Nature of Business Cycles

Nature of Business Cycles

In this lesson, you’re expected to:
– understand what a business cycle is and how it affects an economy
– discover the different stages of a business cycle
– learn about the theories of business cycles and different growth level indicators
Since it’s impossible to cover everything in Macroeconomics in one week, we’ll now build on the concepts introduced last week and relate them to the business world!
Every nation seeks economic growth, full employment, and price level stability, which is not easy to achieve due to business cycles.

Business conditions relate to business cycles. The business cycle is the variation in an economy’s ability to generate wealth.

Decisions such as ordering inventory, borrowing money, increasing staff, and spending capital are dependent on the current and predicted business cycle.

What is a Business Cycle?

A business cycle is the natural rise and fall of economic growth that occurs over time.

The cycle is a useful tool for analyzing the economy. It can also help you make better financial decisions.

Expansion & Contraction

• An expansion, or boom, is the period in the business cycle from a trough up to a peak, during which output and employment rise.

• A contraction, recession, or slump is the period in the business cycle from a peak down to a trough, during which output and employment fall.

Enlarged version:
[Optional] Business Cycles
Stage of Business Cycle
Economists suggest four phases of a business cycle. The duration and strength of each phase is variable.

1) Expansion
2) Peak
3) Contraction
4) Trough

Some prefer to talk of business fluctuations instead of cycles, because cycles imply regularity while fluctuations do not.

Though they don’t occur at regular intervals, each stage has recognizable indicators.

1) Expansion

The expansion or growth stage of the business cycle is marked by a strong economy. During this phase, people are making money and the demand for goods and services begins to increase.

This occurs when the GDP grows month-over-month, and unemployment declines.

As a result of the increased demand for goods and services, the demand often begins to exceed the supply, which eventually results in inflation.

2) Peak

This is known as the prosperity stage and typically follows the expansion stage. As the economy continues to operate at full, or near to full, capacity, and prices for goods and services increase, workers tend to ask for raises.

A peak occurs when real GDP spending is at its highest—the period just before unemployment begins to rise and other economic indicators fall.

3) Contraction

A contraction, or decline, in the business phase marks the end of the expansion or prosperity phase. The economy can only sustain growth for so long before the inflationary results begin to have a negative effect on the economy.

Contraction occurs when GDP growth slows or declines. A recession is specifically defined as two consecutive quarters of declining real GDP.

4) Trough

recession, sometimes referred to as a trough, is the phase of the business cycle that follows a contraction, during which time economic demand is substantially reduced.

During a recession, the decreased demand for goods and services results in an overall decreased GDP level which, in turn, creates high levels of unemployment.

A serious recession is known as a depression.

Factors Affecting a Business Cycle

Three factors cause each phase of the business cycle:

1) the forces of supply and demand
2) the availability of capital
3) consumer confidence

The most critical is confidence in the future. The economy grows when there is faith in the future and in policymakers. It does the opposite when confidence drops.

[Optional] Explanation of the Business Cycle & Its Stages
Theories & Measurement of Business cycles
Theories of Business Cycles

Economists disagree on exactly why the economy fluctuates as it does. Are these fluctuations the result of external or internal causes?

Milton Friedman explains the business cycle as being caused by poor management of the money supply. Periods of over-expansion are produced by too much money, and periods of contraction are caused by too little money in circulation.

Keynes explained the business cycle as being caused by “animal spirits” which represent the emotion that clouds rational decision-making. These animal spirits are expressed through businesses’ willingness to invest.

Most other theorists explain a cycle as ultimately being caused by spending changes.

There are many theories supporting the reasons behind the nature of the four stages and its impact on business activity:

• Innovations have greater impact on investment and consumer spending and therefore on output, employment, and the price level.

• Political and random events such as war have major impact on increasing employment and inflation followed by a slump when peace returns.

• Monetary policy of a government affects business activity. When the government creates too much money, inflation results. When money supply is restricted, it results in lower output and unemployment.

Measurement of Business Cycles

Business cycles are measured by looking at both GDP and unemployment.

During periods of economic expansion, unemployment is reduced and the GDP grows. The opposite happens in periods of recession.

Differences among Business Cycles

The nature and cause of a cycle displays typical behavior. Yet no business cycle of actual experience corresponds precisely to a set pattern, and some cycles bear only a faint resemblance to it.

What history discloses is a succession of business cycles that differ considerably in length, in the intensity of their phases, in the industrial and financial developments that gain prominence during their course, and in their geographic scope.

Industry Growth Levels & Indicators

It’s important to be able to compare the growth of a firm (industry) with that of the economy. Four growth indicators are:

• Supernormal Growth: the part of the lifecycle of a firm in which its growth is much faster than that of the economy as a whole.

• Normal Growth: growth that is expected to continue into the foreseeable future at about the same rate as that of the economy.

• Zero Growth: indicates that a firm experiences a zero percent growth compared to the economy.

• Negative Growth: indicates that firm is experiencing a decline in growth compared to the economy.

[Optional] The Business Cycle
Watch this 11-minute video to learn more:
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