Encyclopedia of Business and Finance | Economic Cycles

Economic cycles, more commonly called business cycles, are the recurring expansion and contraction of the national economy. This is a phenomenon that is unique to a private or free-enterprise economic system, also called a capitalist economy. Other systems do experience some of the same characteristics of the free-enterprise economy; however, business/economic cycles in the capitalistic economy are the focus of attention in this discussion.

The individual who is most famous for research on the business/economic cycle is Wesley Mitchell. He defined the business cycle as follows:

Business cycles 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; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximately their own. (Burns and Mitchell, 1946, p. 3)

This definition illustrates Mitchell's point that business/economic cycles occur in private-enterprise but not other systems. He also pointed out that business cycles are not unique to a single firm or industry; they affect an entire economy. Although all cycles follow the same basic pattern, they differ in many ways, such as longevity and severity. Mitchell also points out that an economic cycle can last from one to twelve years.

UNDERSTANDING THE BUSINESS CYCLE

Business/economic cycles go through increases and decreases while reaching peaks and troughs. To begin thinking about a cycle, think about a trough, or the lowflat part of the cycle, which moves to a peak and then to a terminating trough. In order to determine and isolate a specific cycle, it is necessary to determine the dates of the initial trough and the terminal trough. Most cycles are measured from cycle to cycle regardless of length or magnitude.

Cycle Divisions Every business/economic cycle goes through divisions. The period from the initial trough to the peak is called expansion. The declining period of the cycle is called contraction. Within the expansion period there are two phases, which are called recovery and prosperity. After the cycle reaches its peak and contraction begins, the cycle goes through crisis and depression. Another term used for a mild depression is recession.

The business cycle is often further divided into nine stages. Stage I is centered at the time of the initial trough; Stage V is at the time of the peak; and Stage IX is centered at the terminal trough. Stages II through IV are equally divided into thirds across the expansion period, and Stages VI through VIII are equally divided into thirds across the contraction period. These divisions

are made so economists can more easily analyze date and time periods for the cycles.

Cycle Terminology There is considerable terminology that is related to business/economic cycles, terms such as expansion, contraction, depression, recession, and others. To better understand business cycles, it is important to understand the terminology.

Expansion: When the economy is growing and businesses in general are doing well, the period is known as expansion. There are several ways in which economic growth is measured. One way is gross domestic product (GDP), which is the total value of all goods and services that are produced in a country in a specific time period, such as a month, a quarter, or a year. If production is increasing, this is an indicator that the economy is growing.

Another measure of economic expansion is personal income. If workers have increasing income, the indications are that the economy is growing and workers can be paid more. Likewise, if unemployment rates are declining or remain low, this means that people who want to work are finding jobs and the economy is expanding. One fear is that the economy will expand too rapidly, leading to inflation.

Inflation: In simplest terms, inflation means that there is too much money in the economy and not enough goods and services to purchase. Inflation is a general rise in the prices of goods and services. In economics, this relates to supply and demand. If consumers have high demands for goods and services, but the supply of these goods and services doesn't increase to meet the demands, producers can raise prices and consumers will still be willing to purchase the goods and services at higher prices. There is considerable competition for limited resources. Inflation is measured using the Consumer Price Index (CPI). The CPI is a market basket of goods and services that consumers regularly buy. As the prices of these goods and services rise, so do the Consumer Price Index and all prices in general. This explains why the shoes that cost $50 last year nowcost $55.

Contraction: The economy will reach a point where expansion first slows and then stops. There might be a period of stagnation during which there is no growth or even a decline in economic activity. An economic decline, or contraction, typically follows this period. This is the result of business activity slowing, less money being spent, unemployment rising, and wages and salaries declining or remaining stable.

Recession: If there are two consecutive quarters of decline in economic activity as measured by a decrease in GDP, the economy is said to be in a recession. During a recession, prices fall, consumers don't buy as many products (especially high-priced items), and businesses begin to fail. A recession has severe consequences for the economy, highlighted by high unemployment and an overall drop in living standards. When the fear of a recession begins to surface, the federal government expends considerable effort to change the course of activities. Those activities will be discussed later.

Depression: A depression is a very severe recession. History books talk about the Great Depression of the 1930s in the United States, one of the most severe in the history of the U.S. and world economies. Depressions are characterized by extremely high unemployment, lowwages, business failures due to little money to purchase goods and services, and appalling living standards.

