business cycle

A sequence of economic activity typically characterized by recession, fiscal recovery, growth, and fiscal decline.

The recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. The five stages of the business cycle are growth (expansion), peak, recession (contraction), trough and recovery. At one time, business cycles were thought to be extremely regular, with predictable durations. But today business cycles are widely known to be irregular - varying in frequency, magnitude and duration.

Investopedia Says:
Since the Second World War, most business cycles have lasted three to five years from peak to peak. The average duration of an expansion is 44.8 months and the average duration of a recession is 11 months. As a comparison, the Great Depression - which saw a decline in economic activity from 1929 to 1933 - lasted 43 months from peak to trough.

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Recurrence of periods of expansion (Recovery) and contraction (Recession) in economic activity with effects on inflation, growth, and employment. One cycle extends from a Gross Domestic Product (GDP) base line through one rise and one decline and back to the base line, a period typically averaging about 21⁄2 years. The 1990s, however, saw an extended period of expansion. A business cycle affects profitability and Cash Flow, making it a key consideration in corporate dividend policy, and a factor in the rise and fall of the inflation rate, which in turn affects return on investments. See also Soft Landing.

Recurrent periods (about two and one-half years on the average) in which the nation's economy moves in and out of recession and recovery phases. There is much controversy over whether money should be spent on advertising during the recessionary phase of the cycle, but there seems to be some evidence that companies who do not cut back on their advertising budgets fare slightly better than those who do. However, although there are several studies, they are essentially inconclusive.

The business cycle is the ups and downs of the general level of economic activity. All modern, industrialized countries have fluctuations in their rates of economic activity, leading to the observation that one nation's economy is "booming" while another economy is in a "recession." When an economy goes from a positive to a negative rate of growth, it is said to have reached a "peak" and entered a recession. When an economy goes from a negative to a positive rate of growth, it is said to have reached a "trough" and entered a "recovery."

What Is the Business Cycle?

Although something worthy of being called "the business cycle" does exist, attempts at finer classifications or subcategories of business cycles have not been particularly fruitful. Some economists have simply used a broad dichotomy between "major" and "minor" cycles. Descriptively this can be meaningful. A particularly severe recession is referred to as a "depression." The Depression of the 1930s was quantitatively different from the 1990-1991 recession. The output of the economy fell by almost 50 percent in the former and by less than 1 percent in the latter.

It is sometimes useful to speak of the cycles of specific time series; that is, the interest rate cycle, the inventory cycle, the construction cycle, and so forth. Given the diversity of general economic cycles, one can find turns in the general level of economic activity in which individual sectors of the economy do, at least for a time, appear to be independent of the rest of the economy. The most frequently mentioned individual cycles are the inventory cycle, the building or construction cycle, and the agricultural cycle. The standard business cycle is sometimes referred to as the inventory cycle, and some business cycle theorists popularly explain the severity of turns in the economy by the coincidence of timing in the individual cycles.

The idea of the timing of individual time series relative to the general level of business implies specific dates for the business cycle. How does one establish the peaks and troughs for the business cycle? To say whether something leads or lags the business cycle, one must have some frame of reference; hence, the business cycle is referred to as the reference cycle and its peaks and troughs as reference turning points. (See Table 1.)

For the United States, the reference turning points are established by the National Bureau of Economic Research (NBER), a nonprofit research organization. This organization, originally under the guidance of Wesley Claire Mitchell (1874–1948), pioneered business cycle research in the late 1920s. Today the NBER's decisions regarding the reference cycle are taken as gospel, although they are, in fact, quite subjective. No single time series or group of time series is decreed to be the reference cycle. A committee of professional business cycle analysts convened by the NBER establishes the official peaks and troughs in accordance with the following definition:

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 about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge in the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximately their own. (Burns and Mitchell, 1946, p. 3)

With slight modification, this definition has been used since 1927. Although most of the definition is self-explanatory, it is not all that rigorous. It does not say something like, for example, if the total output of the economy (real GDP) falls at an annual rate of 1 percent for two consecutive quarters, we have entered a recession. The definition does say unambiguously that business cycles are "recurrent but not periodic." The only real constraint in the definition is that if you define a business cycle, say, from peak to peak, you should not be able to find another cycle of equal amplitude between those two peaks. If so, you did it wrong.

As of mid-2000, Table 1 is still relevant. The most recent turning point identified by the NBER was March 1991. As of April 2000, the U.S. economy continued to expand. Notice from the table that all that is established with regard to the business cycle is the peak and trough of each cycle. This determination tells us absolutely nothing about the rate of rise or fall in the general level of economic activity, nothing about the magnitude of the boom or the severity of the recession. The most commonly used series as a proxy for the business cycle when more than just turning points is required is real GDP if one can get by with quarterly data, or the industrial production index if monthly data are required. The industrial production index is a measure of economic activity published monthly by the Federal Reserve Board in Washington, D.C. As might be guessed from the attention given them by the media, the consumer price index and the unemployment rate are commonly used measures of the severity of the business cycle. Neither corresponds very closely to the reference cycle.

