycle?
The 5 phases of the business cycle are expansion, peak, recession, trough, and recovery.
What is an example of a business cycle?
An example is the business cycle since the year 2000. In this business cycle, the activity of expansion took place between 2000 and 2007. Between 2007 to 2009, a great recession followed. This started with the fact that people had easy access to bank loans and mortgages. Because of this, it was easy for new homebuyers to afford loans. Consequently, the number of homebuyers kept on increasing which implied an increase in the demand for homes. This made the price of homes start increasing. The Federal Reserve kept on reducing interest rates and the Federal Government placed specific guarantees on mortgages which allowed banks to lend money to borrowers at a cheaper rate. This is because the government guaranteed money to banks, so there was no way they would lose their money. So, they began to lend to everyone.
Because of the fact that the measurement of expansions and other business cycle phases takes place in real GDP, there was an over speculation. This peak of economic activity took place in the year 2007, in December. It was at this point that people began to notice what happened and the price of housing began to fall.
In addition to this, interest rates increased in order to curtail excess borrowing, and this caused interest payments on mortgages to increase. The increase in interest rates alongside the dramatic fall in the prices of homes left many homeowners with sub-prime loans that they would eventually default on. From 2007 to 2009, the economy contracted down to the trough phase and it started recovering thereby completing the entire cycle.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.