Chapter Four
Chapter Four Business Cycles
Business cycles and reasons for business fluctuations
The business cycle refers to the continual ebb and flow of economic activity. No two cycles are exactly the same. The business cycle is characterized by changes in real Gross Domestic Product (GDP) and other measures such as the rate of unemployment and the rate of inflation.
There are four phases of the business cycle. The intensity and duration of these phases will vary from one business cycle to the next. The four phases are 1. peak, 2. recession (contraction), 3. trough, and 4. expansion (recovery) as shown in the graph below:
Peak R Peak
E A L G D P
Recession Expansion (Recovery)
(Contraction)
Trough
Trend Line
TIME (In Years)
The length of the business cycle is measured by the time elapsed between the peaks.
The recession phase is characterized by increasing unused productive capacity associated with increasing unemployment. The increasing unemployment causes reduced spending and the reduced spending in conjunction with higher levels of unused capacity usually results in a decline in output (GDP). A decline in GDP for two or more quarters constitutes a recession.
However, because many prices are inflexible in terms of price reduction, the price level is likely to decline only if the recession is intense and of long duration. Recessions of high intensity and long duration are called depressions.
Deflation is the opposite of inflation in that during a period of deflation the price levels decline. If price levels are declining, consumers tend to postpone spending in the hopes of paying lower prices in the future. Therefore, governments go to great lengths to avoid deflation by means of monetary and fiscal policy.
When the economy has realized its lowest level of production (GDP) in the business cycle, a trough has been reached.
The trough phase in the business cycle is never recognized until the expansion phase is well under way. Thus, the trough phase can only be recognized in retrospect. What appears to be a trough phase may only be a slight pause in a continuing recession phase. The trough phase may last only a short time or it could persist for a long period.
The expansion, or recovery, phase is characterized by decreasing unemployment, greater utilization of productive capacity and an increase in real GDP. As the expansion phase progresses, the shrinking unused capacity and declining number of unemployed make it more likely that there will be inflationary pressures. As the expansion phase progresses, spending occasioned by the higher level of employment will increase. That increased spending, when considered against a backdrop of actual production creeping closer to productive capacity may lead to more aggressive pricing by producers. The higher levels of income increase demand for products but the diminishing unused productive capacity limits the supply. The result is increased inflationary pressure.
It is during the expansion, or recovery, phase that businesses are likely to make capital expenditures to increase their productive capacity. However, these capital expenditure decisions are not likely to be made until the expansion, or recovery, phase is well under way.
The peak phase is the period during which the economy has reached its highest level of production (GDP) in the business cycle. At the peak, there is often full employment and the level of real output is near the productive capacity. It is at this point that there is likely to be significant upward pressure on price levels as demand increases and supply is restricted by diminished available capacity.
The economy of the United States of America has experienced several recessions in the past fifty years. The duration of those recessions varied from approximately one-half year to two years. The trend however, when measured by Gross Domestic Product, has been consistently upward. That upward growth is suggested by the trend line in the graph shown above.
Although we have explained the phases of business cycles in terms of the level of unused productive capacity and the level of unemployment, the more basic cause of business cycles is total spending as measured by GDP. If total spending declines, production is curtailed to avoid building inventory in the face of declining demand for the products. The result is that unemployment increases and income falls. When the total spending increases, higher levels of production become possible, employees are hired, and incomes rise. However, as the economy nears full employment and the factories approach full productive capacity, further increases in production output become more difficult to achieve. At this point, further increases in total spending will put pressure on prices as consumers earning higher incomes bid for the limited quantity of goods available.
Business cycles affect all sectors of the economy. However, all sectors are not affected to the same extent. Companies producing capital goods and consumer durable goods are greatly affected by business cycles. These companies produce high priced items that require considerable thought and analysis prior to purchase. In the case of capital goods (buildings, trucks, machinery and technology), considerable analysis precedes the decision to purchase. That analysis includes a projection of future cash flows and the calculation of the internal rate of return. If the internal rate of return is not sufficiently high, the purchase of the capital asset will be postponed. In the case of consumer durable goods (automobiles, appliances, furniture and houses), the consumer gives considerable thought to an acquisition. The consumer is unlikely to make the purchase unless the consumer has a genuine need and has the income necessary to support the purchase.
On the other hand, service goods ( haircuts, doctor visits and entertainment) provided by service industries and non-durable consumer goods (toiletries, food, and fuel) are purchased without much analysis. These purchases are not likely to be postponed until the expansion, or recovery, phase of the business cycle. It is true that the quantity and quality of services and non-durable consumer goods demanded will decline during a recession phase; however, the decline will not be nearly as severe as for capital goods and consumer durable goods.
In considering all aspects of the business cycle, it is necessary to discuss the various measures of unemployment. The natural rate of unemployment is the long-run rate of unemployment that would exist even if there were no cyclical unemployment. It is important to consider that the unemployment rate cannot reach zero. People are always switching jobs, getting fired, or quitting. As a result, when the real unemployment rate is equal to the natural rate of unemployment, the economy is deemed to be at full employment. Therefore, when the economy is at full employment, there are still unemployed people.
The frictionally unemployed are capable workers who are “between jobs” and have not been matched-up with their next job yet. The frictionally unemployed also include those young people who are looking for their first job. Frictional unemployment is caused by limited information, unfortunate timing, and geographical separation between potential
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employer and potential employee. The structurally unemployed include workers who have skills that do not match up to the skills necessary for a particular job. Structural unemployment typically results from technological changes in the workplace.
Another type of unemployment is cyclical unemployment. Cyclical unemployment is caused by fluctuations in the business cycle. Cyclical unemployment usually occurs when the GDP begins to decline and the economy begins to go into the a recession.
The graph below shows the relationship that exists among these various types of unemployment:
Natural Unemployment
Cyclical Unemployment Frictional Unemployment
Structural Unemployment
Total Unemployment