Business Cycle

You may have heard in the news that some countries' economy is going through a decline. You may have also heard that some country's economy is experiencing a rapid rise or that it is one of the best performing economies in the world. All these things characterize the business cycle. When an economy experiences a rise or decline in economic activity, it is said to be going through a business cycle. However, simply stating this would be an oversimplification. Let's dig deeper into the topic of business cycles. Keep on reading to find out more!

Business Cycle Definition

First, we will provide the definition of a business cycle. Business cycles refer to short-term fluctuations in the level of economic activity in a given economy. An economy may experience long-term growth where its national output or GDP increases. However, while this economic growth happens, it is often interrupted momentarily by a series of business cycles where economic activity rises or declines.

Let's look at it this way. The economy is eventually (in the long run) going to grow, either negatively or positively. While this growth is being achieved, the economy goes through some ups and downs. We call these ups and downs business cycles. Let's look at a simple example.

The downward and upward changes described above characterize the business cycle. It is important not to rely on duration in understanding business cycles; business cycles can be anywhere from 6 months to 10 years. Look at business cycles as periods of fluctuations!

Types of the Business Cycle

The types of business cycles include cycles caused by exogenous factors and those caused by internal factors. These types exist due to the circumstances that lead to fluctuations in economic activity.

Exogenous factors refer to those factors that are not inherent to the economic system. Examples of such factors include climate change, discoveries of rare resources, wars, and even migrations.

These occur outside the economic system in the sense that they are mainly external factors that cause the economic system to respond in a certain way, which then results in a business cycle. Let's look at an example.

The scenario described above clearly shows a sudden increase in economic activity as a whole new economic activity has been added.

Internal factors, on the other hand, refer to factors that are within the economic system. The simplest example of this is an increase in interest rate, which reduces aggregate demand. This is because an increase in interest rates makes it more expensive to borrow money or get a mortgage, and this makes consumers spend less.

Business Cycle Stages

Here, we will look at the business cycle stages. There are four stages of a business cycle. These include the peak, recession, trough, and expansion. Let's look at each of these.

The peak refers to the period where economic activity has reached a momentary maximum. At a peak, the economy has achieved or almost achieved full employment, and its actual output is near or equal to its potential output. The economy typically experiences an increase in price level during a peak.

A recession follows a peak. During a recession, there is a rapid decline in the national output, income, and employment. Here, there is a contraction of economic activity. In other words, economic activity shrinks, and certain sectors reduce in size. Recessions are characterized by high levels of unemployment as businesses shrink and cut down their number of employees.

After a recession is a trough, which is when economic activity has reached its lowest. This means that there can only be a rise in economic activity after a trough. If the economic activity goes further down, then it was not a trough, to begin with. Here, national output, income, and employment are at their lowest for the cycle.

An expansion is the next movement of economic activity after the trough. It is a rise in economic activity as the national output, income, and employment all begin to rise towards full employment. In this phase, spending may increase rapidly and outpace the production in the economy. This results in a rapid increase in the price level, which is referred to as inflation.

Fig. 1 - Business Cycle Diagram

Business Cycle Recession

A business cycle recession is one of the two main parts of the business cycle (the other being an expansion). It refers to the period in a business cycle where there is a rapid decline in the national output, income, and employment.

Business activity contracts during this phase. A recession ends at the trough and is followed by an expansion.

Expansion Business Cycle

A business cycle expansion is one of the main parts of the business cycle alongside a recession. During an expansion, there is a rapid increase in the national output, income and, employment. Business activity expands during this phase. For instance, certain sectors employ more workers as there is room to increase production.

Fig. 2 - Employment increases during an expansion

The Business Cycle in Action

Let's see what the business cycle looks like in real life. Here, we use the potential real GDP and actual real GDP of the United States. Take a look at Figure 3 below.

Fig. 3 - U.S. Potential Real GDP and Actual Real GDP. Source: Congressional Budget Office¹

Figure 3 above shows the ups and downs of the United States economy from 2001 to 2020. Reading from left to right, we see that there was a period when actual GDP was above the potential GDP (until 2010). After 2010, the actual GDP remained below the potential GDP through 2020. Where the actual real GDP falls above the potential real GDP line, there is a positive GDP gap. On the other hand, there is a negative GDP gap where the actual real GDP falls below the potential real GDP line.

You have reached the end of this article. You should read our explanations on the Business Cycle Graph and Inflation to understand more about related macroeconomic concepts.