Business Cycle Definition
The business cycle refers to the alternating phases of economic growth and decline. Since the phases are recurring, they often occur in an identifiable pattern where one phase usually follows the other.
This cyclical nature of the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society. is taken into account when policymakers make major decisions. Just because the cycles are repetitive doesn’t mean they can be avoided. The fluctuations are caused by parameters like GDP, production, employment, aggregate demand, real income, and consumer spending. Business cycles are also called trade cycles or economic cycles.
- A business cycle is the repetitive economic changes that take place in a country over a period. It is identified through the variations in the GDP along with other macroeconomics indexes.
- The four phases of the business cycle are expansion, peak, contraction, and trough.
- The risk and adverse effects of the phases can be mitigated through wisely devising monetary and fiscal policies.
- The National Bureau of Economic Research (NBER) in the US has formed a Businss Cycle Dating Committee (BCDC) for recognizing, tracking, and reporting the different economic phases.
Business Cycle in Economics Explained
A business cycle is a macroeconomic oscillation that affects the nation’s growth and productivity. They are also called trade cycles or economic cycles. NBER is a US-based non-profit organization. It is a private non-partisan research organization. The National Bureau of Economic Research (NBER) identifies and gauges the economic cycle. It has a Business Cycle Dating Committee responsible for keeping the chronological record of the economic stages. To determine economic conditions NBER uses the following parameters; GDP, production, employment, aggregate demand, real income, and consumer spending.
The Keynesian economic theoryKeynesian Economic TheoryKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression. emphasizes the impact of demand on the business cycle. It believes that the government needs to correct the economic deflation and attain a full employment level when the aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices. shifts to the left. Moreover, the Real Business Cycle (RBC) and New Classical economics suggest that the economy reaches a new equilibrium whenever there is a shift in the aggregate supplyAggregate SupplyAggregate Supply is the projected supply that a business calculates based on the existing market conditions. Various factors such as changing economic trend are considered before calculating the aggregate supply.. Ultimately the economy has a self-healing mechanism and doesn’t require government intervention.
Every capitalist economy repeatedly goes through the different phases of the business cycle, i.e., expansion, peak, contraction, and trough. Although these ups and downs in the economy may correct by themselves in the long run, the government and the central bank use economic policies to reduce the impact of trade cycle fluctuations. At the same time, the central bank can inject expansionary or contractionary monetary policiesContractionary Monetary PoliciesContractionary monetary policy is the type of economic policy that is basically used to deal with inflation and it also involves minimizing the fund’s supply in order to bring an enhancement in the cost of borrowings which will ultimately lower the gross domestic product and moderate or decrease inflation too. like interest rate changes or supply of money. Further, to mitigate fluctuations, the government uses fiscal policyFiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. tools like tax rates and government spending. These measures are taken to avoid risky situations like stagflationStagflationStagflation is an economic scenario where stagnation coincides with inflation. or hyperinflationHyperinflationHyperinflation is an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services. It forces people to lower their holdings in that particular currency to participate in stable foreign currencies..
Business Cycle Phases with Graph
A country keeps track of the trade cycle to ensure that the economy is on the path of growth, unemployment steeps down, and the inflation rateInflation RateThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100. remains under control. To understand the economic fluctuations and pattern, let us have a look at the following graph:
An economy is expected to have constant growth, represented by the growth trend line. In reality, though, the economy is unstable. National output goes up and down periodically. It expands to touch the peak and contracts down to the trough.
Thus, a trade cycle consists of the following four phases:
- Expansion: When a nation’s GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period. shows an upward move or recovers with time, this period of growth is remarked as economic expansion. During this phase, the various economic indicatorsEconomic IndicatorsSome economic indicators are GDP, Exchange Rate Stability, Risk Premiums, Crude Oil Prices etc. like consumer spending, income, demand, supply, employment, output, and business returns shoot up.
- Peak: During the expansion phase, the GDP spikes to its highest level; this is considered the economy’s peak. At this point, economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others. like income, consumer spending, and employment level remain constant.
- Contraction: Next comes the phase of economic slowdown; it occurs when the stagnant peak GDP starts tumbling down towards the trough. With this, the nation’s production, employment level, demand, supply, income level, and other economic parameters plummet.
- Trough: This is the stage at which the GDP and other economic indicators are at their lowest. During this phase, the economy gets stuck at a negative growth rate. Additionally, the demand for goods and services reduces.
Example of Business Cycle
Nigeria is one of the largest economies in Africa. Yet, Nigeria’s economy contracted by almost 1.92% in the second and third quarter of 2020 amidst the Covid 19 Pandemic. According to Reuters, this trashed the nation’s GDP that grew by nearly 2.2% in 2019, after recovering from 2016’s contraction.
The reason behind this trade cycle fluctuation was the fall in demand and prices of crude oil globally. The lockdown and Covid measures imposed in many countries hit hard. Manufacturing, aviation, trade, hospitality, transportation, and many other industrial sectors slowed down. These industries directly or indirectly needed crude oil, the demand for the commodity dropped.
However, this contraction was short-lived; Nigeria showed a recovery in the last quarter of 2020 as Covid restrictions were eased out to some extent. According to the National Bureau of Statistics (NBS), the nation’s growth rate was up by 0.11% in the fourth quarter of 2020. In contrast, the non-oil sectors like food manufacturing, telecom, construction, crop production, and real estate marked a phenomenal growth of 1.69% during the same period.
The effect of the pandemic on Nigeria was not as harsh as IMF anticipated. The contraction was only 3.2%. Subsequently, by 2021 the IMF assumes a 1.5% growth in the nation’s economy.
Predicting the business cycle phase is crucial for policymakers and governments so that they can deal with deflation and inflation accordingly. The cycle also warns investors, owners, consumers, and strategists. However, the following are the disadvantages associated with the business cycle:
- Limited Information: Since the economic cycle analysis is based on research, it becomes difficult for economists to access complete and accurate data. Moreover, the process of correlating and interpreting acquired information is equally challenging.
- Two Contrasting Models: The Keynesian theories consider money supply to be the important factor behind fluctuations. But the Real Business Cycle theory opposes this concept and proposes that market imperfection is the important factor behind fluctuations.
- Human Glitch: Economic researchers are humans; they are the ones who study trade cycle trends and present economic indicators that cause the trend. Thus, this analysis is prone to human errors.
Frequently Asked Questions (FAQs)
A business cycle refers to the long-term fluctuations in the economic output of a nation. In other words, it is the upswing or downfall of a country’s GDP. This is also applied to a particular product or a segment of the market.
The changing Gross Domestic Product (GDP) of any nation triggers the fluctuations. The GDP itself rises or falls due to the impact of various demand factors like monetary policy, credit cycle, consumer confidence, housing prices, accelerator effect, multiplier effect, income effect, and exchange rate.
The economy is affected by the following supply factors: population, financial instability, lending cycle, unemployment, labor market condition, technological changes, and inventory cycle.
A typical business cycle persists for 5.5 years on average; however, it may be shorter or longer than this. While the economy self-corrects over time, various monetary and fiscal policy measures are implemented to create economic balance.
This has been a guide to Business Cycle and its Definition. Here we discuss 4 phases of the business cycle in economics using graphs and examples. You can learn more about economics from the following articles –