Theories of the Business Cycle

The first lecture in an introductory economics course usually makes the point that the expenditures of one economic unit are the incomes of other economic units. This provides a fairly firm basis for expecting sympathetic movements in many sectors of the economy. A good theoretical basis and substantial empirical support exist for cumulative upward and downward movement in the economy. One sector's expansion is the basis for another sector's expansion, general prosperity lowers risk and makes credit more readily available, and so on; but the weakest part of business cycle theory and the toughest problem in forecasting is turning points. Why does the general upward or downward movement end? Sometimes it is obvious. When, for example, a war begins or ends with a commensurate and dramatic change in military expenditures, the cause of the beginning or end of an economic boom is fairly unambiguous. Historically, however, only a small minority of the turning points are the result of specific, identifiable occurrences. There are many theories as to other causes of the business cycle.

In 1917 an eminent American economist by the name of J. M. Clark published an article entitled "Business Acceleration and the Law of Demand: A Technical Factor in Economic Cycles." His technical factor was the observation that with a fixed capital-output ratio, a small percentage change in final sales would give rise to a large percentage change in investment. Each innovation generates a temporary demand for the required investment goods. Once the initial investment has been made, the replacement market requires a lower rate of investment. This is referred to as the principle of acceleration. Ifit takes $10 worth of steel mills to produce $1 worth of steel per year, growth in demand for steel by $1 will temporarily generate $10 worth of demand for steel mills.

Another early business cycle theorist, Joseph Schumpeter (1883–1950), noted that nothing is constant over the business cycle and nothing ever really returns to its starting place. That is what makes each business cycle unique. The economy grows and changes with each cycle—new products, new firms, new consumers. As Schumpeter observed in 1939, "As a matter of history, it is to physiology and zoology, not to mechanics, that our science is indebted for an analogous distinction which is at the threshold of all clear thinking about economic matters" (p. 37). The economy grows and changes. He referred to this as the process of "creative destruction."

Schumpeter concluded that what most of us consider "progress" is at the source of the problem.

Survey Of Current Business
BUSINESS CYCLE EXPANSIONS AND CONTRACTIONS

He felt that as entrepreneurs come up with new ways of doing things, this disturbs the equilibrium and creates fluctuations. Schumpeter distinguishes between inventions (which may gather dust for years) and innovations, which are commercial applications of previous inventions. Inventions occur randomly through time. Innovations tend to be bunched, thereby creating cycles of economic activity.

Many business cycle theorists give a prominent role to the monetary system and interest rates. Early in the twentieth century, a Swedish economist, Knut Wicksell (1851–1926), argued that if the "natural" rate of interest rose above the "bank" rate of interest, the level of economic activity would begin to increase. In contemporary terms, the natural rate of interest is what businesses expect to earn on real investment. The bank rate is the return on financial assets in general and commercial bank loans in particular. The boom begins when, for whatever reason, the cost of borrowing falls significantly below expected returns on investment. This difference between the rate of return on real and financial assets generates a demand for bank loans by investors seeking to exploit the opportunity for profit. The economy booms.

At some point the bank rate will start to rise and/or the real rate will start to fall. When the expected rate of return on investment falls below the rate at which funds can be borrowed, the process will begin to reverse itself—and the recession is on. As bank loans are paid off (or defaulted on), bank credit is reduced, and the economy slows accordingly.

In recent years, business cycles theory has centered on the argument about the source of cyclical instability. The question of the root causes of ups and downs in the level of economic activity received a lot of attention in the 1980s and 1990s.

Figure 1 shows how the parties to the debate are divided up. First, there is the question of whether the private sector of the economy is inherently stable or unstable—which is to say, do the observed fluctuations originate in the government or private sector? On one side are what might be called classical economists, who are convinced that the economy is inherently stable. They contend that, historically, government policy has destabilized it in a perverse fashion. On the other side are what might be called Keynesians, named after the famous British economist John Maynard Keynes (1883–1946). Keynesians think that psychological shifts in consumers' purchasing and savings preferences and in businesses' confidence are a substantial source of instability.

There is a whole body of literature on political business cycles. As a contemporary economist, William D. Nordhaus, noted in 1989, "The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power" (p. 1). The idea is that politicians in power will tend to follow policies to promote short-term prosperity around election time and allow recessions to occur at other times. The evidence that the state of the economy influences voting patterns is strong, as is the apparent desire of incumbent politicians to influence the economy; but it is difficult to make a case that the overwhelming determinant of the level and timing of business fluctuations is politically determined. At some points in recent history, politically determined policies were apparently a determining factor and at other times not.

With respect to the impact of governmental policies, there is a dispute as to the relative importance of monetary policy (controlling the money supply) and fiscal policy (government expenditures and taxes). Those who believe that monetary policies have had a generally destabilizing effect on the economy are known as monetarists. Most economists accept the fact that fiscal policy, especially in wartime, has been a source of cyclical instability.

As noted above, it is the so-called Keynesian economists who think that the private sector is inherently unstable. While noting the historical instability of investment in tangible assets, they have also emphasized shifts in liquidity preference (demand for money) as an independent source of instability. As a counter to the standard Keynesian position, there has in recent years arisen a school of thought emphasizing real business cycles. This school contends that nonmonetary variables in the private sector are a major source of cyclical instability. They contend that the observed sympathetic movements between monetary variables and the level of economic activity result from a flow of causation from the latter to the former. The changes in real factors cause the monetary factors to change, not vice versa. In this way they are somewhat like Wicksell, discussed earlier.

