Business Cycles Chapter Notes | Business Economics for CA Foundation PDF Download

Chapter Overviews

Introduction

Business cycles refer to the fluctuations in economic activity, such as gross national product (GNP), employment, and income. These cycles are characterized by alternating periods of expansion and contraction in overall business activity.

Business Cycle:

(i) Boom: This phase is marked by a significant increase in economic activity, characterized by rising prices and low unemployment rates. During a boom, there is a general sense of prosperity, and various sectors of the economy experience growth.
(ii) Recession:. recession is the opposite of a boom. It is characterized by a decline in economic activity, with falling prices and rising unemployment rates. During a recession, businesses may struggle, consumer spending may decrease, and overall economic conditions worsen.
The business cycle is a natural phenomenon observed in economies, where periods of good trade and bad trade alternate. These cycles are recurrent, meaning they happen repeatedly, but not at regular intervals or with the same duration. Some business cycles can be long, lasting for several years, while others are shorter, ending within two to three years.

1. Boom Phase:
Definition: The boom phase of the business cycle is characterized by a surge in economic activity and growth. It is a period of expansion where various economic indicators show positive trends.

Key Features:

• Increased Economic Activity: During the boom, there is a significant rise in production, consumption, and investment. Businesses expand their operations, and consumers increase their spending.
• Low Unemployment: The demand for labor rises as businesses seek to meet the growing demand for goods and services. As a result, unemployment rates decrease, and more people find jobs.
• Rising Income Levels: With more people employed and businesses thriving, income levels across the economy increase. This leads to higher disposable incomes for individuals, further fueling consumption.
• Increased Business Profits: Companies experience higher profits due to increased sales and production. This encourages further investment and expansion within the business sector.
• Positive Consumer Confidence: Consumer confidence is typically high during the boom phase. People feel optimistic about their financial situations and are more willing to spend money on goods and services.
• Rising Stock Prices: The stock market often reflects the positive sentiment during a boom. As companies report higher profits and growth prospects, their stock prices tend to rise, attracting more investors.

Historical Example (UK in the 1920s):

Description: The boom phase in the UK during the 1920s is a historical example of a strong economic upturn.

Features Observed:

• Rapid GDP Growth: The UK experienced significant growth in its Gross Domestic Product (GDP), indicating a robust expansion of economic activity.
• Increased Production and Living Standards: New technologies and production processes, such as the assembly line, contributed to higher production levels and improved living standards for the population.
• Stock Market Surge: The economic growth during this period led to an unprecedented rise in stock market values, reflecting investor confidence and optimism about future prospects.

2. Recession Phase:
Definition: The recession phase of the business cycle is characterized by a decline in economic activity and a downturn in various economic indicators. It is a period of contraction where the economy faces challenges and setbacks.

Key Features:

• Decreased Economic Activity: During a recession, there is a noticeable decline in production, consumption, and investment. Businesses may scale back their operations, and consumer spending tends to decrease.
• Rising Unemployment: As economic activity contracts, the demand for labor decreases. This leads to rising unemployment rates, with more people finding it challenging to secure jobs.
• Falling Income Levels: With increased unemployment and reduced economic activity, income levels across the economy may decline. This results in lower disposable incomes for individuals, impacting their ability to spend.
• Decreased Business Profits: Companies may experience lower profits during a recession due to reduced sales and production. This can lead to cost-cutting measures, including layoffs and reduced investments.
• Negative Consumer Confidence: Consumer confidence typically declines during a recession. People may feel uncertain about their financial situations and are more cautious about their spending habits.
• Falling Stock Prices: The stock market often reflects the negative sentiment during a recession. As companies report lower profits and uncertain prospects, their stock prices may decline, leading to reduced investor confidence.

Historical Example (China's Recent Economic Slowdown):
Description: China's recent economic slowdown serves as a contemporary example of a recession phase in the business cycle.

Features Observed:

• Economic Contraction: China experienced a decline in economic activity, impacting various sectors and leading to a slowdown in growth.
• Rising Financial Risks: The slowdown in China contributed to escalating risks of prolonged economic slumps and financial disruptions in other countries, reflecting the interconnectedness of global economies.

