Business Cycle (Encyclopedia of Business and Finance)
The business cycle is the ups and downs of the general level of economic activity. All modern, industrialized countries have fluctuations in their rates of economic activity, leading to the observation that one nation's economy is "booming" while another economy is in a "recession." When an economy goes from a positive to a negative rate of growth, it is said to have reached a "peak" and entered a recession. When an economy goes from a negative to a positive rate of growth, it is said to have reached a "trough" and entered a "recovery."
WHAT IS THE BUSINESS CYCLE?
Although something worthy of being called "the business cycle" does exist, attempts at finer classifications or subcategories of business cycles have not been particularly fruitful. Some economists have simply used a broad dichotomy between "major" and "minor" cycles. Descriptively this can be meaningful. A particularly severe recession is referred to as a "depression." The Depression of the 1930s was quantitatively different from the 1990-1991 recession. The output of the economy fell by almost 50 percent in the former and by less than 1 percent in the latter.
It is sometimes useful to speak of the cycles of specific time series; that is, the interest rate cycle, the inventory cycle, the construction cycle, and so forth. Given the diversity of general economic cycles, one can find turns in the general level of economic activity in which individual sectors of the economy do, at least for a time, appear to be independent of the rest of the economy. The most frequently mentioned individual cycles are the inventory cycle, the building or construction cycle, and the agricultural cycle. The standard business cycle is sometimes referred to as the inventory cycle, and some business cycle theorists popularly explain the severity of turns in the economy by the coincidence of timing in the individual cycles.
The idea of the timing of individual time series relative to the general level of business implies specific dates for the business cycle. How does one establish the peaks and troughs for the business cycle? To say whether something leads or lags the business cycle, one must have some frame of reference; hence, the business cycle is referred to as the reference cycle and its peaks and troughs as reference turning points. (See Table 1.)
For the United States, the reference turning points are established by the National Bureau of Economic Research (NBER), a nonprofit research organization. This organization, originally under the guidance of Wesley Claire Mitchell (1874948), pioneered business cycle research in the late 1920s. Today the NBER's decisions regarding the reference cycle are taken as gospel, although they are, in fact, quite subjective. No single time series or group of time series is decreed to be the reference cycle. A committee of professional business cycle analysts convened by the NBER establishes the official peaks and troughs in accordance with the following definition:
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 in 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)
With slight modification, this definition has been used since 1927. Although most of the definition is self-explanatory, it is not all that rigorous. It does not say something like, for example, if the total output of the economy (real GDP) falls at an annual rate of 1 percent for two consecutive quarters, we have entered a recession. The definition does say unambiguously that business cycles are "recurrent but not periodic." The only real constraint in the definition is that if you define a business cycle, say, from peak to peak, you should not be able to find another cycle of equal amplitude between those two peaks. If so, you did it wrong.
As of mid-2000, Table 1 is still relevant. The most recent turning point identified by the NBER was March 1991. As of April 2000, the U.S. economy continued to expand. Notice from the table that all that is established with regard to the business cycle is the peak and trough of each cycle. This determination tells us absolutely nothing about the rate of rise or fall in the general level of economic activity, nothing about the magnitude of the boom or the severity of the recession. The most commonly used series as a proxy for the business cycle when more than just turning points is required is real GDP if one can get by with quarterly data, or the industrial production index if monthly data are required. The industrial production index is a measure of economic activity published monthly by the Federal Reserve Board in Washington, D.C. As might be guessed from the attention given them by the media, the consumer price index and the unemployment rate are commonly used measures of the severity of the business cycle. Neither corresponds very closely to the reference cycle.
THEORIES OF THE BUSINESS CYCLE
The first lecture in an introductory economics course usually makes the point that the expenditures of one economic unit are the incomes of other economic units. This provides a fairly firm basis for expecting sympathetic movements in many sectors of the economy. A good theoretical basis and substantial empirical support exist for cumulative upward and downward movement in the economy. One sector's expansion is the basis for another sector's expansion, general prosperity lowers risk and makes credit more readily available, and so on; but the weakest part of business cycle theory and the toughest problem in forecasting is turning points. Why does the general upward or downward movement end? Sometimes it is obvious. When, for example, a war begins or ends with a commensurate and dramatic change in military expenditures, the cause of the beginning or end of an economic boom is fairly unambiguous. Historically, however, only a small minority of the turning points are the result of specific, identifiable occurrences. There are many theories as to other causes of the business cycle.
In 1917 an eminent American economist by the name of J. M. Clark published an article entitled "Business Acceleration and the Law of Demand: A Technical Factor in Economic Cycles." His technical factor was the observation that with a fixed capital-output ratio, a small percentage change in final sales would give rise to a large percentage change in investment. Each innovation generates a temporary demand for the required investment goods. Once the initial investment has been made, the replacement market requires a lower rate of investment. This is referred to as the principle of acceleration. Ifit takes $10 worth of steel mills to produce $1 worth of steel per year, growth in demand for steel by $1 will temporarily generate $10 worth of demand for steel mills.
Another early business cycle theorist, Joseph Schumpeter (1883950), noted that nothing is constant over the business cycle and nothing ever really returns to its starting place. That is what makes each business cycle unique. The economy grows and changes with each cycleew products, new firms, new consumers. As Schumpeter observed in 1939, "As a matter of history, it is to physiology and zoology, not to mechanics, that our science is indebted for an analogous distinction which is at the threshold of all clear thinking about economic matters" (p. 37). The economy grows and changes. He referred to this as the process of "creative destruction."