(See also: Economic Cycles)

Bibliography

Blanchard, Oliver. (2000). "What Do We Know about Macroeconomics That Fisher and Wicksell Did Not?" National Bureau of Economic Research Working Paper No. W7550, February. New York: National Bureau of Economic Research.

Burns, Arthur F., and Mitchell, Wesley C. (1946). Measuring Business Cycles. New York: National Bureau of Economic Research.

Clark, J. M. (1917). "Business Acceleration and the Law of Demand: A Technical Factor in Economic Cycles." Journal of Political Economy March: 217-235.

Hicks, J. R. (1958). The Trade Cycle. London: Oxford University Press.

King, Robert, and Plosser, Charles. (1984). "Money, Credit and Prices in a Real Business Cycle." American Economic Review June: 363-380.

King, Robert, and Rebelo, Sergio. (2000). "Resuscitating Real Business Cycles." National Bureau of Economic Research Working Paper No. W7534, February. New York: National Bureau of Economic Research.

Long, John, and Plosser, Charles. (1983). "Real Business Cycles." Journal of Political Economy February: 777-793.

Lucas, Robert E. (1981). Studies in Business Cycle Theory. Cambridge, MA: MIT Press.

Lucas, Robert E., and Sargent, Thomas J., ed. (1981). Rational Expectations and Econometric Practice. Minneapolis: University of Minnesota Press.

Mankiw, N. Gregory. (1989). "Real Business Cycles: A New Keynesian Perspective." The Journal of Economic Perspectives Summer: 79-90.

Mitchell, Wesley Claire. (1952). The Economic Scientist. New York: National Bureau of Economic Research.

Nordhaus, William D. (1989). "Alternative Approaches to the Political Business Cycle." Brookings Papers on Economic Activity 2:1-50.

Rotemberg, Julio J., and Woodford, Michael. (1996). "Real-Business-Cycle Models and the Forecastable Movements in Output, Hours, and Consumption." The American Economic Review March: 71-89.

Schumpeter, Joseph. (1939). Business Cycles. New York: McGraw-Hill.

Schumpeter, Joseph. (1961). The Theory of Economic Development. New York: Oxford University Press.

Su, Vincent. (1996). Economic Fluctuations and Forecasting. New York: HarperCollins.

Wicksell, Knut. (1901). Lectures on Political Economy. New York: Augustus M. Kelly.

Willet, Thomas D., ed. (1988). Political Business Cycles: The Political Economy of Money, Inflation, and Unemployment. Durham, NC: Duke University Press.

Zarnowitz, Victor. (1992). Business Cycles, Theory, History, Indicators, and Forecasting. Chicago: University of Chicago Press.

[Article by: DAVID A. BOWERS]

Economies seem to prosper and decline in cycles; some economists have detected a five-year sequence, although others argue that the fluctuations are entirely random. See kondratieff cycle.

For more information on business cycle, visit Britannica.com.

Business Cycles are the irregular fluctuations in aggregate economic activity observed in all developed market economies. Aggregate economic activity is measured by real gross domestic product (GDP), the sum weighted by market prices, of all goods and services produced in an economy. Comparisons of real GDP across years are adjusted for changes in the average price level (inflation). A business cycle contraction or recession is commonly defined as at least two successive three-month periods (quarters) in which real GDP falls. A business cycle then contains some period in which real GDP grows followed by at least half a year in which real GDP falls. Some business cycles are longer than others. As Table 1 shows, most contractions last for less than a year, with real GDP falling by 1 to 6 percent. Expansions are more variable, though most last from two to six years.

Business cycles date from at least colonial times. The data for the colonial period are limited; thus, it is more difficult to date cycles precisely. When the United States was primarily agricultural, fluctuations in climate exerted a strong influence on economic cycles. While business cycles are defined in terms of GDP, a number of other economic variables tend to move in concert with GDP. Aggregate consumption expenditures rise and fall with GDP. Investment does too, but it tends to rise much faster than GDP during expansions and to fall much faster in recessions. The trade balance increases as GDP falls and vice versa, and imports in particular tend to rise during expansions and fall during contractions. Interest rates, notably short-term interest rates, tend to rise in expansions and fall in contractions. The aggregate price level often moves up and down with GDP, as do profits.

Aggregate employment also rises during expansions and falls during contractions, usually fluctuating less than GDP. The unemployment rate rarely rises by more than 4 percent in a recession, in part because the average hours worked per worker rises and falls with the cycle. Also, firms tend to "hoard" some workers during recessions to obviate the need to rehire as the expansion begins. Consequently, output per worker falls during recessions.

Other economic variables sometimes move in concert with GDP. The "leading indicators," which tend to precede changes in GDP, include capacity utilization by industry, construction starts or construction plans, orders received for capital equipment, new business formation, new bond and equity issues, and business expectations. Studying these along with the aggregate variables, analysts attempt to forecast cycles, which is especially difficult when predicting the timing of turning points between expansion and contraction. While severe contractions affect every sector of the economy, milder contractions are observed only in some sectors, and employment continues to rise in about a quarter of industries.