Phases of Business Cycle

1. Expansion (Boom or Upswing): During the expansion phase, the economy experiences a significant increase in various indicators, including:

• National Output: There is a rise in the total production of goods and services in the country. 
• Employment: Job opportunities increase, leading to lower unemployment rates. 
• Aggregate Demand: The overall demand for goods and services rises. 
• Capital and Consumer Expenditure: Both businesses and consumers increase their spending. 
• Sales and Profits: Businesses see higher sales and, consequently, higher profits. 
• Stock Prices and Bank Credit: Stock prices rise, and banks are more willing to extend credit. 

This phase continues until the economy reaches full employment of resources and production is at its maximum capacity. At this point, involuntary unemployment is minimal, with any remaining unemployment being either frictional (due to job changes, strikes, or labor mobility issues) or structural (due to fundamental changes in the economy). Prices and costs begin to rise more quickly during this phase. There is a substantial increase in net investment, and the demand for all types of goods and services is on the rise. Overall, the expansion phase is marked by increasing prosperity, with people enjoying a higher standard of living due to elevated levels of consumer spending, business confidence, production, factor incomes, profits, and investment. However, this growth rate eventually slows down and reaches its peak.

2. Peak: The peak phase represents the highest point of the business cycle. As the economy approaches this stage, several challenges emerge:

• Input Scarcity: It becomes difficult to find necessary inputs, leading to a rise in input prices. 
• Output Price Increase: Output prices also rise rapidly, contributing to a higher cost of living and placing additional strain on fixed-income earners. 
• Consumer Behavior: Consumers start reevaluating their spending on items such as housing and durable goods. 
• Demand Stagnation: Actual demand begins to stagnate. The peak phase marks the end of the expansion period and occurs when economic growth reaches a point of stabilization before reversing direction.

3. Contraction

• The economy cannot grow forever without limits. After reaching its peak, demand starts to decline in certain sectors. During this phase, investment and employment levels also drop.
• Initially, producers do not immediately sense the change in economic conditions and continue to expect high demand, maintaining their levels of investment and production. This leads to a mismatch between supply and demand, with supply exceeding demand.
• At first, this imbalance occurs in only a few sectors and at a slow pace, but it quickly spreads to all sectors.
• As producers realize they have over-invested and over-produced, they respond by cutting back on future investment plans, canceling orders for equipment, and reducing labor. This triggers a chain reaction in input markets, affecting producers of capital goods and raw materials who also begin to cancel and reduce their orders.
• This marks the turning point and the onset of recession.
• Decrease in Input Demand. As the demand for inputs decreases, their prices start to fall. This decline in input prices leads to a decrease in incomes for wage and interest earners, which further reduces their ability to spend on goods and services.
• Price Adjustments by Producers. To manage their financial obligations and clear out excess inventories, producers begin to lower their prices. However, consumers anticipate further price drops and start postponing their purchases.
• Aggregated Demand Decline. With reduced consumer spending, aggregate demand continues to fall, leading to a further decline in prices. This exacerbates the mismatch between supply and demand.
• Investment and Employment Decline. As the recession deepens, investments, production, and employment begin to decline. This results in a further decrease in incomes, impacting the demand for both capital goods and consumer goods.
• Business Pessimism and Credit Shrinkage. Businesses become increasingly pessimistic about the economic outlook, leading to lower profit expectations and reduced investments. Bank credit also contracts as borrowings for investment decrease, contributing to the overall decline in economic activity.
• Stock Prices and Unemployment. Investor confidence plummets, stock prices fall, and unemployment rises despite declining wage rates. This completes the recession process and triggers a severe contraction in economic activities, pushing the economy into a phase of depression.

