Effects Of Business Cycles

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In general the economy tends to experience different trends. These trends can be grouped as the business/trade cycle and may contain a boom, recession, depression and recovery. A business/trade cycle (see figure 1) is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real Gross Domestic Product (GDP) and other macroeconomic variables. Samuelson and Nordhaus (1998), defined it as ‘a swing in total national input, income and employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy’. These fluctuations in economic activity usually have implications on employment, consumption, business confidence, investment and output.

Theories and the nature and causes of business cycle fluctuations

The Keynesian Approach
This theory shows how the collaboration of multiplier and accelerator can lead to regular cycles in aggregate demand. The Keynesians believe that economic activity is generally unstable and is subject to inconsistent shocks, usually causing the economic fluctuations and are attributed to the changes in autonomous expenditures especially investment.

The Keynesian approach is pretty simple; higher investment will lead to a larger rise in income and output in the short run. This means that consumers will spend some of their income on consumption goods. This will give rise to further increase in expenditure. Ceteris paribus an initial rise in autonomous investment produces a more than proportionate rise in income. The rise in income will increase investment to meet the increase demand for output. The Keynesian also points out that as the economy is inconsistently unstable there is the need for government to intercede to make the economy stable when necessary.

The Monetarist Approach
This approach was developed by M. Friedman and A. J. Schwartz in their classic study A Monetary History of the United States, 1867-1960 (1963). The monetarist approach acclaims economic instability to fluctuations in the money supply swayed by the authorities. In such a situation the economy will return moderately back to the normal level of output and employment. They made it clear that the changes in the rate of monetary growth give rise to short term fluctuations in output and employment. Therefore in the long run, the trend rate of monetary growth only cause movements in the price level and other normal variables.

They also attributed business cycle to the expansion and contraction of money and credit. Their views were that monetary factors are the primary source of fluctuations in aggregate demand.

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They claimed to have established a strong correlation between changes in the money supply and changes in economic activity. However, major recessions have been associated with absolute declines in the money supply and minor recessions with the slowing of the rate of increase in the money supply below its long-term trend.

The New Classical Approach
Developed by Robert Lucas (1975), this theory points out unforeseen monetary shocks are the cause of business cycles. Lucas (1975) defined business cycles as ‘the serially correlated movements about trend of real output that are not explainable by movements in the availability of factors of production’. The equilibrium theory of this approach illustrate that economic agents react ideally to the prices they observe and markets continue to clear.

The approach is of the view that changes in monetary or fiscal policy can have effect on output and employment if they are unforeseen, for instance if the money supply is determined by the authorities according to a standard and the general public knows that the standard may base its behaviour and decisions making on the anticipated growth of the money supply.

Stages of the Business Cycle
Boom - This is the stage in the economy where there is high consumer spending and output capacity is at its maximum. Business profits are high and there is also high level of spending.

Recession - A decline in the real GDP that occurs for at least two or more quarters. During a recession business people spend less because sales are fail and businesses do what they can to reduce their spending. They lay off workers, buy less merchandise and postpone plans to expand. As a result of this business suppliers also lay off workers and reduce spending.

Depression - This is the state of the economy where there are high levels of unemployment, a decline in annual income, and overproduction. There are also low interest rates, low consumer demand and low profitability.

Recovery - This is the stage where businesses begin to improve a bit, firms hire a few more workers and increase their orders of materials from their suppliers. Increased orders lead other firms to increase production and rehire workers. More employment leads to more consumer spending, further business activity, and still more jobs. There is also rising interest rates, rising levels of investment and profits.

Policies Applied to Address Critical Economic Issues at each Stage

Recession and the USA Economy
The USA economy is in a recession when real output declines in two successive quarters. An economy goes into recession when there is a decline in a country's real Gross Domestic Product (GDP) for two or more successive quarters of a year. According to Former U.S. Federal Reserve Chairman Alan Greenspan, American economy may slip into recession by the end of the year. The USA economy grew at a surprisingly strong 3.5% rate in the fourth quarter of 2006, up from a 2% rate in the third quarter. USA budget deficit, which for 2006 fell to $247.7 billion, the lowest in four years is of much concern.