Different Types of Cycles

Scholars in the early post–World War II period often distinguished "growth cycles," in which contractions were defined as a decline in the rate of GDP growth, from the less frequent business cycles, in which contractions were defined as decreases in GDP. Some held out hope that the business cycle could be replaced with less severe growth cycles.

While the chronology of business cycles produced by the National Bureau of Economic Research (NBER) (Table 1) is widely accepted, different definitions of the term "contraction" could easily combine or subdivide particular cycles. Indeed, the NBER does not adhere strictly to the definition of a recession as two successive quarters of GDP decline. Instead, a committee determines, by looking at movements in variables, when turning points have occurred. Some scholars have criticized this committee's decisions.

Economists from time to time have hypothesized the existence of at least three other economic cycles, including a shorter Kitchin or inventory cycle, identified by Joseph Kitchin in 1923, of about forty months in length; a Kuznets cycle, suggested by Simon Kuznets in 1958, of fifteen to twenty-five years in duration; and a Kondratiev or Long Wave cycle, popularized by Nikolai Kondratiev in 1922, of fifty to sixty years in duration. However, none of these is accepted as widely as the business cycle, which bears a strong similarity to the cycle identified by Clément Juglar in the 1860s.

Debate regarding Long Waves has been intense. If these exist, only a handful would have occurred in the modern era, and the major wars complicate interpretation of the historical record. Moreover, explaining fairly regular fluctuations of a half-century duration is arguably a more difficult theoretical task than explaining business cycles. Analyzing the same variables, most scholars of Long Waves emphasize the interplay among technological and economic phenomena. While the existence of fairly regular Long Waves is disputed both empirically and theoretically, the historical record clearly shows periods of more than one business cycle in length in which economic growth and employment were high, such as the 1950s and 1960s, and other periods of more than a business cycle in length in which economic growth was sluggish at best and unemployment was high, such as the 1930s or the 1970s and 1980s. Such periods likely require a different type of explanation. An understanding of the causes of economic growth in general should in turn inform the understanding of business cycles, because fluctuations would not likely be seen in a world without growth.

Table 1 Table 1 The fact that growth rates are higher in some periods than others poses difficulties for the empirical evaluation of business cycles. Ascertaining the severity of the business cycle requires knowing the growth rate around which cyclical fluctuations occur. But observation of a change in GDP from one year to the next conflates the effect of the trend growth rate and the effect of the cycle. Thus, analysts use complex and controversial statistical techniques to distinguish trends from cycles. This task would increase in complexity if economists accepted the existence of more than one type of cycle.

Table 1

The existence of natural seasonal fluctuations in economic activity, associated with climatic changes and the bunching of purchases around holidays such as Christmas, adds another complication. Economists prefer to look at "seasonally adjusted" figures when evaluating economic performance. Has the change from month to month been greater or less than is usually observed between those two months? But as the economy evolves, so does the desirable seasonal adjustment.

Causes of Business Cycles

Economists have long debated the causes of business cycles, especially since the Great Depression. At that time, macroeconomics, the study of aggregate economic activity, emerged. Economists increasingly have recognized, however, that an understanding of business cycles requires microeconomic foundations, that is, an under-standing of how the interaction of individuals and firms in the markets for goods and services, finance, and labor generates business cycles.

Theories of business cycles can be divided into two broad categories. The first argues that cycles are exogenous or due to a variety of shocks. These shocks stimulate either economic expansion or contraction. The second argues that cycles are endogenous or self-generated by the market economy. Theoretical debates often have an ideological tinge influenced by scholarly attitudes toward the market economy and the desirability of government interference. Nevertheless, after decades of often heated debate, economists widely recognize that one right answer is not likely. Different forces have differential impacts on different cycles, and both exogenous and endogenous arguments have some explanatory power.

Exogenous theories emphasize a variety of shocks. Some speak of political shocks; for instance, politicians may encourage economic expansion just before elections. Shocks to the prices of important raw materials, such as oil, are often mentioned at least with respect to particular cycles.

More commonly, scholars argue that increases in the money supply encourage expansions and that central banks, fearing inflation, then restrict the money supply and trigger a contraction. To be sure, the supply of money does tend to rise and fall through cycles, but the debate concerns whether this is in large part a result of or a cause of cycles. Central banks, such as the Federal Reserve Bank, are not the sole influences on the money supply, which is affected also by the level of economic activity and the behavior of individual banks.

During the Great Depression and again later, some economists pointed to technological shocks. If, as seems to be the case, innovation does not occur evenly through time, then investment, consumption, and employment decisions would be expected to vary through time as a result. One problem that plagues this analysis is the difficulty of measuring innovation. Moreover, different innovations likely have different effects on different sectors. The development of new products likely has a positive effect on employment, while the development of better ways of producing existing products likely has a negative effect on employment.

Theories of business cycles must grapple with two opposing questions: Why is economic activity not stable, and how is complete chaos avoided (why do both contractions and expansions always end)? The common presupposition is that equilibrating mechanisms take the economy back toward the trend growth rate but are sluggish in operation. Examples of equilibrating mechanisms include the tendency of firms to increase production as inventories fall, the tendency of people to buy more as prices fall, or the tendency of firms to hire more as wages fall. Another rarely discussed possibility is that shocks of opposing effects may hit the economy. Most of the time these shocks are roughly balanced, and thus cycles are not too severe. Occasionally, as during the Great Depression, shocks are unbalanced and produce lengthy expansions or contractions.