4. Trough and Depression

• Trough: This phase marks the lowest point of the business cycle, where economic activity is at its minimum. Indicators such as GDP, employment, and industrial production are at their lowest levels. However, this phase also represents the turning point where the economy begins to recover.
• Depression:Depression is an extreme form of recession characterized by very weak economic activities. In this phase, the growth rate becomes negative, and national income and expenditure decline rapidly. Key features of depression include:
  • Declining Demand: There is a significant decrease in the demand for goods and services.
  • Falling Prices: Prices hit their lowest levels and continue to decline, forcing firms to shut down several production facilities.
  • Rising Unemployment: With companies unable to sustain their workforce, unemployment rises sharply, leaving consumers with very little disposable income.
  • Low-Interest Rates:. typical feature of depression is a fall in interest rates, which aims to stimulate economic activity.

5. Recovery: The recovery phase marks the end of the trough and the beginning of economic expansion. During this phase:

• Labour market improvement: Initially, the recovery is felt in the labour market as pervasive unemployment forces workers to accept lower wages.
• Anticipation of lower costs: Producers anticipate lower costs and a better business environment, leading to increased business confidence.
• Investment and credit expansion: As business confidence improves, companies start to invest and build stocks, and the banking system begins to expand credit.
• Technological advancements: New technological advancements require fresh investments in machines and capital goods, leading to increased employment and aggregate demand.
• Price mechanism: The price mechanism acts as a self-correcting process in a free enterprise economy, spurring investment and contributing to economic recovery.
• Turning point: The recovery phase acts as a turning point from depression to expansion. As investment rises, production increases, employment improves, and consumer spending increases, leading to a cycle of increased aggregate demand and production.
• Economic expansion: As unemployment falls and economic activity increases, the economy shifts into an expansion phase.

Variability of Business Cycles: It is important to note that no economy follows a perfectly timed cycle, and business cycles are irregular, varying in intensity and length. Some cycles may have longer periods of boom, while others may experience longer periods of depression.

Predicting Turning Points: Predicting the turning points of business cycles is challenging. Economists use various indicators to measure and predict the business cycle, which can signal the direction in which the economy is headed.

Economic Indicators

Economic indicators are statistical metrics that provide insights into the overall health and direction of an economy. These indicators can be categorized into three main types: leading indicators, lagging indicators, and coincident indicators.

Leading Indicators

• Definition: Leading indicators are measurable economic factors that change before the economy begins to follow a specific pattern or trend. They serve as early signals of potential economic shifts.
• Examples:
  • Changes in stock prices
  • New orders for capital and consumer goods
  • Building permits for private houses
  • Index of consumer confidence
  • Money growth rate
• Purpose: Leading indicators are used to predict changes in the economy, such as upturns or downturns. However, they are not always accurate, and experts may disagree on their timing. For instance, a stock market crash may not immediately reflect in economic data.

Lagging Indicators

• Definition: Lagging indicators reflect the historical performance of the economy and change after an economic trend or pattern has already occurred. They confirm the trends identified by leading indicators.
• Examples:
  • Unemployment rates
  • Corporate profits
  • Labour cost per unit of output
  • Interest rates
  • Consumer price index
• Purpose: Lagging indicators provide a retrospective view of economic conditions and are used to confirm the onset of business cycles.

Coincident Indicators

• Definition: Coincident indicators, also known as concurrent indicators, occur simultaneously with business-cycle movements. They provide information about the current state of the economy at the same time changes are happening.
• Examples:
  • Gross Domestic Product (GDP)
  • Industrial production
  • Inflation rates
  • Personal income
  • Retail sales
  • Stock market trends
• Purpose: Coincident indicators help describe the current rate of change in economic expansion or contraction, providing real-time insights into economic conditions.

Examples of Business Cycles

Great Depression of 1930: The Great Depression of the 1930s was the longest, deepest, and most widespread economic downturn of the 20th century. It began in the United States and quickly spread globally, causing a significant decline in global GDP by around 15% between 1929 and 1932. During this period, production, employment, and income plummeted.

• Causes of the Great Depression: Economists have differing views on the causes of the Great Depression. British economist John Maynard Keynes believed that lower aggregate expenditures were responsible for the massive decline in income and employment. On the other hand, monetarists argued that the depression was caused by a banking crisis and a low money supply. Other economists pointed to factors such as deflation, over-indebtedness, lower profits, and pessimism as contributing causes.
• Impact: Regardless of the specific causes, the Great Depression led to widespread distress as production, employment, income, and expenditure fell sharply. The world economies began to recover in 1933, thanks to factors such as increased money supply, a significant inflow of gold, and increased government spending, partly due to World War II. These factors helped economies gradually emerge from recession and enter a phase of expansion and recovery.

