Business cycles

The business cycle - or trade cycle - refers to the upturns and downturns of economic activity which commonly affect all economies.

While business cycles have been known about for centuries, it was not until the 1940s that they were fully analysed.[1] Since then, numerous theories have been put forward to explain the causes of cycles and how policy-makers can influence them.

Today, most economists [2] prefer to use the term 'short term fluctuations' in economic activity, rather than 'cycles' given that the idea of a cycle implies a balanced and symmetrical increase and decrease in economic activity, which is rarely the case with real-world cycles.

What happens in a business cycle?

The starting point for economists is to try to understand when an economy is in a stable equilibrium state and then explain the forces that can move it away from its stable equilibrium.

However, equilibrium does not mean 'ideal' - hence economists have traditionally referred to 'full-employment' equilibrium as optimum. While equilibrium means stable and balanced, an economy is constantly in a state of flux, pulled this way and that way by forces that can move it away from full-employment equilibrium towards a less desirable level of activity. Hence, economic fluctuations are the 'norm' rather than being abnormal.

Most economists argue that it is the role of policy-makers to prevent the extreme variations in economic activity that can result in significant economic problems.

Features of business cycles

Two features of business cycles are worth considering:

  1. Trends tend to persist over time. Once an economy moves into an upturn, with positive real growth, the trend is likely to continue.
  2. The variables involved in changes in real GDP, such as consumer spending, investment, productivity, employment and output, tend to move together - albeit with time lags.

Stages in the business cycle

Expansion

If we assume a stable equilibrium as a starting point - with a growth rate at around the economy's trend - say at 2.5% (which will vary from economy to economy), an expansion is the first phase in the cycle where real GDP increases. This could be triggered by an external (exogenous) shock. It is also suggested that changes within an economy's fundamental structure are cyclical, so that even in the absence of a shock, there is a tendency towards an increase in activity. In other words, external shocks - such as a fall in oil prices - may not be needed for an economy to expand.

The stages in a business cycle

The peak or 'boom' phase

Expansion may see growth rates rising above trend, and if the growth rates are significantly above trend and sustained the economy will experience a 'boom' phase. While this phase may continue for several years, growth is likely to slow, and at some point the cycle will reach its peak.

The downturn

At some point, either as a result of a shock, or because of an inbuilt tendency, rates of growth may start to slow down, and begin to decline. The economy may simply be readjusting, and moving back to a stable equilibrium, or a shock could trigger a fall in economic activity.

Recession and slump

When rates of growth turn negative, the economy will contract. This may be a temporary phenomenon, and result in a short-lived recession, or it may turn into a full-blown slump with several years of negative growth. It could be triggered by a significant global shock, such as the financial crisis of 2008-2010, or the COVID-19 pandemic, which started in early 2020.

The recovery

At some point economic activity will pick up, and the economy may recover some lost ground. This could occur as a 'natural' response to the recession, or more typically it may follow expansionary monetary and fiscal policy.

Expansion

The cycle is complete when an economy has 'fully' recovered and returns to its previous levels of real GDP, and once more enters an expansion phase.

Problems arising

At extreme points in the cycle economic problems will emerge which are likely to require corrective action.


    Problems associated with the boom phase

  1. Increases in economic activity may eventually lead to demand-pull inflation. Costs may also rise as a result of shortages, leading to cost-push inflation. Inflation can affect particular markets which cause specific difficulties, such as accelerating house prices and falling affordability.
  2. As the economy over-heats exports become relatively more expensive, and imports less expensive. Export competitiveness suffers, and trade problems arise - perhaps leading to a balance of payments deficit.
  3. The labour market becomes 'tight', with labour shortages in combination with rising wages. Wages may be driven up above productivity levels.
problems and policies associated with a business cycle

    Short term policy options to constrain growth

  1. Policy makers [governments and central banks] are likely to put the brakes on the economy with a range of contractionary policies, including:
  2. Tighter monetary policy, with monetary controls and higher interest rates.
  3. Tighter fiscal policy, with higher taxes and controls on public sector spending.
  4. Specific policies to reduce heat in the economy, such as public sector pay controls, price-caps, and encouraging inward migration.

    Problems associated with the slump phase

  1. Falling economic activity may lead to price deflation, postponed consumption, and falling consumer and business confidence.
  2. Falling activity means falling revenue to firms, lower profits, and rising unemployment.
  3. Business investment is postponed, leading to further job losses.
  4. Some wages may fall as firms look to cut costs - given that unemployment is high, workers cannot easily find higher paid jobs.
  5. Poverty levels may rise as a consequence of rising unemployment.

