The Business Cycle

What is the Business Cycle in economics?

The business cycle can be described as successive periods of rising and falling economic activities. It can also be called the economic cycle or the trade cycle. A business cycle is measured by the upward and downward movement of the gross domestic product (GDP) and fluctuates constantly. The fluctuations are sometimes bigger than others and vary in length.

Business Cycle with trendline

The changes in the business cycle is repetitious but not periodic like the phases of the moon. What this means is that after a period where the business cycle moves down it will always be followed by a period that makes the cycle move up. But, the periods at which the cycle moves up or down always differ.

A business cycle's length is measured by looking at the distance between a peak and a peak, and a trough and a trough. When the next peaks/troughs are higher than the ones before it, an upward trend can be seen. The same is applied for when the next peaks/troughs are lower than the ones before, a downward trend can be seen.

Because of the nature of the business cycle with times where it goes up and times where it goes down, we can distinguish these parts of the cycle. Again, the lengths of these parts vary every time.

We can distinguish between two main periods of the business cycle namely the contraction and the expansion. The contraction phase refers to periods where the GDP is smaller than before and therefore the cycle will contract and indicate a downward trend. The expansion phase refers to periods where the GDP is bigger than before and therefore the cycle will expand and indicate an upward trend.

These two phases can be broken down further into more phases:

Contraction:

Recession:

In the economy, a recession refers to a period of negative economic growth for two consecutive quarters. When this happens, production, income, investments and tax income declines. All of this, in turn, can lead to lower inflation.

Depression:

In the economy, depression is a sustained, long period of economic downturn. When this happens, sentiment becomes negative and bankruptcies are more than usual. Economic activity drops too low levels which means that unemployment is high, consumption, investments and imports are low. Deflation can also be present. This is bad because when money increases in value people will just save their money because it will be worth more in a weeks time.
Learn more of how money flows in the economy and why it is important here.

Expansion:

Recovery:

In the recovery phase of the business cycle, national incomes and expenditures start to rise. Unemployment starts to decrease. Consumption, investments and imports start to rise. Sentiments become positive.

Prosperity:

In the prosperity phase of the business cycle, GDP growth is high. Full employment is prevalent. Inflation is high because there are a lot more money flowing in the economy(more on inflation in the future). Consumption, investments and tax income are high. Loans, profits and imports rise because the economy is doing well.

In theory business cycles will always follow this pattern of prosperity, recovery, peak, recession, depression and then a trough. In reality, this isn't always the case as the economy is everchanging. The following extract shows the real GDP of the United States from the year 1948. The grey bars show all the recessions that happened.

Real Business Cycle of the USA

Source:https://fas.org/sgp/crs/misc/IF10411.pdf

As you can see, although there have been recessions, it doesn't have a distinct downward trend followed by a trough. This happens because the periods which the phases lasts all differ, so the business cycle have longer periods of contraction than expansion. Some other great sources(https://www.thebalance.com/where-are-we-in-the-current-business-cycle-3305593) state that the US business cycle is currently nearing the end of an expansion trend and is now heading to a recession. The periods of contraction usually last shorter than periods of expansion because of government intervention which we will discuss later on. 

Why do business cycles exist in the economy?

This has been a debate as long as the economy has been studied. The most popular arguments as to why the business cycle occurs are the works of Milton Friedman's monetarist theory and John Maynard Keynes' Keynesian theory.

Keynesian theory

The Keynesian view states that the markets are inherently unstable and that government intervention is needed to change the pattern of consumption, investments and changes in production quantities. 

 Monetarist theory

The monetarist theory states the opposite of the Keynesian theory that business cycles occur because the markets in the economy are inherently stable and that the fluctuations exist because of exogenic factors such as climate change, technological advancements, war and government intervention etc.

Although no one argument has been crowned the winner, both believers in the Keynesian Theory, as well as the Monetarist Theory, agrees that in a modern economy a mix of the theories should be used to explain why this happens and that both the theories can justify certain aspects when it comes to controlling the business cycle.

Brick wall theory explanation:

When looking at why my neighbour built the wall I think it is safe to say that he did not build the wall in a time of economic downturn. When the economy is performing badly people tend to prioritise their spending to things essential to keep on living. 

This can be used as an economic indicator to see in what phase the business cycle is. In the next post, we will look at the different indicators that point to where in the business cycle we are and what they mean. We will analyze what the effects on building the wall would have had on my neighbour and the wall-building company during the different phases of the business cycle.

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