Definition of Business Cycle
A business cycle or trade cycle is defined as an alternation of periods of good trade i.e. increasing trends of economic variables and periods of bad trade i.e. falling trends of macroeconomic variables.
Business conditions never remain unchanged. A business cycle refers to oscillations in aggregate economic activities, particularly in employment, output, income, prices, profits, etc.
However, every oscillation in economic activities cannot be called a business cycle. Only those fluctuations are called business cycle, which happens periodically with some regularity.
It has been interpreted separately by different economists. According to Prof. Benham, “Trade cycle refers to a period of prosperity followed by a period of depression.”
Prof. Haberler’s definition is very simple when he says, “The business cycle in the general sense may be defined as an alternation of periods of prosperity and depression of good and bad trade”.
Keynes’s definition in his ‘Treaties of Money’ is more explicit, “A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages, altering with periods of bad trade characterized by falling prices and high unemployment percentages”.
According to Burn and Mitchell, “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 the output at 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 duration, business cycles vary from more than one year to ten or twelve years.”
Characteristics of Business Cycle
A business cycle must possess the following characteristics:
Fluctuation of Aggregate Economic Activity
Business cycles refer to the fluctuations of aggregate economic activity rather than fluctuations in a single specific economic variable such as GDP.
Alteration of Expansion and Contraction in Economic Activity
A trade cycle is characterized by the alteration of expansion (prosperity) and contraction (depression) in economic activity. They are repetitive and rhythmic.
The period of prosperity is followed by depression which again is followed by a period of prosperity. This indicates that the movement is wave-like, it is not an erratic fluctuation.
Comovement
Business cycles do not occur in just a few sectors or just a few economic variables. Instead, expansions or contractions occur at about the same time in many economic activities.
Thus, although some industries are more sensitive to the business cycle than others, output and employment in most industries tend to fall in recessions and rise in expansions.
Many other economic variables such as prices, productivity, investment, government purchases, and predictable patterns of behavior throughout the business cycle.
The tendency of many economic variables to move together in a predictable way over the business cycle is called co-movement.
Self-Reinforcing
A trade cycle is self-reinforcing. It means that the process of expansion and contraction is of a cumulative self-reinforcing nature.
Each upswing or downswing feeds on itself and generates further movement (change) in the same direction until its direction is reversed by external forces.
Degree of Regularity
A trade cycle has a degree of regularity. The upswing of a trade cycle may be longer than the downswing or vice versa, but it maintains regularity.
Presence of Crisis
A trade cycle is characterized by the presence of crisis, i.e. the peak and the trough are, not symmetrical. In other words, the change from upward to downward may be more sudden and violent than the change from downward to upward movement.
Consequently, the peak of the trade cycle is pointed with steep bends on either side whereas the trough has a gently sloping swing of 16-22 years duration.
4 Phases of Business Cycle
A business cycle is commonly divided into four well-defined and inter-related recurring,
- Phase 1: Prosperity (Boom) phase – Expansion or the upswing.
- Phase 2: Recession – The turn from prosperity to depression (or upper turning point)
- Phase 3: Depression phase – Contraction or downswing
- Phase 4: Revival or Recovery phase – The turn from depression to prosperity (or lower turning point)
Prosperity
Prosperity is that phase at which all macroeconomic variables such as employment, output, income, etc. are in a rising trend.
Prosperity is that phase at which demand, output, and employment are rising at a high level. They tend to raise prices.
But wages, salaries, interest rates, rentals, and taxes do not rise in proportion to the rise in the prices. The gap between prices and costs increases the margin of profit.
The prosperity stage of the business cycle is characterized by:
- A large volume of production and output
- A large expansion of bank credit
- High marginal efficiency of capital
- A rising price level
- A rising structure of interest rate
- A high level of employment and income
- A high level of real investment
- A rise in wages and profits
- Overall business optimism
- Operation of the economy at full capacity
The prosperity phase comes to an end when the forces leading to expansion become progressively weak. Bottlenecks begin to appear at the peak the prosperity.
The peak is defined as the high point of prosperity or the upper turning point of aggregate economic activities.
The peak of prosperity may lead the economy to over-full employment and to an inflationary rise in prices. It is a symptom of the end of the prosperity phase and the beginning of the recession.
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Recession
A recession refers to an upper turning point at which macroeconomic variables start to fall low rate.
Where prosperity ends recession begins. A recession refers to a turning stage rather than a phase. It lasts relatively for a short period.
During a recession phase of the business cycle, the banking system and the people, in general, try to attain greater liquidity. Therefore, credit supplies contracts.
There is a tendency to reduce the scale of operation, which leads to an increase in unemployment and a decline in the level of income.
The decline in income leads to a decrease in aggregate expenditure i.e., effective demand. The decline in effective demand causes a decline in prices and profits. This process becomes cumulative.
A recession is characterized by:
- An increase in liquidity.