    Short term policy options to encourage growth

  1. Policy makers are likely to intervene to stimulate the economy with a range of expansionary policies, including:
  2. Looser monetary policy, with relaxations in monetary controls and lower interest rates.
  3. Looser fiscal policy, with lower taxes and increases in public sector spending, often financed by borrowing.
  4. Specific policies to increase economic activity in the economy, such as an increase in the national minimum wage, spending on infrastructure and green technology, and increased welfare benefits to the unemployed. As a result of the COVID-19 pandemic, governments around the world adopted aggressive policies to pump demand into the economy, and protect vulnerable workers, including furlough schemes and 'bounce-back' loans to businesses.

Footnote - Causes of business cycles


Much work has been directed at trying to understand the causes of business cycles.

The demand-side

Keynesians

Keynesian theories tend to focus on aggregate demand, and how changes in the components of aggregate demand can create upswings and downswings, especially changes in investment.

Multiplier-accelerator model

The multiplier-accelerator model places capital investment at its centre. The multiplier component suggests that an increase in investment may have a significant impact on national income and output.

Firstly, increased investment adds to AD, and secondly, the effect is multiplied by a continued circulation of additional spending.

The accelerator component looks at the consequences of an increase in income and output on the level of investment. If firms expect increases in income and output to be sustained and that their future profits will increase, they will invest more (perhaps significantly more) today, and by a greater proportion if they assume that the upward trend in income and output will be sustained.

Putting the two effects together we can see that an increase in investment can trigger an increase in income and output (the multiplier) which then triggers an increase in investment as a response to the possibility of increased profit (the accelerator).

For example, as economies emerge out of the COVID-19 pandemic consumers will release ‘pent-up’ demand and spending will rise - this will trigger an increase in output, investment and employment, which in turn will increase consumer confidence.

The increased investment then feeds back into increased aggregate demand, output and employment and the upward trend continues.

Downturns are also likely to be caused by downward changes in investment, such as those following the financial crisis.

Keynesians are skeptical that there are adjustment mechanisms within an economy which automatically bring the business cycle back towards stability, and hence support active government intervention to reduce the amplitude of the natural business cycle.

Monetarists

In contrast, monetarists propose that business cycles are monetary phenomena, and that changes in the money supply and financial conditions determine how an economy moves over time. The policy implication of this is that central banks should control the money supply, which in turn will help stabilise an economy.

Stock price cycles

Stock markets tend to move 'in sympathy' and slightly ahead of changes in the real economy. Share prices are influenced by people's expectations of future share price changes, which depend on business profits. When share (and other asset) prices rise holders of shares experience a positive wealth effect which encourages 'equity withdrawal' and stimulates spending. However, business cycles are difficult to predict, and changes in share prices are not a consistently reliable indicator of upturns or downturns.

Stock price models can demonstrate that a productivity boom may lead to a stock price and output boom that eventually collapses. [3]

The supply-side

Real Business Cycle Theory

In contrast Real Business Cycle Theory focuses on the role of technological shocks and productivity improvements in building and sustaining growth periods. [4]

In these theories, demand-side shocks, such as changes in the money supply, are seen as less significant. Graphically, the cycle is related much more to shifts in LRAS than to shifts in AD. [5]

This means that it is potential output that changes, and not AD. The observed cycles are simply the efficient adjustment of the economy to supply shocks.

Critics argue that Real Business Cycle Theory is more an explanation of the persistence of upward trends resulting from technological progress rather than being a complete theory of both upward and downward trends. [6]


Consumer spending

Consumer spending and aggregate demand

Consumer spending
Investment spending

What determines export spending?

Investment
Supply-side policy

How effective is supply-side policy?

Supply-side policy

[1] US economists, Arthur Burns and Wesley Mitchell first analysed business cycles in Measuring Business Cycles,, 1946 published by the National Bureau of Economic Research (NBER).

[2] Romer, Christina D, Business Cycles, viewed 21 May 2021, https://www.econlib.org/library/Enc/BusinessCycles.html

[3] Adam, K, Merkel, S, Working Paper Series Stock Price cycles and Business cycles, ECB September 2019, viewed June 4, 2021 https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2316~4effe6153e.en.pdf

[4] Ahmad, S, Real Business Cycles: A Survey of Theories And Evidence, 1996, https://www.lpem.org/repec/lpe/efijnl/199617.pdf

[5] Lipsey, R G, Chrystal, A, 2004, Economics, OUP.

[6] Begg, D, Vernasca, G, Fischer, S, Dornbusch, R, Economics, 2014, McGraw-Hill Education