Information Technology Bubble Burst of 2000: The Information Technology (IT) bubble, also known as the Dot.Com bubble, spanned roughly from 1997 to 2000. During this period, numerous internet-based companies, commonly referred to as dot-com companies, were established. Low interest rates in 1998-99 encouraged these start-up internet companies to borrow from the markets. The rapid growth of the internet and the perceived vast potential in this area led venture capitalists to invest heavily in these companies.

• Rise of the Bubble: Over-optimism in the market resulted in a lack of caution among investors. There was a significant increase in stock prices, and companies could boost their stock prices merely by adding an "e-" prefix to their name or a ".com" to the end. These companies offered their services or products for free initially, expecting to build brand awareness and charge profitable rates later. This led to high growth and the development of a bubble.
• Unsustainable Practices: The "growth over profits" mentality prompted some companies to engage in extravagant internal spending, such as creating elaborate business facilities. However, these companies could not sustain their growth.
• Collapse of the Bubble: The collapse of the bubble occurred between 1999 and 2001, with many dot-com companies running out of capital, being acquired, or liquidated. Nearly half of the dot-com companies either shut down or were taken over by other firms. Stock markets crashed, and economies began to experience a downturn in economic activities.

Recent Example of Business Cycle: Global Economic Crisis (2008-09)

• The global economic crisis of 2008-09 originated in the US financial markets. After the burst of the Information Technology bubble in 2000, the US economy entered a recession. To counter this, the US Federal Reserve (the Central Bank of the US) lowered interest rates, resulting in increased liquidity and money supply within banks.
• With cheaper credit, households with even low creditworthiness began purchasing houses in greater numbers. This surge in demand led to rising housing prices, creating a belief that prices would continue to escalate. The excess liquidity and new financial instruments prompted banks to lend without adequately assessing borrowers' creditworthiness, granting loans to sub-prime households and individuals without income or assets.
• During the boom period, houses were built in excess, leading to an oversupply in the market. By 2006, housing prices began to decline as a result. The housing bubble burst in the latter half of 2007. As mortgage-holding house prices fell, sub-prime households started defaulting on their payments in large numbers, causing significant losses for banks. These losses triggered a chain reaction, impacting the entire US economy and subsequently the global economy.

Features of Business Cycles

(a) Periodicity and Variability: Business cycles occur periodically, but not with the same regularity. Their duration and the intensity of fluctuations can vary significantly from one cycle to another.

(b) Phases of Business Cycles: Business cycles consist of distinct phases: expansion, peak, contraction, and trough. However, these phases do not occur smoothly or regularly, and their length is not fixed.

(c) Origin and Transmission: Business cycles typically originate in free market economies and are pervasive in nature. Disturbances in one sector can easily spread to others, affecting the entire economy.

(d) Sectoral Impact: While all sectors are impacted by business cycles, some sectors, such as capital goods and durable consumer goods industries, are disproportionately affected. The industrial sector is generally more susceptible to the adverse effects of trade cycles compared to the agricultural sector.

(e) Complexity and Predictability: Business cycles are complex phenomena with varying characteristics and causes. Predicting trade cycles accurately before they occur is challenging due to their complexity.

(f) Economic Variables: The effects of business cycles are felt simultaneously across nearly all economic variables, including output, employment, investment, consumption, interest rates, trade, and price levels.

(g) Contagion and International Spread: Business cycles are contagious and have an international character. They often begin in one country and spread to others through trade relations, as seen in historical events like the Great Depression of the 1930s.

(h) Societal Consequences: Business cycles have serious consequences for societal well-being, impacting various aspects of life and the economy.

Causes of Business Cycles

Business cycles can arise from various factors, including external causes, internal causes, or a combination of both. For instance, the 2001 recession followed a period of intense speculation in dot-com and technology stocks, while the 2007-09 recession was preceded by unprecedented speculation in the U.S. housing market.