Exogenous theories need only posit some set of shocks and usually some imperfect equilibrating mechanisms. Endogenous theories must argue both for equilibrating mechanisms and for nonequilibrating mechanisms that take the economy away from its trend growth rate. One early example was the general theory of John Maynard Keynes in 1936. Keynes noted that any expenditure has a multiplier effect, as the person receiving the money in turn spends it and so on. He also recognized an accelerator effect in that any attempt to increase output would require a much greater increase in the rate of investment. The multiplier-accelerator mechanism would cause any positive or negative growth impulse to be magnified and the economy to move further away from the trend growth rate. Writing during the Great Depression, Keynes was skeptical that any equilibrating mechanisms were strong enough always to reverse a contraction. Subsequently, the followers of Keynes stressed that inflexibility in wages and prices can cause an economy to move away from the trend growth rate.

A variety of other endogenous approaches is possible. Banks may naturally increase and decrease credit through time. Businesses may habitually overinvest as they fight for market share and then cut back in the face of over-capacity. Businesses may also saturate markets for consumer durables and inevitably experience a sudden drop in demand for such goods, which in turn induces them to reduce production.

Theories of business cycles strive to explain not only movements in GDP but in those variables that tend to move in concert with GDP. Some theories posit that unemployment is largely voluntary. Workers adjust work decisions in response to changes in real wages, or perhaps only to perceptions of such changes if they are fooled by changes in price levels. Other theories stress the involuntary nature of unemployment. During contractions many individuals cannot find work, at least not at anything approaching previously available wage rates. The evidence from unemployed individuals seems to support the latter position, though unemployment rates are constructed on surveys that tend not to ask the unemployed what sort of wage offer they seek.

All theories of business cycles face the problem of the role of expectations. No doubt expectations influence important economic variables, notably business investment and consumer durable purchase decisions. But how are expectations formed? Do they respond primarily to movements in economic variables, and if so, do they respond in a predictable fashion?

Effects of Business Cycles

As noted, business cycles affect variables such as employment, profits, hours of work, and often prices and wages. They thus have a significant impact on people's lives. In severe contractions a sizable proportion of the population loses its income. This was especially true before the creation of unemployment insurance and welfare, when the unemployed depended on charity. Unemployment in turn can affect a variety of noneconomic variables, including decisions regarding marriage and having children; mental health; attitudes toward the wider society, including the potential for civil disorder; and voting patterns, giving politicians a greater chance of reelection during times of economic expansion.

With the advantage of hindsight, economists know that all contractions end, and most end fairly quickly. It is thus all too easy to downplay the effects of cycles. Families may be unable to either borrow or save enough in advance to avoid serious hardship during a contraction, and fears of a future recession may cause families to forgo investments in houses and cars. Moreover, individuals who come of age during a serious recession may find their entire lives affected, as during the next expansion prospective employers may eschew those who have been long unemployed.

Changes in Business Cycles

Since business cycles involve an interaction among several economic and likely several noneconomic variables, some changes in the character of business cycles, including average duration, severity of fluctuations, or impact upon different sectors of the economy, should occur as an economy develops. Some have argued for the existence of a "new economy," in which the application of information technology would lessen the severity of cycles, yet most economists have been skeptical.

Considerable debate has focused on this question: Have business cycle fluctuations become less severe than they were before World War I? The debate has hinged primarily on the estimation of movements in GDP before such statistics were collected by the government. Most economists accept that business cycles involve longer expansions and shorter and shallower recessions than did those before World War I.

Most scholars attribute the longer expansions and shorter recessions primarily to government initiatives. The establishment of automatic stabilizers, such as unemployment insurance, have ensured that workers do not lose their entire incomes and thus their ability to spend when they lose their jobs in a recession. In addition, the government and the Federal Reserve have striven to adjust spending, taxation, and the money supply to reduce the severity of cycles. By putting more or less money in people's hands, they aim to increase or decrease the level of economic activity. Some economists worry that the government, due to a limited ability to predict cycles plus the time required to actually adjust spending or tax decisions, as often as not worsens cycles by, say, increasing spending after a contraction has already ended. Another concern is that taxpayers, faced with an increase in government debt, may reduce their own spending to save in anticipation of future tax increases. Nevertheless, substantial empirical evidence indicates that changes in government spending and taxation do affect the level of economic activity.

Other possible explanations of increased economic stability include the lesser incidence of financial panics, which were an important component of nineteenth-century recessions, due in large part to deposit insurance, introduced in 1934; increased flexibility of wages and prices, important for equilibrating mechanisms; management of inventories so firms do not build them up at the start of a downturn, then slash production to compensate; increased importance of the service sector, which tends to be less volatile than industry because many goods are purchased irregularly; and increased business confidence that downturns will be short.

Analysis of Particular Cycles

The discussion above suggests that different theoretical approaches have different explanatory power with respect to particular cycles. No approach should be ignored in studying any cycle. An obvious danger is to ignore endogenous arguments in favor of unique exogenous shocks when analyzing a particular cycle. It is possible though that exogenous shocks loom larger in the more severe cycles that attract most historical attention.