Schumpeter concluded that what most of us consider "progress" is at the source of the problem.
Survey Of Current Business
BUSINESS CYCLE EXPANSIONS AND CONTRACTIONS
|Business cycle reference dates||Duration in months|
|Trough||Peak||Contraction (trough from previous peak)||Expansion (trough to peak)||Cycle|
|Trough from previous trough||Peak from previous peak|
|1. 30 cycles.|
|2. 15 cycles.|
|3. 25 cycles.|
|4. 13 cycles.|
|December 1854||June 1857||/td>||30||/td>||/td>|
|December 1858||October 1860||18||22||48||40|
|June 1861||April 1865||8||46||30||54|
|December 1867||June 1869||32||18||78||50|
|December 1870||October 1873||18||34||36||52|
|March 1879||March 1882||65||36||99||101|
|May 1885||March 1887||38||22||74||60|
|April 1888||July 1890||13||27||35||40|
|May 1891||January 1893||10||20||37||30|
|June 1894||December 1895||17||18||37||35|
|June 1897||June 1899||18||24||36||42|
|December 1900||September 1902||18||21||42||39|
|August 1904||May 1907||23||33||44||56|
|June 1908||January 1910||13||19||46||32|
|January 1912||January 1913||24||12||43||36|
|December 1914||August 1918||23||44||35||67|
|March 1919||January 1920||71||0||51||17|
|July 1921||May 1923||18||22||28||40|
|July 1924||October 1926||14||27||36||41|
|November 1927||August 1929||13||21||40||34|
|March 1933||May 1937||43||50||64||93|
|June 1938||February 1945||13||80||63||93|
|October 1945||November 1948||8||37||88||45|
|October 1949||July 1953||11||45||48||56|
|May 1954||August 1957||10||39||55||49|
|April 1958||April 1960||8||24||47||32|
|February 1961||December 1969||10||106||34||116|
|November 1970||November 1973||11||36||117||47|
|March 1975||January 1980||16||58||52||74|
|July 1980||July 1981||6||12||64||18|
|November 1982||July 1990||16||92||28||108|
|Average, all cycles:|
|1854991 (31 cycles)||18||35||53||153|
|1854919 (16 cycles)||22||27||48||249|
|1919945 (6 cycles)||18||35||53||53|
|1945991 (9 cycles)||11||50||61||61|
|Average, peacetime cycles:|
|1854991 (26 cycles)||19||29||48||348|
|1954919 (14 cycles)||22||24||46||447|
|1919945 (5 cycles)||20||26||46||45|
|1945991 (7 cycles)||11||43||53||53|
He felt that as entrepreneurs come up with new ways of doing things, this disturbs the equilibrium and creates fluctuations. Schumpeter distinguishes between inventions (which may gather dust for years) and innovations, which are commercial applications of previous inventions. Inventions occur randomly through time. Innovations tend to be bunched, thereby creating cycles of economic activity.
Many business cycle theorists give a prominent role to the monetary system and interest rates. Early in the twentieth century, a Swedish economist, Knut Wicksell (1851926), argued that if the "natural" rate of interest rose above the "bank" rate of interest, the level of economic activity would begin to increase. In contemporary terms, the natural rate of interest is what businesses expect to earn on real investment. The bank rate is the return on financial assets in general and commercial bank loans in particular. The boom begins when, for whatever reason, the cost of borrowing falls significantly below expected returns on investment. This difference between the rate of return on real and financial assets generates a demand for bank loans by investors seeking to exploit the opportunity for profit. The economy booms.
At some point the bank rate will start to rise and/or the real rate will start to fall. When the expected rate of return on investment falls below the rate at which funds can be borrowed, the process will begin to reverse itselfnd the recession is on. As bank loans are paid off (or defaulted on), bank credit is reduced, and the economy slows accordingly.
In recent years, business cycles theory has centered on the argument about the source of cyclical instability. The question of the root causes of ups and downs in the level of economic activity received a lot of attention in the 1980s and 1990s.
Figure 1 shows how the parties to the debate are divided up. First, there is the question of whether the private sector of the economy is inherently stable or unstablehich is to say, do the observed fluctuations originate in the government or private sector? On one side are what might be called classical economists, who are convinced that the economy is inherently stable. They contend that, historically, government policy has destabilized it in a perverse fashion. On the other side are what might be called Keynesians, named after the famous British economist John Maynard Keynes (1883946). Keynesians think that psychological shifts in consumers' purchasing and savings preferences and in businesses' confidence are a substantial source of instability.
There is a whole body of literature on political business cycles. As a contemporary economist, William D. Nordhaus, noted in 1989, "The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power" (p. 1). The idea is that politicians in power will tend to follow policies to promote short-term prosperity around election time and allow recessions to occur at other times. The evidence that the state of the economy influences voting patterns is strong, as is the apparent desire of incumbent politicians to influence the economy; but it is difficult to make a case that the overwhelming determinant of the level and timing of business fluctuations is politically determined. At some points in recent history, politically determined policies were apparently a determining factor and at other times not.
With respect to the impact of governmental policies, there is a dispute as to the relative importance of monetary policy (controlling the money supply) and fiscal policy (government expenditures and taxes). Those who believe that monetary policies have had a generally destabilizing effect on the economy are known as monetarists. Most economists accept the fact that fiscal policy, especially in wartime, has been a source of cyclical instability.