Deflation: The opposite of inflation, deflation means that prices are going down. The CPI goes down because the prices of the goods and services that are used to measure it are in general decline. Deflation often follows inflation but normally is shorter in length and of a lesser magnitude.

Stagnation: Stability in growth is a goal of the private-enterprise system. This means that there aren't any drastic changes in prices and the economy is moving forward at an acceptable rate. However, stability can lead to stagnation, a time when there is too much complacency, which in turn leads to a decline in new-product development and marketing. If this occurs, consumers become dissatisfied with what is available and spending slows down, followed by a decline in the economy. For example, if consumers are spending at a steady rate and they are willing to pay reasonable prices for goods and services, manufacturers don't feel the need for innovation and growth in new areas. This causes stagnation, which leads to decline.

Stagflation: The term stagflation is sometimes used to describe a situation in which there is slow to zero growth in real output, high inflation exists, and unemployment is higher than normal. This situation usually begins with rising prices at times when production is declining. Because of declining production, unemployment also increases. All three of these factors combined cause stagflation—stagnation in production and employment together with increasing inflation.

HISTORICAL PERSPECTIVE

The economies of the United States and of the world generally have been through numerous economic cycles. This discussion will not be an extensive one, but rather an overview to show the effects and relationships of the economy and business cycles.

The First Cycle Following the end of The Revolutionary War in 1783, the U.S. economy experienced rapid development and growth. This was a period when the population was growing rapidly and there was expansion to the West. Even though the manufacturing and agricultural processes were primitive by today's standards, the country was full of new activities. There were newoutlets for goods and services, and trade opportunities were enhanced. This new growth and expansion lasted until the beginning of the Civil War.

The Second Cycle Rapid growth in economic activity continued in the period between the beginning of the Civil War and the start of World War I. This was caused in part by the steady increase in population growth, with immigrants arriving in the United States virtually daily. During this time, manufacturing became more dominant and replaced agriculture as the primary industry. At the beginning of this period, about 30 percent of production in the United States was from agriculture; and at the end of the period, it had declined to about 20 percent.

This period wasn't without setbacks, however. In 1873 a major depression began that lasted until the middle of 1879. This depression resulted from a financial panic that caused banks to call for repayment of many of their loans. Very few banks failed, but in the wake of the panic many businesses were affected and did fail.

The Third Cycle The third cycle of economic activity began in 1914 and lasted through 1950. This period was one of major economic variations. Following World War I, demand for goods and services was high, so the economy flourished. Manufacturing continued to flourish and grow, and mechanization in agriculture increased the efficiency of production and reduced the demand for labor. People who were farm laborers became laborers in the manufacturing sector, especially after the introduction of the gasoline-powered tractor.

In 1929, signs of a troubled economy began to surface. The stock market was greatly affected because investors were borrowing large amounts of money to purchase stocks. In late October, the stock market crash had a profound effect on all business activity. Business activity continued to decline through 1932. This was the Great Depression—a worldwide depression. In 1933, a recovery began that lasted until 1937. There was again a decline in economic activity and a recession, which lasted until late in 1938.

The United States entered World War II in December 1941. Because of military operations, the demand for goods and services rose dramatically, employment levels increased, and consumers had more money to spend. The economy was on the mend but rising too rapidly, causing fears of inflation. These fears caused the government to set price ceilings on some products and to ration others. Following the war, the country converted from wartime to peacetime production, causing many industries to slowdown; but the economy continued to grow.

The Fourth Cycle This period, which began with 1950, has been characterized by many economic cycles. The first twenty years of this period saw satisfactory economic growth. The Korean conflict and the Vietnam War greatly influenced the economy. There were some downturns in the economy, but they were minimal. These occurred in 1953, 1957, and 1960. During this period, unemployment was becoming a problem because the demand for unskilled labor was decreasing and the labor force was growing at a rate faster than the demand for employees.

In more recent years, the economy has grown and prospered. There has been a shift to a service economy, which has largely resulted from rapid changes in technology. In this last cycle, there have been recessions that have been relatively short but have caused hardships for some business sectors. There was a period of recession from 1973 to 1975, in 1980, and again in late 1981. Inflation was a severe problem in 1981, and recovery didn't start again until late in 1982. Then, in late 1987, the stock market crash caused problems for many businesses and investors. In addition to those events, there have been several smaller cycles.

CONCLUSION

This overview of business/economic cycles has provided some insight to the cause of changes in the U.S. economy, highlighting terminology that it is important to understand. The role of the U.S. government in controlling changes in economic activity could not be discussed for reasons of length.