External Causes: These include factors such as:

• War
• Post-war reconstruction
• Technology shocks
• Natural factors
• Population growth

Internal Causes: These refer to endogenous factors that can lead to economic booms or busts, including:

• Fluctuations in Effective Demand: According to economist John Maynard Keynes, variations in economic activity are driven by fluctuations in aggregate effective demand. Effective demand refers to the willingness and ability of consumers to purchase goods at various prices. In a free market economy where businesses aim to maximize profits, a higher level of aggregate demand encourages increased production, leading to higher output, income, and employment. Conversely, if aggregate demand exceeds aggregate supply, it results in inflation. On the other hand, low aggregate demand leads to reduced output, income, and employment, triggering a downward spiral where investors sell stocks and shift to safer investments like bonds, gold, and the U.S. dollar. As companies lay off workers and consumers cut back on spending, the cycle of decline continues. Eventually, the bust cycle may self-correct when prices drop to levels that attract investors back into the market, although this process can be lengthy and may even lead to a depression.
• Net Foreign Demand: The difference between exports and imports constitutes the net foreign demand for goods and services, which is a component of aggregate demand in the economy. Variations in exports and imports can contribute to business fluctuations. An increase in aggregate effective demand leads to conditions of expansion or boom, while a decrease results in recession or depression. (These concepts will be explored in greater detail at the Intermediate level in Economics for Finance).
• Fluctuations in Investment: Some economists argue that fluctuations in investment are the primary cause of business cycles. Investment spending is considered one of the most volatile components of aggregate demand. Changes in profit expectations, driven by factors such as new inventions or lower interest rates, can significantly impact investment levels. When entrepreneurs anticipate higher profits or when borrowing costs are low, investment increases, shifting aggregate demand to the right and fostering economic expansion. Conversely, decreases in investment have the opposite effect, leading to economic contraction.

Factors causing Business Fluctuations

Business fluctuations can be attributed to various factors, including variations in government spending, macroeconomic policies, money supply, and psychological factors.

1. Variations in Government Spending

• Fluctuations in government spending can have a significant impact on aggregate economic activity, leading to business fluctuations. Government spending, particularly during and after wars, can have destabilizing effects on the economy.

2. Macroeconomic Policies

• Macroeconomic policies, including monetary and fiscal policies, play a crucial role in causing business cycles. Expansionary policies, such as increased government spending and tax cuts, are commonly used to boost aggregate demand, resulting in economic booms. Conversely, anti-inflationary measures like reducing government spending, increasing taxes, and raising interest rates can lead to economic slowdowns and, in severe cases, recessions.

3. Money Supply

• The trade cycle, according to economist Hawtrey, is primarily a monetary phenomenon. Unplanned changes in the money supply can cause business fluctuations. An increase in the money supply can stimulate aggregate demand and economic activity, while excessive increases can lead to inflation. Conversely, a decrease in the money supply can initiate a recession.

4. Psychological Factors

• Psychological factors, as suggested by economist Pigou, also play a significant role in business fluctuations. The anticipations and psychological states of businesspeople, whether optimistic or pessimistic, can influence their investment decisions. When entrepreneurs are optimistic about future market conditions, they are more likely to invest, leading to economic expansion. Conversely, pessimism can lead to reduced investments and economic contraction.

5. Innovation Theory and Cobweb Theory

• According to Schumpeter’s innovation theory, trade cycles occur due to innovations that take place in the economic system from time to time. The cobweb theory, proposed by Nicholas Kaldor, suggests that business cycles result from the influence of present prices on future production, leading to fluctuations in output and employment at a later date.

External Causes of Business Cycles

Business cycles can also be influenced by external factors, known as exogenous causes. These factors can lead to either a boom or a bust in the economy.

Wars

• During times of war, the production of war goods such as weapons and arms increases significantly. This diversion of resources towards war production impacts the availability of resources for other goods, including capital and consumer goods.
• As a result, the overall production of these goods declines, leading to a decrease in income, profits, and employment. This contraction in economic activity can trigger a downturn in the business cycle.

