INTRODUCTION
Business Cycle, term used by economists to designate a periodic increase and decrease in an economy’s production and employment. Ever since the Industrial Revolution of the 1800s, the overall level of production in industrialized capitalist countries has varied from high output and employment to low output and employment. Economists study business cycles because they have a significant impact on all aspects of an economy.
BUSINESS CYCLE CHARACTERISTICS
A business cycle has a period of expansion and a period of contraction. Although each business cycle has its own unique characteristics, all business cycles share certain similarities. For example, in the expansion phase, production increases while employment, wages, and business profits also rise. During the contraction phase of the business cycle, production, employment, wages, and business profits all fall. These phases sometimes go by different names. Expansions are referred to as recoveries, booms, upturns, periods of prosperity, and upswings. Contractions are variously called recessions, downturns, downswings, and liquidations. The word “depression” also applies to business cycle contractions but is normally reserved for the worst or most severe contractions.
All business cycles also have peaks and troughs, words that economists use for the turning points in a business cycle. A peak marks the end of an expansion and the beginning of a contraction, while a trough marks the end of a contraction and the beginning of an expansion.
In the typical business cycle expansion, business firms will exhibit optimism about the economic outlook. They will express this optimism by investing in facilities, thereby expanding their ability to produce goods and services. The firms will also hire more people to work in their stores, factories, and offices. Consumers will also be optimistic during an expansion. Their optimism leads them to increase their purchases, typically resorting to additional borrowing to finance the acquisition of more goods and services.
As the upswing continues, however, obstacles begin to develop that hinder further expansion. For example, production costs may increase, shortages of raw materials may develop, interest rates will start to rise, and prices will begin to increase, or, if already increasing, will start to rise more rapidly. Consumers react to higher prices and higher interest rates by buying less. As purchases begin to lag behind production, business firms begin to accumulate inventories (the merchandise or goods that a company or store has on hand). Producers begin to cut back on investment in facilities and reduce employment. Despite these adjustments, profits fall and further cutbacks are made. The economy now enters the contraction phase of the business cycle.
Several different factors can trigger a recovery from a contraction, including an increase in consumer demand, the depletion of inventories, or government action to stimulate the economy. Although generally slow and uneven at the start, the recovery soon gathers momentum. Production and employment begin to increase again, putting additional purchasing power into the hands of consumers. Investment expands in industries that make goods or machinery for sale to other businesses, rather than directly to consumers—industries that are known as capital goods industries. Optimism returns, old businesses expand, and new businesses are created. A new cycle has started.
Business cycles are important not just for their economic consequences but also for their broader social consequences. Several studies have shown that declines in economic activity coincide with declines in birth rates and increases in death and divorce rates. The higher unemployment rates caused by recessions are also associated with higher suicide rates and higher crime rates.
MEASURING THE BUSINESS CYCLE
Economists use contractions as a way to document the beginning and end of a business cycle. They can determine when a contraction, or recession, has begun by using a variety of measurements. The common definition of a recession is two consecutive quarterly declines in the gross domestic product (GDP, the total of all goods and services produced within a country). Many economists, however, regard this definition as simplistic because it measures national economic performance according to a single, although important, economic statistic. In short, by looking at only one aspect of national economic activity—the GDP—an evaluation is made of the whole economy.
A more detailed definition of a recession is the one used by the National Bureau of Economic Research (NBER), a nonprofit organization regarded as the official agency for the measurement of business cycles. According to the NBER, a recession is “a period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy.”
Using this definition, the NBER has identified nine complete business cycles during the period from 1945 to 1991. The average duration of these business cycles, measured from trough to previous trough—that is, from the end of one recession to the end of the previous recession—is 53 months. During these cycles the average contraction lasted 18 months, and the average expansion lasted 35 months. For the current business cycle an expansion began in March 1991 and ended in March 2001. This expansion covering 120 months was the longest in United States economic history. As of November 2002, the NBER had not declared an official end to the recession that began in March 2001.
Besides differing in length, business cycles differ considerably in degree, especially in the severity of contractions. The most significant contraction in American economic history occurred during the 1930s. This contraction was so severe that it became known as the Great Depression. The NBER marks August 1929 as the start of the Great Depression with an initial contraction that lasted for 43 months. During this downturn the unemployment rate rose from about 3 percent to 25 percent while the production of goods and services fell by 30 percent. A very modest recovery began in March 1933, but the economy experienced another contraction that began in 1937 and lasted for another 13 months. A true economic recovery did not begin until 1941.