The September 11 terrorism attacks has aided to the retrenchment of economic activity and this has also affected the level of confidence in businesses and consumers. In 2000, consumer debt growth of 8.6% compared with real disposable income growth of 4.8%. During the first quarter of 2006, private household debt grew to 11.6% annually compared with zero real disposable income growth.

The thriving technology in the USA led to a large number of investment in information processing equipment and software resulting in high equity values which also resulted in a decline by the second quarter of 2000. In October 2001employment fell by 439,000 jobs, and unemployment rate soared from 4.9% to 5.4%. Over 500,000 jobs were lost in the recession and a further one million jobs were destroyed in the weak “job-loss” recovery from November 2001 to June 2003. People who lived below the poverty line jumped from 31.06 million to 34.06 million by 2002.

This recession could have been avoided, however the argument against government intervention using discretionary fiscal policy to tackle recession accentuates the long time lags involved in altering fiscal policy in USA. There was proof in 2000 that the USA economy was slowing. Congress passed a tax cut in 2001, but it took Congress until March 2002 to pass the Economy Recovery Act to provide further inducement to the economy.

Recovery and the USA Economy
Monetary and Fiscal policies
Economic recovery is where there is a rise in consumer spending, business confidence, investment levels, employment and also interest rates. In 2001, the Federal reduced interest rates in rapid succession. After September 11, the Federal granted extraordinary liquidity to the markets, and further cut the target rate down to 1.75 percent, the lowest rate in about forty years. The Fiscal policy was more expansionary as the federal government budget swung from a surplus of $236 billion in 2000 (205% the GDP) to a projected 2002 deficit of $157 billion (1.5% of GDP) since the government increased expenditures and reduced taxes.

“This active use of fiscal policy during a recession is somewhat unusual. During the last U.S. recession, in 1990, then President George H.W. Bush resisted attempts to use fiscal policy to stimulate the economy. In fact, his Council of Economic Advisers, in their February 1992 report, argued that increases in fiscal expenditures or reductions in taxes might hamper the economy’s recovery. In contrast, during the current recession, both Congress and the President have supported increases in expenditures and tax cuts as ways to stimulate economic growth, culminating in the passage of the Economic Recovery Act in March 2002. The current recession and the 1990–1991 recession offer contrasting examples of the use of fiscal policy, and they also highlight some elements of the longstanding debate in economics over whether fiscal policy can play a useful role in combating business cycle downturns”.

Boom and the USA Economy
This is the stage of the cycle where there is high consumer spending, maximum output capacity, high levels of investment, high business profits and high interest rates. The 1990s expansion of the USA economy was very remarkable. Gross Domestic Product (GDP) grew by 39%, profits more than doubled, unemployment also fell to 30-year lows and for the first time in decades, real wages increased. GDP per capita grew by 26% against Japan’s 9% growth, Germany’s 5% and France’s 15%.

In the USA, in the third quarter of 2004, GDP grew by 8.2%, output by 10.3%, productivity by 9.4%, durable manufacturing productivity an astonishing 14.8%. Such figures were last seen in the recovery from the sharp 1982 recession. Unit labour costs dropped by 5.8%. With rising productivity, virtually no new hiring and stagnant wages, everything flowed to profits. Profits soared to a record $1 trillion, 30% more than 2003 and 45% more than 2002.
Business cycle fluctuations in output, employment and prices are often caused by shifts in aggregate demand. These often occur as consumers, businesses and governments change total spending relative to the economy’s productive capacity.

These fluctuations have had acute repercussions for many firms and resulted in cataclysm for others. The growing share of sectors such as health and education in economic activity as a nation becomes prosperous, among other reasons accounted for the more stable performance of the industrialised economies.

Although economic fluctuations have occurred since the Great Depression they have not been severe as the Great Depression. This is due to the timeliness that of policies such as monetary and fiscal policies used to address economic issues during each particular stage of the cycle.

Begg D., Fischer S., & Dornbusch R., Economics, 8th Ed, 2005, McGraw Hill

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