Post-War Reconstruction

• After a war, countries embark on reconstruction efforts, building infrastructure such as houses, roads, and bridges. This surge in economic activity boosts effective demand, leading to an increase in output, employment, and income. 
• The reconstruction phase stimulates the economy and contributes to a positive shift in the business cycle.

Technology Shocks

• Advancements in technology can lead to the production of new and improved products and services. The adoption of new technology often requires significant investments, which can result in expanded employment, income, and profits. 
• For instance, the advent of mobile phones transformed the telecom industry, leading to increased production, employment, income, and profits. Such technology shocks can provide a substantial boost to the economy.

Natural Factors

• Natural factors, particularly weather cycles, can cause fluctuations in agricultural output, impacting economies that are heavily reliant on agriculture. Adverse weather conditions such as droughts or excessive floods can severely affect agricultural production. When agricultural output declines, farmers' incomes decrease, leading to reduced demand for industrial goods. 
• Additionally, lower agricultural output can drive up food prices, further constraining disposable income for purchasing industrial goods. This reduced demand for industrial products can trigger an industrial recession.

Population Growth

• If the population growth rate exceeds the economic growth rate, it can result in lower savings within the economy. Reduced savings lead to decreased investment, which in turn affects income and employment levels. 
• With lower employment and income, effective demand diminishes, resulting in a slowdown of economic activities.

Global Interconnectedness

• Economies are interconnected through trade, and business fluctuations in one part of the world can easily transmit to other regions. Factors such as changes in tax laws, trade regulations, government expenditure, capital transfer, production shifts to other countries, and shifts in consumer preferences can disrupt economies and contribute to business cycle fluctuations.

Importance of Business Cycles in Business Decision Making

Business cycles have a significant impact on all aspects of the economy, and understanding these cycles is crucial for businesses of all types. The demand for products and, consequently, the profits of a business are influenced by the business cycle, which ultimately determines the success or failure of the business. Knowledge of Business Cycles Prosperity and Recession Business Decisions Strategic Decisions

• Prosperity: During periods of prosperity, new and superior opportunities for investment, employment, and production arise, promoting business growth.
• Recession: Conversely, periods of recession or depression reduce business opportunities and profits.

A profit-maximizing firm must consider the nature of the economic environment when making business decisions, particularly those related to forward planning.

Influence on Business Decisions

• The stage of the business cycle is crucial for managerial decisions regarding expansion or downsizing.
• Businesses need to adjust production levels in response to changing demand, which varies with different phases of the cycle.
• Input Use. Different stages of the business cycle require varying levels of input, especially labor input.
• Production Operations. Firms should be capable of expanding or rationalizing production operations to align with the current stage of the business cycle.
• Strategic Decision-Making. Business managers must make sound strategic decisions throughout the entire business cycle, including periods of boom, downturn, recession, and recovery.

Cyclical Businesses

• Definition: Businesses closely linked to economic growth are called cyclical businesses.
• Examples: These include industries like fashion retail, electrical goods, house-building, restaurants, advertising, overseas tour operations, construction, and infrastructure firms.
• Impact of Economic Phases: During economic booms, cyclical businesses experience strong demand for their products. However, during economic slumps, they face a sharp decline in demand.

Benefiting from Economic Downturns

• Value for Money: Some businesses thrive during economic downturns because their products are perceived as good value for money or cheaper alternatives to more expensive products.

Challenges during Economic Downturns

• Sustaining Business: Overcoming the effects of economic downturns and recessions is a major challenge for long-term business sustainability.
• Market Entry: The phase of the business cycle is a critical factor for new businesses considering market entry.
• Product Launch: The success of a new product launch is also influenced by the stage of the business cycle.
• Planning and Policy Setting: Surviving sluggish business cycles requires businesses to plan and set policies regarding product offerings, pricing, and promotion.

Economic forecasts are not always accurate, just like the instincts and gut feelings of entrepreneurs. However, understanding the current phase of the business cycle and its implications for present and future business activities can help companies anticipate market changes and respond more effectively. When used carefully, economic forecasts can assist businesses in preparing for economic shifts, either before they happen or shortly after.