As noted above, it is the so-called Keynesian economists who think that the private sector is inherently unstable. While noting the historical instability of investment in tangible assets, they have also emphasized shifts in liquidity preference (demand for money) as an independent
source of instability. As a counter to the standard Keynesian position, there has in recent years arisen a school of thought emphasizing real business cycles. This school contends that nonmonetary variables in the private sector are a major source of cyclical instability. They contend that the observed sympathetic movements between monetary variables and the level of economic activity result from a flow of causation from the latter to the former. The changes in real factors cause the monetary factors to change, not vice versa. In this way they are somewhat like Wicksell, discussed earlier.
Blanchard, Oliver. (2000). "What Do We Know about Macroeconomics That Fisher and Wicksell Did Not?" National Bureau of Economic Research Working Paper No. W7550, February. New York: National Bureau of Economic Research.
Burns, Arthur F., and Mitchell, Wesley C. (1946). Measuring Business Cycles. New York: National Bureau of Economic Research.
Clark, J. M. (1917). "Business Acceleration and the Law of Demand: A Technical Factor in Economic Cycles." Journal of Political Economy March: 217-235.
Hicks, J. R. (1958). The Trade Cycle. London: Oxford University Press.
King, Robert, and Plosser, Charles. (1984). "Money, Credit and Prices in a Real Business Cycle." American Economic Review June: 363-380.
King, Robert, and Rebelo, Sergio. (2000). "Resuscitating Real Business Cycles." National Bureau of Economic Research Working Paper No. W7534, February. New York: National Bureau of Economic Research.
Long, John, and Plosser, Charles. (1983). "Real Business Cycles." Journal of Political Economy February: 777-793.
Lucas, Robert E. (1981). Studies in Business Cycle Theory. Cambridge, MA: MIT Press.
Lucas, Robert E., and Sargent, Thomas J., ed. (1981). Rational Expectations and Econometric Practice. Minneapolis: University of Minnesota Press.
Mankiw, N. Gregory. (1989). "Real Business Cycles: A New Keynesian Perspective." The Journal of Economic Perspectives Summer: 79-90.
Mitchell, Wesley Claire. (1952). The Economic Scientist. New York: National Bureau of Economic Research.
Nordhaus, William D. (1989). "Alternative Approaches to the Political Business Cycle." Brookings Papers on Economic Activity 2:1-50.
Rotemberg, Julio J., and Woodford, Michael. (1996). "Real-Business-Cycle Models and the Forecastable Movements in Output, Hours, and Consumption." The American Economic Review March: 71-89.
Schumpeter, Joseph. (1939). Business Cycles. New York: McGraw-Hill.
Schumpeter, Joseph. (1961). The Theory of Economic Development. New York: Oxford University Press.
Su, Vincent. (1996). Economic Fluctuations and Forecasting. New York: HarperCollins.
Wicksell, Knut. (1901). Lectures on Political Economy. New York: Augustus M. Kelly.
Willet, Thomas D., ed. (1988). Political Business Cycles: The Political Economy of Money, Inflation, and Unemployment. Durham, NC: Duke University Press.
Zarnowitz, Victor. (1992). Business Cycles, Theory, History, Indicators, and Forecasting. Chicago: University of Chicago Press.
Business Cycles (Encyclopedia of Small Business)
A business cycle is a sequence of economic activity in a nation's economy that is typically characterized by four phasesecession, recovery, growth, and declinehat repeat themselves over time. Economists note, however, that complete business cycles vary in length. The duration of business cycles can be anywhere from about two to twelve years, with most cycles averaging about six years in length. In addition, some business analysts have appropriated the business cycle model and terminology to study and explain fluctuations in business inventory and other individual elements of corporate operations. But the term "business cycle" is still primarily associated with larger (regional, national, or industrywide) business trends.
STAGES OF A BUSINESS CYCLE
RECESSION A recessionlso sometimes referred to as a troughs a period of reduced economic activity in which levels of buying, selling, production, and employment typically diminish. This is the most unwelcome stage of the business cycle for business owners and consumers alike. A particularly severe recession is known as a depression.
RECOVERY Also known as an upturn, the recovery stage of the business cycle is the point at which the economy "troughs" out and starts working its way up to better financial footing.
GROWTH Economic growth is in essence a period of sustained expansion. Hallmarks of this part of the business cycle include increased consumer confidence, which translates into higher levels of business activity. Because the economy tends to operate at or near full capacity during periods of prosperity, growth periods are also generally accompanied by inflationary pressures.
DECLINE Also referred to as a contraction or downturn, a decline basically marks the end of the period of growth in the business cycle. Declines are characterized by decreased levels of consumer purchases (especially of durable goods) and, subsequently, reduced production by businesses.
FACTORS THAT SHAPE BUSINESS CYCLES
For centuries, economists in both the United States and Europe regarded economic downturns as "diseases" that had to be treated; it followed, then, that economies characterized by growth and affluence were regarded as "healthy" economies. By the end of the 19th century, however, many economists had begun to recognize that economies were cyclical by their very nature, and studies increasingly turned to determining which factors were primarily responsible for shaping the direction and disposition of national, regional, and industry-specific economies. Today, economists, corporate executives, and business owners cite several factors as particularly important in shaping the complexion of business environments.