Banking panics were a common characteristic of recessions as late as the Great Depression. The resulting bank failures surely exacerbated contractionary tendencies, for people could not spend money they had lost. The question is how great this contractionary tendency was relative to the size of particular recessions. Likewise, stock market crashes can have a contractionary impact; these dramatic events may receive more attention than warranted by their economic impact. More generally, changes in interest rates and money supply often are associated with cycles and are attributed an important causal role. The 1929 crash has often been blamed for inducing the Great Depression, although the crash of 1987 was not associated with a serious economic downturn.

Sudden increases in raw material prices, such as occurred with copper during the early days of electrification in 1907 or oil in the 1970s, likely played some role in inducing recessions. Electrification, the assembly line, the automobile, and the television are among a number of major technological innovations that almost certainly had some impact on the level of economic activity and employment. As prices of many products rose, consumers and investors reduced their purchases. Saturated markets for houses, cars, and other durables have been observed during contractions in the 1930s and the 1970s. New products usually, but not always, cause increased investment and employment, while new production processes generally cause employment to fall.

Since the Great Depression, governments have taken an active role in trying to affect economic activity by adjusting the level of taxes and spending. Central banks too have tried to affect economic activity through adjustments to the money supply or interest rates. Even before the Great Depression, major government expenditures, such as during war or for the development of transport infrastructure, would have had some expansionary effect. As noted above, economists debate whether governments thus alleviate cycles or instead make these worse by increasing spending during expansions or reducing spending in recessions.

Bibliography

Berry, Brian J. L. Long-Wave Rhythms in Economic Development and Political Behavior. Baltimore: Johns Hopkins University Press, 1991.

Burns, Arthur F., and Wesley C. Mitchell. Measuring Business Cycles. New York: National Bureau of Economic Research, 1946. A classic work by two leading scholars of business cycles of the time.

Diebold, Francis X., and Glenn D. Rudebusch. Business Cycles: Durations, Dynamics, and Forecasting. Princeton, N.J.: Princeton University Press, 1999. Discusses the statistical analysis of business cycles, and compares pre–World War I and post–World War II cycles.

Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867–1960. Princeton, N.J.: Princeton University Press, 1963. Classic argument for the importance of changes in monetary variables in generating cycles; unusually relies on examinations of particular cycles rather than on statistical analysis across several cycles.

Goldstein, Joshua S. Long Cycles: Prosperity and War in the Modern Age. New Haven, Conn.: Yale University Press, 1988.

Hall, Thomas E. Business Cycles: The Nature and Causes of Economic Fluctuations. New York: Praeger, 1990. A rare combination of a theoretical survey and application to selected twentieth-century cycles.

Keynes, John Maynard. The General Theory of Employment, Interest, and Money. London: Macmillan, 1936. Generally recognized as having spawned the field of macroeconomics.

National Bureau of Economic Research. "U.S. Business Cycle Expansions and Contractions." Available at http://www.nber.org/cycles.html.

Ralf, Kirsten. Business Cycles: Market Structure and Market Inter-action. New York: Physica-Verlag, 2000. Surveys modern theories, with an emphasis on microeconomic foundations.

Schumpeter, Joseph A. Business Cycles. New York: McGraw-Hill, 1939. Classic argument for the existence of four cycles of differing average durations.

Solomou, Solomos. Phases of Economic Growth, 1850–1973: Kondratieff Waves and Kuznets Swings. New York: Cambridge University Press, 1987. Argues for the existence of Kuznets cycles.

Zarnowitz, Victor. Business Cycles: Theory, History, Indicators, and Forecasting. Chicago: University of Chicago Press, 1992. Discussion of the evolution of the measurement of business cycles by a scholar long connected with the NBER.

—Rick Szostak

The periodic expansion and contraction of economic activity.

A period during which business activity reaches a low point, recovers, expands, reaches a high point, decreases to a new low point, and so on.

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The business cycle or economic cycle refers to the fluctuations of economic activity about its long term growth trend. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product. Despite being named cycles, these fluctuations in economic growth and decline do not follow a purely mechanical or predictable periodic pattern.

An abstract business cycle

Types of business cycle

Traditional business cycle models

The main types of business cycles enumerated by Joseph Schumpeter and others in this field have been named after their discoverers or proposers:

1. the Kitchin inventory cycle (3-5 years) - after Joseph Kitchin.
2. the Juglar fixed investment cycle (7-11 years) -- after Clement Juglar.
3. the Kuznets infrastructural investment cycle (15-25 years) -- after Simon Kuznets, Nobel Laureate.
4. the Kondratieff wave or cycle (45-60 years) -- after Nikolai Kondratieff.

Even longer cycles are occasionally proposed, often as multiples of the Kondratiev cycle.

Juglar cycle

In the Juglar cycle, which is sometimes called "the" business cycle, recovery and prosperity are associated with increases in productivity, consumer confidence, aggregate demand, and prices. In the cycles before World War II or that of the late 1990s in the United States, the growth periods usually ended with the failure of speculative investments built on a bubble of confidence that bursts or deflates. In these cycles, the periods of contraction and stagnation reflect a purging of unsuccessful enterprises as resources are transferred by market forces from less productive uses to more productive uses. Cycles between 1945 and the 1990s in the United States were generally more restrained and followed political factors, such as fiscal policy and monetary policy. Automatic stabilisation due to the government's budget helped defeat the cycle even without conscious action done by policy-makers.