- Contraction of credit supply.
- Decrease in output, employment, and income.
- Decrease stage in effective demand, price level, and profit.
All these changes occur at a low rate.
To cite Prof. Lee, “A recession, once started tends to build upon itself as much as a forest fire, once underway, tends to create its draft and give internal impetus to its destructive ability.”
Depression
Depression is that phase at which all macroeconomic variables such as employment, output, income, etc. are in a declining trend.
Depression is that phase at which real income is consumed, real income produced, and the rate of employment falls due to idle resources and capacity.
In other words, there is a substantial decline in the production of goods and services and the volume of employment.
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The general decline in economic activity leads to a fall in bank deposits. These forces are cumulating and self-reinforcing and the economy is at the trough.
In other words, the falling trend of all macroeconomic variables at a high rate results in economic darkness in the economy.
A depression phase of the business cycle is characterized by:
- Shrinkage in the volume of output, trade, and transactions
- A rise in the level of unemployment
- Price deflation
- Fall in the aggregate income of the community
- Fall in the structure of interest rates
- Reduction in the level of effective demand
- The collapse of the M.E.C. and the decline in the level of investment
- Contraction of bank credit
When the economy bottoms out, a trough occurs. A trough is defined as the lowest point of depression or lower turning point of aggregate economic activities.
It may be short-lived or it may continue for a considerable time. But sooner or later limiting forces are set in motion, which ultimately tend to bring the contraction phase to an end.
The main causes responsible for ending depression are as follows:
- During the depression, businessmen postpone the replacement of their plants and machinery and consumers postpone the purchase of durable goods. Hence, the need for replacement and the purchase of durable goods gradually accumulate. This, after some time, causes a moderate increase in the purchase of durable goods by the consumers and machinery by the producers.
- Business firms formulate new business strategies or innovations (i.e. cost-reducing innovations or demand-raising innovations).
Recovery
Recovery refers to lower a turning stage at which macroeconomics starts to rise at a low rate.
Revival or recovery refers to the lower turning stage. The recovery begins with the improvement in demand for capital goods. To meet this increased demand, investment and employment increased in capital goods industries, which in turn led to a rise in incomes.
The increased income pushes up the level of effective demand, which in turn, leads to a rise in prices, profits, further investment, employment, output, and income starts rising slowly and steadily.
During the recovery stock markets become sensitive. A rise in the prices of stocks favors expansion and strengthens revival.
The process of recovery is cumulative. The wave of recovery once initiated soon begins to feed upon itself.
The recovery phase of the business cycle is characterized by:
- Increase in effective demand
- Increase in investment in capital industries
- Increase in the price level, profit, and MEC
- Improvement in the financial market
- Increase in employment, output, and income in a whole economy.
All these changes occur at a low rate.
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Importance of Understanding Business Cycle
Understanding the business cycle is crucial for various stakeholders in the economy, as it provides insights into economic fluctuations and helps in planning and decision-making.
Below are six key importance of understanding the business cycle:
Economic Policy Formulation
Governments use knowledge of the business cycle to design and implement fiscal and monetary policies.
For instance, during a recession, policymakers might increase public spending or reduce taxes to stimulate demand.
Conversely, during periods of inflation or boom, policies may focus on controlling prices and preventing overheating of the economy. This ensures economic stability and sustainable growth.
Business Planning and Decision-Making
Businesses can align their production, investments, and inventory management with the phases of the business cycle.
For example, companies might expand operations during a boom but adopt a conservative approach during a recession. This helps firms minimize risks and maximize profitability.
Investment Strategies
Understanding the business cycle enables investors to identify opportunities and risks.
For instance, stock markets typically perform better during recovery and boom phases, while bond markets may offer safer returns during recessions.
This knowledge aids investors in optimizing their portfolios and achieving higher returns.
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Employment and Workforce Management
During booms, organizations may hire more employees and increase wages, while during recessions, layoffs and cost-cutting measures might occur.
By understanding the cycle, employers can plan workforce adjustments proactively. It helps maintain organizational efficiency and reduces the adverse impact on employees.
Consumer Spending and Saving Decisions
Consumers can plan their expenditures and savings better by understanding the phases of the business cycle.
For example, during a recovery or boom, they might spend more, while in a recession, they may prioritize savings. This ensures financial stability and resilience during economic downturns.
Global Trade and Economic Integration
In a globally interconnected economy, understanding the business cycles of major trading partners helps countries plan their trade policies and strategies.
For instance, if a partner country is in a recession, exports might decline, necessitating adjustments. This helps maintain balanced trade relationships and supports domestic economic growth.
By understanding these dynamics, governments, businesses, investors, and individuals can make informed decisions, mitigate risks, and seize opportunities during various phases of the business cycle.
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Sujan Chaudhary holds a BBA degree. He loves to share his business knowledge with the rest of the world.