CAUSES OF BUSINESS CYCLES
A variety of explanations have been offered for business cycles. The Austrian American economist Joseph Schumpeter published his innovation theory in the late 1930s. He related upswings in the business cycle to new inventions, which stimulate investment in capital-goods industries. Because new inventions develop unevenly, business conditions alternate between expansion and contraction, according to Schumpeter’s theory.
In the early 1960s American economist Milton Friedman offered another explanation of the business cycle, known as a monetarist theory. In a careful review of American economic history Friedman and his collaborator Anna Schwartz found that turning points in the growth rate of the money supply (the total amount of money circulating in the economy) preceded business cycle turning points. They also found that the sources of the changes in the money supply’s growth rate—for example, the spread of commercial banking and the output of gold during the 19th century—were independent of the changes in economic activity. This finding indicated that the money supply was the primary cause of changes in business conditions.
Some business cycle analysts, including statistician Edward Tufte, have argued that politics plays a major role in the business cycle. These analysts believe that elected officials manipulate monetary and fiscal policies in an effort to win reelection. According to this viewpoint, as a presidential election approaches, officeholders seek to stimulate the economy with reductions in taxes, increases in government spending, and decreases in interest rates. The elected officials do this because they believe voters, enjoying the favorable economic conditions, will reward them by reelecting them to office. But in the process they may be stimulating an expansion that cannot be sustained and so may lead soon to a contraction.
Still another explanation for business cycles, advanced by American economist Robert E. Lucas, Jr., and others, examines misperceptions about the movements of wages and prices. In this view producers mistakenly perceive an overall increase in the level of prices in the economy as increased demand for their products. They respond by expanding production and employment within their firms. If enough firms make the same mistake, overall business activity will accelerate, followed by a contraction when the firms realize that they were mistaken in perceiving a growing demand.
A fifth explanation for business cycles is known as real business cycle theory and was developed in the 1980s by American economist Edward C. Prescott and others. It looks beyond political, monetary, and perception considerations to “real” factors, such as significant changes in technology and productivity.
Some business cycle analysts believe that there is no single consistent cause of business cycles. Instead they study what might be called shocks to the economy—a positive shock promoting a business expansion and a negative shock pushing the economy into recession. World War II (1939-1945) might be considered a positive economic shock that ended the Great Depression, whereas the events leading up to the 1991 Persian Gulf War represented a negative shock that explained the recession of 1990-1991. Other negative shocks might include agricultural failures associated with droughts. Discoveries of precious resources such as oil or gold would represent positive shocks. So these economists view the history of business cycles as a history of alternating positive and negative shocks.
REGULATING THE BUSINESS CYCLE
Because of the severity of the Great Depression, action was taken during the 1930s to both promote recovery and to reduce the likelihood and severity of future business downturns. Legislation known as New Deal programs created federal unemployment insurance, the Social Security system, the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission (SEC).
Unemployment insurance provides workers with income when they are laid off. Social Security furnishes some income to retired or disabled persons. These two programs thus provide greater income stability because people retain some purchasing power even when they are no longer working. The FDIC gives consumers confidence in their financial institutions and helps prevent a repeat of the massive withdrawals of funds or bank panic that led to the collapse of several thousand banks during the Great Depression. The SEC helps prevent financial fraud by requiring corporations that publicly trade their stock to report accurate financial information.
Other aspects of New Deal legislation also helped promote economic stability. The New Deal’s National Industrial Recovery Act of 1933 enabled workers to bargain collectively in trade unions. Although not as powerful as they once were, labor unions help prevent spiraling wage declines that have worsened previous downturns. Similarly, government support of crop prices shields farmers from disastrous loss of income. Whether or not these changes represent all or part of the explanation, the fact remains that since the Great Depression all economic contractions have been significantly less severe.
Beyond these structural changes, the government can also engage in direct intervention to counter a recession. Two main counter-cyclical policy options are available: monetary policy and fiscal policy. Economists disagree on the effectiveness of these options.
Monetary policy involves control of the money supply and interest rates by a central bank. In the United States the central bank is known as the Federal Reserve System, or simply the Fed. These controls determine the amount of credit available to businesses and consumers and the cost of that credit. By reducing the rate of money supply growth and allowing interest rates to rise, the Fed reduces the amount of available credit and increases the cost of borrowing in order to slow an economic expansion. This practice is known as contractionary monetary policy. Alternatively, expansionary monetary policy involves increasing the rate of growth in the money supply and lowering interest rates. In this fashion the Fed increases the availability of credit and lowers the cost of borrowing in an effort to stimulate the economy.
Fiscal policy consists of changes in government spending or taxation or both. If the government seeks to constrain an economic expansion by engaging in contractionary fiscal policy, it can lower its purchases of goods and services, reduce the amount of money it spends on social services and subsidies, or increase taxes. Expansionary fiscal policy involves the opposite actions—namely, increases in purchases of goods and services, increases in social service spending and subsidies, or reductions in taxes—in an effort to stimulate production and employment.