VOLATILITY OF INVESTMENT SPENDING Variations in investment spending is one of the important factors in business cycles. Investment spending is considered the most volatile component of the aggregate or total demand (it varies much more from year to year than the largest component of the aggregate demand, the consumption spending), and empirical studies by economists have revealed that the volatility of the investment component is an important factor in explaining business cycles in the United States. According to these studies, increases in investment spur a subsequent increase in aggregate demand, leading to economic expansion. Decreases in investment have the opposite effect. Indeed, economists can point to several points in American history in which the importance of investment spending was made quite evident. The Great Depression, for instance, was caused by a collapse in investment spending in the aftermath of the stock market crash of 1929. Similarly, prosperity of the late 1950s was attributed to a capital goods boom.
There are several reasons for the volatility that can often be seen in investment spending. One generic reason is the pace at which investment accelerates in response to upward trends in sales. This linkage, which is called the acceleration principle by economists, can be briefly explained as follows. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. As a result, changes in sales result in magnified percentage changes in investment expenditures. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates. In more concrete terms, the response of the investment spending is related to the rate at which sales are increasing. In general, if an increase in sales is expanding, investment spending rises, and if an increase in sales has peaked and is beginning to slow, investment spending falls. Thus, the pace of investment spending is influenced by changes in the rate of sales.
MOMENTUM Many economists cite a certain "follow-the-leader" mentality in consumer spending. In situations where consumer confidence is high and people adopt more free-spending habits, other customers are deemed to be more likely to increase their spending as well. Conversely, downturns in spending tend to be imitated as well.
TECHNOLOGICAL INNOVATIONS Technological innovations can have an acute impact on business cycles. Indeed, technological breakthroughs in communication, transportation, manufacturing, and other operational areas can have a ripple effect throughout an industry or an economy. Technological innovations may relate to production and use of a new product or production of an existing product using a new process. The video imaging and personal computer industries, for instance, have undergone immense technological innovations in recent years, and the latter industry in particular has had a pronounced impact on the business operations of countless organizations. However, technological innovationsnd consequent increases in investmentake place at irregular intervals. Fluctuating investments, due to variations in the pace of technological innovations, lead to business fluctuations in the economy.
There are many reasons why the pace of technological innovations varies. Major innovations do not occur every day. Nor do they take place at a constant rate. Chance factors greatly influence the timing of major innovations, as well as the number of innovations in a particular year. Economists consider the variations in technological innovations as random (with no systematic pattern). Thus, irregularity in the pace of innovations in new products or processes becomes a source of business fluctuations.
VARIATIONS IN INVENTORIES Variations in inventoriesxpansion and contraction in the level of inventories of goods kept by businesseslso contribute to business cycles. Inventories are the stocks of goods firms keep on hand to meet demand for their products. How do variations in the level of inventories trigger changes in a business cycle? Usually, during a business downturn, firms let their inventories decline. As inventories dwindle, businesses ultimately find themselves short of inventories. As a result, they start increasing inventory levels by producing output greater than sales, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate. However, as the rate of increase in sales slows, firms begin to cut back on their inventory accumulation. The subsequent reduction in inventory investment dampens the economic expansion, and eventually causes an economic downturn. The process then repeats itself all over again. It should be noted that while variations in inventory levels impact overall rates of economic growth, the resulting business cycles are not really long. The business cycles generated by fluctuations in inventories are called minor or short business cycles. These periods, which usually last about two to four years, are sometimes also called inventory cycles.
FLUCTUATIONS IN GOVERNMENT SPENDING
Variations in government spending are yet another source of business fluctuations. This may appear to be an unlikely source, as the government is widely considered to be a stabilizing force in the economy rather than a source of economic fluctuations or instability. Nevertheless, government spending has been a major destabilizing force on several occasions, especially during and after wars. Government spending increased by an enormous amount during World War II, leading to an economic expansion that continued for several years after the war. Government spending also increased, though to a smaller extent compared to World War II, during the Korean and Vietnam wars. These also led to economic expansions. However, government spending not only contributes to economic expansions, but economic contractions as well. In fact, the recession of 1953-54 was caused by the reduction in government spending after the Korean War ended. More recently, the end of the Cold War resulted in a reduction in defense spending by the United States that had a pronounced impact on certain defense-dependent industries and geographic regions.
POLITICALLY GENERATED BUSINESS CYCLES
Many economists have hypothesized that business cycles are the result of the politically motivated use of macroeconomic policies (monetary and fiscal policies) that are designed to serve the interest of politicians running for re-election. The theory of political business cycles is predicated on the belief that elected officials (the president, members of congress, governors, etc.) have a tendency to engineer expansionary macroeconomic policies in order to aid their re-election efforts.
MONETARY POLICIES Variations in the nation's monetary policies, independent of changes induced by political pressures, are an important influence in business cycles as well. Use of fiscal policyncreased government spending and/or tax cutss the most common way of boosting aggregate demand, causing an economic expansion. Moreover, the decisions of the Federal Reserve, which controls interest rates, can have a dramatic impact on consumer and investor confidence as well.