Politically based business cycle models

Another set of models tries to derive the business cycle from political decisions.

The partisan business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. Regime A adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high. The replacement, Regime B, adopts contractionary policies reducing inflation and growth, and the downwards swing of the cycle. It is voted out of office when unemployment is too high, being replaced by Party A.

The political business cycle is an alternative theory stating that when an administration of any hue is elected, it initially adopts a contractionary policy to reduce inflation and gain a reputation for economic competence. It then adopts an expansionary policy in the lead up to the next election, hoping to achieve simultaneously low inflation and unemployment on Polling Day. The business cycle is the rises and falls of the economy. This maintains neutrality between supply and demand.

Preventing business cycles

Because the periods of stagnation are painful for many who lose their jobs, pressure arises for politicians to try to smooth out the oscillations. An important goal of all Western nations since the Great Depression has been to limit the dips. Government intervention in the economy can be risky, however. For instance, some of Herbert Hoover's efforts (including tax increases) are widely, though not universally, believed to have deepened the depression.

No one argues that managing economic policy to even out the cycle is an easy job in a society with a complex economy, even when Keynesian theory is applied. According to some theorists, notably nineteenth-century advocates of communism, this difficulty is insurmountable. Karl Marx in particular claimed that the recurrent business cycle crises of capitalism were inevitable results of the system's operations. In this view, all that the government can do is to change the timing of economic crises. The crisis could also show up in a different form, for example as severe inflation or a steadily increasing government deficit. Worse, by delaying a crisis, government policy is seen as making it more dramatic and thus more painful.

Additionally, Neoclassical economics plays down the ability of Keynesian policies to manage an economy. Challenging the Phillips Curve since the 1960's, men like Nobel Laureate Milton Friedman or 2006 Nobel Laureate Edmund Phelps have made ground in their arguments that inflationary expectations negate the Phillips Curve in the long run. The stagflation of the 70's supported their theory by flying in the face of Keynesian predictions. Friedman has gone so far as to argue all the Fed can do is to avoid making large mistakes, as he believes they did by contracting the money supply very rapidly in the face of the Stock Market Crash of 1929, in which they made what would have been a recession a great depression. (Friedman calls the Great Depression The Great Contraction because of this).

Alternative interpretations of business cycles

Austrian School

The Austrian School of economics rejects the suggestion that the business cycle is an inherent feature of an unregulated economy and argues that it is caused by intervention in the money supply. Austrian School economists, following Ludwig von Mises, point to the role of the interest rate as the price of investment capital, guiding investment decisions. In an unregulated (free-market) economy, it is posited that the interest rate reflects the actual time preference of lenders and borrowers. Some follow Knut Wicksell to call this the "natural" interest rate.[1] Government control of the money supply through central banks and regulations allowing Fractional-reserve banking disturbs this equilibrium such that the interest rate no longer reflects the real supply of and demand for investment capital. Austrian School economists conclude that, if the interest rate is artificially low, then the demand for loans will be higher than the actual supply of willing lenders, and if the interest rate is artificially high, the opposite situation will occur. This misinformation leads investors to misallocate capital, borrowing and investing either too much or too little in long-term projects. Periodic recessions, then, are seen as necessary "corrections" following periods of fiat credit expansion, when unprofitable investments are liquidated, freeing capital for new investment.

The Austrian theory also predicts that the imposition of artificially low interest rates, and the resulting increase in the supply of fiat credit, generates (is) inflation, which obliges the central bank to increase the supply of credit yet further to maintain the artificially low interest rate, thus prolonging the "boom" and worsening the inevitable "correction." In Austrian theory, depressions and recessions are positive forces in-so-much that they are the market's natural mechanism of undoing the misallocation of resources present during the “boom” or inflationary phase. Austrian School economists point to the dot-com investment frenzy as a modern example of artificially abundant credit subsidizing unsustainable overinvestment.

In the Keynesian view, this Austrian theory assumes that the "natural" rate of interest is unique at any given time and cannot be affected by policy. To Keynesian economists, this rate is only unique if the economy is assumed to always be at full employment. If the economy is operating with less than full employment, i.e., with high unemployment above the NAIRU, then in theory monetary policy and fiscal policy can have a positive role to play rather than simply creating booms that necessarily collapse on themselves. It should be noted that, in the Austrian School, the natural interest rate is not affected by the employment rate and the absence of full employment is typically attributed to government interference in the labour markets, such as minimum wage laws, employment regulations, and taxes levied against employers, which prevent the employment market from fully clearing.

Marxist views

Michal Kalecki's [2] Marxian-influenced "political business cycle" theory blames the government: he argued that no democratic government under capitalism would allow the persistence of full employment, so that recessions would be caused by political decisions: persistent full employment would mean increasing workers' bargaining power to raise wages and to avoid doing unpaid labor, potentially hurting profitability. (He did not see this theory as applying under fascism, which would use direct force to destroy labor's power.) In recent years, proponents of the "electoral business cycle" theory have argued that incumbent politicians encourage prosperity before elections in order to ensure re-election -- and make the citizens pay for it with recessions afterwards.