FLUCTUATIONS IN EXPORTS AND IMPORTS The difference between exports and imports is the net foreign demand for goods and services, also called net exports. Because net exports are a component of the aggregate demand in the economy, variations in exports and imports can lead to business fluctuations as well. There are many reasons for variations in exports and imports over time. Growth in the gross domestic product of an economy is the most important determinant of its demand for imported goodss people's incomes grow, their appetite for additional goods and services, including goods produced abroad, increases. The opposite holds when foreign economies are growingrowth in incomes in foreign countries also leads to an increased demand for imported goods by the residents of these countries. This, in turn, causes U.S. exports to grow. Currency exchange rates can also have a dramatic impact on international tradend hence, domestic business cycless well.
KEYS TO SUCCESSFUL BUSINESS CYCLE MANAGEMENT
Small business owners can take several steps to help ensure that their establishments weather business cycles with a minimum of uncertainty and damage. "The concept of cycle management may be relatively new," wrote Matthew Gallagher in Chemical Marketing Reporter, "but it already has many adherents who agree that strategies that work at the bottom of a cycle need to be adopted as much as ones that work at the top of a cycle. While there will be no definitive formula for every company, the approaches generally stress a long-term view which focuses on a firm's key strengths and encourages it to plan with greater discretion at all times. Essentially, businesses are operating toward operating on a more even keel."
Specific tips for managing business cycle downturns include the following:
- Flexibilityccording to Gallagher, "part of growth management is a flexible business plan that allows for development times that span the entire cycle and includes alternative recession-resistant funding structures."
- Long-Term Planningonsultants encourage small businesses to adopt a moderate stance in their long-range forecasting.
- Attention to Customershis can be an especially important factor for businesses seeking to emerge from an economic downturn. "Staying close to the customers is a tough discipline to maintain in good times, but it is especially crucial coming out of bad times," stated Arthur Daltas in Industry Week. "Your customer is the best test of when your own upturn will arrive. Customers, especially industrial and commercial ones, can give you early indications of their interest in placing large orders in coming months."
- Objectivitymall business owners need to maintain a high level of objectivity when riding business cycles. Operational decisions based on hopes and desires rather than a sober examination of the facts can devastate a business, especially in economic down periods.
- StudyTiming any action for an upturn is tricky, and the consequences of being early or late are serious," said Daltas. "For example, expanding a sales force when the markets don't materialize not only places big demands on working capital, but also makes it hard to sustain the motivation of the sales-people. If the force is improved too late, the cost is decreased market share or decreased quality of the customer base. How does the company strike the right balance between being early or late? Listening to economists, politicians, and media to get a sense of what is happening is useful, but it is unwise to rely solely on their sources. The best route is to avoid trying to predict the upturn. Instead, listen to your customers and know your own response-time requirements."
Daltas, Arthur J. "Manage Now for the Upturn." Industry Week. May 4, 1992.
Gallagher, Matthew. "An Even Keel." Chemical Marketing Reporter. July 24, 1995.
Hartwig, Robert P. "Riding the Economic Cycles: How Growth and Recession Affect Workers' Compensation." Compensation and Benefits Review. May/June 1997.
Hendrix, Craig, and Jan Amonette. "It's Time to Determine Your E-Business Cycle." Indianapolis Business Journal. May 8, 2000.
Mansfield, Edwin. Principles of Macroeconomics. 7th ed. New York: W.W. Norton, 1992.
Walsh, Max. "Goldilocks and the Business Cycle." The Bulletin with Newsweek. December 7, 1999.
Wilson, Robert A. "Where Were You When the Cycle Died?" Pulp and Paper. February 1997.
Business Cycles (Encyclopedia of Business)
- FOUR PHASES OF THE BUSINESS CYCLES
- CAUSES OF BUSINESS FLUCTUATIONS
- VARIATIONS IN INVENTORIES
- POLITICALLY GENERATED BUSINESS CYCLES
- VARIATIONS IN THE MONEY SUPPLY
- FURTHER READING:
In the most basic terms, business cycles refer to fluctuations in the economic growth of a nation's economy. Sometimes, business cycles are simply referred to as ups and downs in the economy. The U.S. economy has experienced economic fluctuations throughout its history. For example, while the U.S. income has grown more than six-fold during the last 70 years, the U.S. economy has also experienced many economic downturns, some of which were very severe. The Great Depression (1929-33) was the worst downturn of this century. More recently, a fairly deep downturn was experienced during the Reagan administration (1981-82) and a mild downturn during the Bush administration (1990-92). Economists have studied the causes, consequences, and possible cures for the recurrent business cycles, however, they have not been fully conquered. After all, the most recent downturn ended only in 1992, and the next one might be around the corner. Nevertheless, the severity of economic downturns has been mitigated to a considerable degree. It is now widely believed that business cycles are here to coexist, at least in a mild form, with every economy based on capitalism. In what follows, common characteristics of business cycles are discussed in detail.
BUSINESS CYCLES AND FLUCTUATIONS IN OUTPUT AND EMPLOYMENT
Usually, when one talks about business or economic fluctuations, some notion of the aggregate economic output or income is assumed. The most commonly used measure of the national output is called gross national product, or GNP. The government also started using a related measure of output known as gross domestic productDP). GNP, in turn, measures the country' aggregate output by simply evaluating all final goods and services produced in the economy during a year at their market prices. When an economist examines fluctuations in gross national product, he or she uses a GNP measure that is adjusted for inflation. The inflation-adjusted measure is called real GNP, or gross national product in constant dollars. It makes sense to use only the real GNP in studying business fluctuations, as we are interested in real fluctuations in economic activity.
While business cycles are expressed in terms of fluctuations in real gross national product, they are usually accompanied by fluctuations in the labor unemployment rate as well. When the nation's output of goods and services falls, unemployment typically rises direct consequence of the fact that fewer workers are needed to produce the reduced volume of output. It is important not to forget the employment (or unemployment) dimension of an economic downturn, as the higher unemployment rate leads to a number of economic and social costs that can have political repercussions. The unemployment rate during the depth of economic downturn during the Great Depression rose above 25 percent. The unemployment rate during the economic downturn under the Bush administration remained below 8 percent, peaking at 7.7 percent. Despite the fact that this downturn was a mild one, Bush lost his bid for the second term, a sign of increased expectations of the federal government on part of the public.
FOUR PHASES OF THE BUSINESS CYCLES
While economic fluctuations are often simply referred to as ups and down in the economy, these fluctuations follow a broad pathach business cycle displays all phases of a cycle, but its characteristics differ from one cycle to another. In other words, business cycles are not regular or consistent. This will become clearer below.
Each business cycle can be divided into four phases. As the economic downturn continues, the output level reaches a bottom, called a "trough." A trough is basically a turning pointhe real output stops declining any further and starts to increase after hitting the trough. The phase when the economy's real output is rising from the trough is termed expansion. The expansion continues to a peak where it achieves the highest output level for this particular business cycle. When output starts declining from the level achieved at the peak, a recession or contraction is said to have set in. The four phasesrough, expansion, peak, and recessiononstitute a business cycle.
SOME NOTABLE PERIODS OF EXPANSION AND CONTRACTION
Duration and force of expansion and contractions vary from cycle to cycle. A particularly severe recession is called a depression. The Great Depression of the 1930s has been unparalleled in terms of severity. In October of 1929, the stock market witnessed a drastic decline, often referred to as the great stock market crash of 1929. After the stock market crash, the economy started declining at a staggering pace. The real gross national product declined by about one-third between 1929 and 1933. At the peak of the Depression in 1933, the unemployment rate rose above 25 percent of the labor force, resulting in inordinate hardship for a large number of Americans.
In the post World War II period, recessions have been generally mild in comparison to the Great Depression. In more recent years, the recessions of 1974-75 (due in part to a large increase in oil prices) and 1981-82 have been fairly severe. However, even these recessions are considered quite tame relative to the Great Depressionhe unemployment rate rose to only 8.5 percent in 1975, and to 9.7 percent in 1982 during the 1981-82 recession.
A particularly robust period of expansion is often called prosperity. The United States economy experienced an unprecedented period of prosperity during and after World War II. In fact, the effects of the Great Depression lingered on in the U.S. economy until the outbreak of World War II. The increase in government spending necessitated by the war provided an enormous expansionary forcehe real U.S. gross national product increased by about 75 percent between 1939 and 1945. Prosperous periods of somewhat lower magnitudes were experienced during the Korean and Vietnam wars. Because the economy tends to operate at or near full capacity during periods of prosperity, inflationary pressures also generally accompany such periods.
CAUSES OF BUSINESS FLUCTUATIONS
There are a multitude of factors that are considered responsible for causing business cycles. In a theoretical sense, though, they can be broadly characterized as belonging either to the demand side (the aggregate demand from all sectionsonsumers, investors, government, and foreignor the economy's goods and services) or the supply side (which pertains to factors relevant to supply of goods and services, such as changes in input costs, technological advances, etc.).
To understand why economic activities fluctuate at all, one needs to understand a little bit of macro-economics theory. Basically, this theory explains how the equilibrium level of output is determined in the economy. The equilibrium output also determines the associated equilibrium price level. Aggregate demand for and aggregate supply of goods and services ultimately determine the equilibrium output (and thus the price level). These concepts are briefly explained below.
An aggregate demand schedule specifies the amount of goods and services demanded by all sectors of the economy at each price level. It is common sense that the quantity of goods and services demanded will be lower at higher prices and vice versa. In other words, price level and aggregate demand are inversely relatedhey move in the opposite directions. Economists formalize this relationship by saying that the aggregate demand curve (the graph that illustrates the relationship between aggregate demand and price) slopes downward to the right. Aggregate demand is made up of demands from all sectors of the economy. These sectors are primarily put under four headingsonsumption spending, investment spending, government spending, and net exports.
Consumption spending is an important component of the aggregate demand. Private consumption expenditures constituted roughly 68 percent of aggregate demand in the United States economy in the mid-1990s. Private consumption expenditures are further subdivided into expenditures on consumer durables (such as a washer, dryer, or an automobile), consumer nondurables (such as a shirt or a bag of groceries) and services (such as a hair cut or manicure).
Investment spending is a much smaller part of the aggregate demand in the economyross domestic private investment currently accounts for roughly 15 percent of total real gross domestic product. Investment is influenced by a number of tangible and nontangible factors. The cost of borrowing (the long-term interest rate is the main basis for determining the cost of borrowing) and expected profit rates (on proposed projects) are considered the major determinants of investment spending. However, investment is susceptible to a number of economic and psychological factors, including businessmen's confidence regarding the future of the economy.
As of the mid-1990s, government spending in the United States constituted a fairly sizable portion of the aggregate demand in the economystimated to be about 19 percent of the total spending in the economy. During wars or periods of international tension, government spending tends to rise to meet the actual or perceived threat. However, during normal times, it is hard to pin down the factors that determine the level of government spending. In general, there exists a strong political inertia in changing spending.