Ravi Batra's interpretation

In his 1984 book Regular Cycles of Money, Inflation, Regulation and Depressions Ravi Batra presented a calculation of decennial averages for i) money growth, ii) number of new regulatory laws or institutions and iii) inflation in the USA for a period exceeding two hundred years. The cycles were of a regular rise and then decline in the above mentioned variables. While an unrelated prediction for a depression to unfold in the 1990s failed to materialise, the evolution of these variables in the 1990s and 2000s has broadly conformed to the regular decennial pattern.

Milton Friedman's interpretation

Milton Friedman has stated on a number of occasions that calling the business cycle a "cycle" is a misnomer, because of its non-cyclical nature. He thinks that for the most part and excluding very large supply shocks, business declines are more of a monetary phenomenon.

Cycles or fluctuations?

In recent years economic theory has moved towards the study of economic fluctuation rather than a 'business cycle' - though some economists use the phrase 'business cycle' as a convenient shorthand.

Rational expectations theory states that no deterministic cycle can persist because it would consistently create arbitrage opportunities. Much economic theory also holds that the economy is usually at or close to equilibrium.

These views led to the formulation of the idea that observed economic fluctuations can be modelled as shocks to a system.

A moving average of a stochastic stationary variable also bears resemblance to a graph of an economic time-series, such as inflation, unemployment, or investment. Such graphs arguably resemble actual events more closely than deteministic cycle formulae.

These fluctuations can be modelled in terms of fluctuations of aggregate demand. However, the main influence in this direction has been real business cycle models which consider fluctuations in supply (technology shocks). This theory is most associated with Finn E. Kydland and Edward C. Prescott, winners of the 2004 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.

Why will there not be a prolonged recession?

Firstly, productive capital used by firms will be worn out over time and require replacements. Spending on capital equipment such as machinery is necessary, which increases aggregate expenditure (AE) and causes the economy to slowly climb. Secondly, the low prices characteristic of a trough phase will cause increased demand for them, resulting in inflation which is characteristic of the boom phase. The low interest rates will stimulate increased borrowing. The repayments and interest which need to be paid back will contribute to the rise in AE. Governments also aim to improve the business cycle so as to provide stability, get re-elected and to ease worries about the state of the economy. They also do this to attract foreign investors and improve their international reputation.

Random Walks and chaotic patterns

In 1900 Louis Bachelier proposed that the fluctuations in share prices follow random walks, being complete random with no cyclic properties. While this was a ground breaking work, Bachelier's model failed to account for big fluctuations such as the Great Depression. In the 1960s, Benoît Mandelbrot proposed that fluctuation in cotton prices follow a Lévy flight distribution, which have a fat tail allowing greater probability for large fluctuations.^[1] In 1995, physicists R. Mantegna and G. Stanley analyzed over a million records of stock market indices from the previous five years, and they found that the actual distribution lay between the Gaussian random walks and Lévy flights. They also found that similar distributions were found regardless of the time scale exhibiting self-similarity^[2]. An accurate model is yet to be found.

Problems of measurement

Some argue that modern business cycle theory often measures growth by using the flawed measure of the economy's aggregate production, i.e., real gross domestic product, which is not useful for measuring well-being and also generates distortions in the perception of economic growth because the price changes of the various products are disproportional. Accordingly, there is a mismatch between the state of economic health as perceived by many individuals and that perceived by the bankers and economists, which most likely drives them further apart politically. However, unlike with issues of long-term economic growth, the economists and bankers may be right to use real GDP when studying business cycles. After all, it is fluctuations in real GDP, not those of measures of well-being, that cause changes in employment, unemployment, interest rates, and inflation, i.e. economic issues which are their main concern of business cycle experts.

Business cycle theory has been most effective in microeconomics where it aids in the preparation of risk management scenarios and timing investment, especially in infrastructural capital that must pay for itself over a long period, and which must fund itself by cashflow in late years. When planning such large investments, it is often useful to use the anticipated business cycle as a baseline, so that unreasonable assumptions, e.g. constant exponential growth, are more easily eliminated.

See also

• Real business cycles
• Elliott wave theory
• Economic policy
• Grand supercycle
• Market trends
• Ravi Batra
• Joseph Schumpeter
• Carlota Perez
• Austrian School

References

1. ^ Philip Ball, Critical mass Random House, 2004. ISBN 0-09-945786-5
2. ^ Rosario N. Mantegna, H. Eugene Stanley, An Introduction to Econophysics: Correlations and Complexity in Finance, Cambridge University Press (Cambridge, 1999)

External links

• An Austrian Theory of Business Cycles
• What is the Business Cycle?
• List of U.S. recessions in terms of peak and trough of business cycle
• From the New School for Social Research, by Gonçalo L. Fonseca and Leanne J. Ussher:

1. Do business cycles really exist?
2. Climate-driven cycles
3. Over-investment cycles
4. Psychological & lead/lag cycles
5. Monetary cycles
6. Underconsumption theories
7. Exogenous shock-based cycles
8. Keynesian theories of the cycle:
   1. Oxford/Cambridge theories
   2. Accelerator/multiplier theories
   3. Endogenous theories of the cycle

• on whether planned economies also have business cycles
• Current Business-Cycle Conditions from American Institute for Economic Research (AIER)be-x-old:Каньюнктура

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