The fourth component of the aggregate demand, the net foreign demand (measured by the difference between what the United States is exporting to other countries and what it imports from them) is not a significant component for the American economy. Actually, the United States imports more than it exports. As a result, the net foreign demand for the United States is negative. However, this negative amount is not a large percentage of the total gross domestic product for the United States, often as low as 1 percent of the GDP. One can reasonably assume that the net foreign demand for U.S. products is not significant in aggregate demand.
Variations in the aggregate demand can occur due to variations in any component of the aggregate demand described above.
An aggregate supply schedule specifies the amount of goods and services supplied (produced) by all producers of goods and services in the economy at each price level. It is reasonable to expect that the quantity of goods and services supplied will be higher at higher prices and vice versa. In other words, price level and aggregate supply are positively relatedhey move in the same direction. Economists formalize this relationship by saying that the aggregate supply curve (the graph that illustrates the relationship between the aggregate supply and price) slopes upward to the right. Why producers charge higher prices to supply greater output can be explained in terms of the cost of producing increased output. In general, the average cost (cost per unit) of producing output rises due to increasing input pricesncreased competition among producers for the given raw materials and labor raises prices. As costs of production increase, so do prices of commodities produced.
The supply curve can shift for a number of reasons. Suppose, there is sudden increase in the price of a necessary input such as oil. This will shift the supply curve to the left. In other words, prices of goods produced will rise in general, due to the increased input price.
FLUCTUATIONS IN THE ECONOMY
Business cycles or fluctuations in the economy result from shifts in the aggregate demand curve, the aggregate supply curve, or both. A rightward shift in the aggregate demand curve leads to an expansion (putting, in general, an upward pressure on the price level) and a leftward shift leads to an opposite effect. Similarly, a rightward shift in the aggregate supply curve leads to an expansion (generally putting down-ward pressure on the price level) and a leftward shift has the opposite effect. A number of key factors do that lead to business fluctuations.
VOLATILITY OF INVESTMENT SPENDING.
Variation in investment spending is one of the important causes of business cycles. Investment spending is considered the most volatile component of the aggregate demandt varies much more from year to year than the largest component of the aggregate demand, the consumption spending. Empirical studies by economists have revealed that the volatility of the investment component is an important factor in explaining business cycles in the United States. As explained above, increases in investment shift the aggregate demand to the right, leading to an economic expansion. Decreases in investment have the opposite effect. According to popular belief, the Great Depression was caused by a collapse in investment spending in the aftermath of the stock market crash of 1929. Similarly, prosperity of the late 1950s was attributed to a capital goods boom.
There are several reasons for the volatility in the investment spending. One generic reason is the pace at which investment accelerates in response to changes in saleshis linkage is termed as the acceleration principle by economists, briefly explained as follows: Suppose, a firm is operating at full capacity. When sales increase, output will have to be increased by increasing plant capacity through further investment. However, because of the nature of investment goods, many dollars worth of investment must be made to meet the increased sales worth one dollarnvestment goods are expensive, but they are worth-while as they will continue to generate additional output for a long period. As a result, changes in sales result in magnified percentage changes in investment expenditures. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates. In more concrete terms, the response of the investment spending is related to the rate at which sales are increasing. In general, if an increase in sales is expanding, investment spending rises, and if an increase in sales has peaked and is beginning to slow, investment spending falls. Thus, the pace of investment spending is influenced by changes in the rate of sales, which vary greatly over time, leading to business cycles.
Another reason for variations in investment is the timing of technological innovation. Technological innovations may relate to production and use of a new product or producing an existing product using a new process. The video imaging and personal computer industries have undergone immense technological innovations in recent years. When a new product is invented, large amounts of investment are needed to produce and market the product. Personal computers are now a commonplace item, available not only in most offices, but also in many homes. Large investments were made in the personal computer industry to bring it to its current level of product prices and competition in the market. As explained earlier, investment augments the aggregate demand and leads to an economic expansion. However, technological innovations, and consequent increases in investment, take place at irregular intervals. Fluctuating investments, due to variations in the pace of technological innovations, lead to business fluctuations in the economy.
There are many reasons why the pace of technological innovation varies. Major innovations do not occur every day, nor do they occur at a constant rate. Chance factors greatly influence the timing of major innovations, as well as the number of innovations in a particular year. Economists consider the variations in technological innovations as random (with no systematic pattern). Thus, irregularity in the pace of innovations in new products or processes becomes a source of business fluctuations.
VARIATIONS IN INVENTORIES
Variations in inventoryxpansion and contraction in the level of inventories of goodslso generate business cycles. Inventories are the stocks of goods firms keep on hand to meet unexpected demand for products. Variations in the level of inventories lead to business cycles usually during a business downturn, when firms let inventories decline. As inventories are cut down considerably, businesses ultimately find themselves short. As a result, they start increasing inventory levels by producing output greater than sales, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate. However, as the rate of increase in sales slows, firms begin to cut back on inventory accumulation. The subsequent reduction in inventory investment dampens the economic expansion, and eventually causes an economic downturn. The process then repeats itself. It should be noted that while variations in inventory levels produce business cycles, the resulting business cycles are not terribly long. The business cycles generated by fluctuations in inventories are called "minor" or "short" business cycles. They usually last about two to four years, and they are sometimes also called inventory cycles.
FLUCTUATIONS IN GOVERNMENT SPENDING
Variations in government spending are yet another source of business fluctuations. This may appear to be an unlikely source, as the government is widely considered to be a stabilizing force in the economy, not a source of economic fluctuations or instability. Nevertheless, government spending has been a major destabilizing force at several occasions, especially during and after wars. Government spending increased by an enormous amount during World War II, leading to an economic expansion that continued for several years after the war. Government spending also increased, though to a smaller extent, during the Korean and Vietnam wars. These also led to economic expansions. However, government spending not only contributes to economic expansions, but economic contractions as well. In fact, the recession of 1953-54 was caused by the reduction in government spending after the Korean War ended. More recently, the end of the Cold War resulted in a reduction in defense spending by the United States. While this did not injure the U.S. economy as a whole, the California economy (heavily dependent on defense spending) came to a grinding halt as a result of the defense cuts.
POLITICALLY GENERATED BUSINESS CYCLES
Many economists have hypothesized that business cycles are the result of the politically motivated use of macroeconomic policies (monetary and fiscal policies) that are designed to serve the interest of politicians running for re-election. Political business cycles can be explained as follows. Usually a year or two before an election, the incumbent president, members of congress, and/or senators engineer expansionary macroeconomic policies. Use of fiscal policy, that isncreased government spending and/or tax cutss the most common way of boosting aggregate demand, causing an economic expansion. However, the president may also induce the use of monetary policy to aid in the economic expansion. Technically, the Federal Reserve Bank that conducts the monetary policy is independent of the President and Congress; its independence is created, in part, by the long 14-year terms granted to the regular members of the Board of Governors of the Federal Reserve. Nevertheless, realistically, it is hard for the Federal Reserve to completely ignore the pressure put on it by the President and the Congress. Because of expansionary macroeconomic policies, economic growth picks up before elections and the labor unemployment rate declines, making people feel good about the state of the economy. People find it easier to land jobs and incomes rise, putting them in an upbeat mood to reelect incumbents to their offices.
Once elections are over, the inflationary effects of expansionary macroeconomics policies start to become evident. The closer the economy was to the full employment level before the elections, the greater the inflationary pressure. To curb inflationary tendencies in the economy, the President and Congress turn to anti-inflationary measures, such as reducing government spending and increasing taxes. The Federal Reserve is likely to further aid these efforts by increasing interest rates. The net effect of these anti-inflationary fiscal and monetary policies is that there is a downward pressure on the aggregate demand and the economy, as a result, slows down. At times, the slowdown may actually result in a recession period of negative, not just slower, economic growth. Once again, before the next election, the economy will need to be stimulated to put the people in an upbeat mood. These fluctuations are often called political business cycles.
FLUCTUATIONS IN EXPORTS AND IMPORTS
As mentioned earlier, the difference between exports and imports is the net foreign demand for goods and services, also called net exports. Because net exports are a component of the aggregate demand in the economy, variations in exports and imports can lead to business fluctuations as well. There are many reasons for variations in exports and imports over time. Growth in the gross domestic product of an economy is the most important determinant of its demand for imported goodss people's incomes grow, they want more goods and services, including goods produced abroad. The opposite holds when foreign economies are growingrowth in incomes in foreign countries also leads to an increased demand for imported goods by the residents of these countries. This in turn causes U.S. exports to grow. Net foreign demand for the U.S. goods and services has been negative for some years. However, because of the size of the U.S. economy, the net foreign demand is not considered a major source of business cycles. However, this is quite often a source of business cycles in export-dependent smaller economies.
VARIATIONS IN THE MONEY SUPPLY
We have alluded to the role monetary policy plays in business fluctuations in the context of political business cycles. However, many economists consider variations in the nation's money supply, independent of changes induced by political pressures, as an important source of business cycles. The Federal Reserve has been entrusted by Congress with the power to use monetary policy to stabilize the economy around full employment (with low and stable inflation). It is argued that the Federal Reserve, in its attempt to stabilize the economy, manipulates the money supply. However, the Federal Reserve, due in part to inadequate knowledge, is unable to successfully fine tune the economy. Policy mistakes ultimately become a major source of business fluctuations in the economy. Both the inflationary pressures of the 1970s and the recession of 1981-82 are attributed to variations in money supply.
CAN BUSINESS CYCLES BE ELIMINATED?
As mentioned at the beginning of this essay, business cycles have long been a part of the U.S. economy. After the Great Depression of the 1930s, it became apparent that the government should conduct macroeconomic policies to manipulate the level of aggregate demand and to stabilize the economy around full employment with price stability. One of the two macroeconomic policy instruments, fiscal policy, is conducted by Congress and the President. The conduct of the other instrument, monetary policy, is left to the independent federal institution, the Federal Reserve Bank. U.S. experience has shown that the burden of stabilizing the economy has fallen disproportionately on the Federal Reserveiscal policy is said to be slow to respond and less decisive due to political conflicts among policy makers. Despite many shortcomings and imperfections of monetary and fiscal policies, the evidence seems to suggest that they had an effect on moderating business cycles. While business fluctuations continue to exist in the U.S. economy, recessions in the post-Depression period have been relatively modest. While not all economists subscribe to the conclusion that macroeconomic policies have moderated business cycles, these policies continue to be used to this day for stabilizing the economy.
[Anandi P. Sahu, Ph.D.]