In discussing the relative merits of monetary and fiscal policies as counter-cyclical tools, economists often argue over which policy to pursue. Some economists note that changes in monetary policy can be implemented quickly whereas changes in fiscal policy take much longer. The Fed’s Open Market Committee, for example, makes decisions regarding the money supply and interest rates. All that is needed to change monetary policy is a vote by this committee. Fiscal policy, on the other hand, typically requires the approval of both the legislative and executive branches of the federal government. For example, a lowering of taxes needs approval from both the U.S. House of Representatives and Senate as well as the approval of the U.S. president, approvals that sometimes may take longer than a year to secure.
However, many economists also note that it takes fiscal policy less time than monetary policy to have an impact on the economy once a specific action has been implemented. For example, a fiscal-policy reduction in the personal income tax will show up immediately in higher take-home pay for workers. By contrast, consumers and business firms may take awhile before they modify their spending in response to a monetary-policy change, such as a reduction in interest rates. For example, not everyone goes out to buy a new car just because the interest rate on car loans has decreased.
Recognition of the delays involved with both monetary and fiscal policies has led some economists to conclude that policy actions may actually contribute to economic instability and make the business cycle worse. According to these economists, the best strategy for monetary policy is the provision of steady growth in the money supply and credit, and the best strategy for fiscal policy is efficient and effective tax and spending programs.
Business Cycle, term used by economists to designate a periodic increase and decrease in an economy’s production and employment. Ever since the Industrial Revolution of the 1800s, the overall level of production in industrialized capitalist countries has varied from high output and employment to low output and employment. Economists study business cycles because they have a significant impact on all aspects of an economy.
BUSINESS CYCLE CHARACTERISTICS
A business cycle has a period of expansion and a period of contraction. Although each business cycle has its own unique characteristics, all business cycles share certain similarities. For example, in the expansion phase, production increases while employment, wages, and business profits also rise. During the contraction phase of the business cycle, production, employment, wages, and business profits all fall. These phases sometimes go by different names. Expansions are referred to as recoveries, booms, upturns, periods of prosperity, and upswings. Contractions are variously called recessions, downturns, downswings, and liquidations. The word “depression” also applies to business cycle contractions but is normally reserved for the worst or most severe contractions.
All business cycles also have peaks and troughs, words that economists use for the turning points in a business cycle. A peak marks the end of an expansion and the beginning of a contraction, while a trough marks the end of a contraction and the beginning of an expansion.
In the typical business cycle expansion, business firms will exhibit optimism about the economic outlook. They will express this optimism by investing in facilities, thereby expanding their ability to produce goods and services. The firms will also hire more people to work in their stores, factories, and offices. Consumers will also be optimistic during an expansion. Their optimism leads them to increase their purchases, typically resorting to additional borrowing to finance the acquisition of more goods and services.
As the upswing continues, however, obstacles begin to develop that hinder further expansion. For example, production costs may increase, shortages of raw materials may develop, interest rates will start to rise, and prices will begin to increase, or, if already increasing, will start to rise more rapidly. Consumers react to higher prices and higher interest rates by buying less. As purchases begin to lag behind production, business firms begin to accumulate inventories (the merchandise or goods that a company or store has on hand). Producers begin to cut back on investment in facilities and reduce employment. Despite these adjustments, profits fall and further cutbacks are made. The economy now enters the contraction phase of the business cycle.
Several different factors can trigger a recovery from a contraction, including an increase in consumer demand, the depletion of inventories, or government action to stimulate the economy. Although generally slow and uneven at the start, the recovery soon gathers momentum. Production and employment begin to increase again, putting additional purchasing power into the hands of consumers. Investment expands in industries that make goods or machinery for sale to other businesses, rather than directly to consumers—industries that are known as capital goods industries. Optimism returns, old businesses expand, and new businesses are created. A new cycle has started.
Business cycles are important not just for their economic consequences but also for their broader social consequences. Several studies have shown that declines in economic activity coincide with declines in birth rates and increases in death and divorce rates. The higher unemployment rates caused by recessions are also associated with higher suicide rates and higher crime rates.
MEASURING THE BUSINESS CYCLE
Economists use contractions as a way to document the beginning and end of a business cycle. They can determine when a contraction, or recession, has begun by using a variety of measurements. The common definition of a recession is two consecutive quarterly declines in the gross domestic product (GDP, the total of all goods and services produced within a country). Many economists, however, regard this definition as simplistic because it measures national economic performance according to a single, although important, economic statistic. In short, by looking at only one aspect of national economic activity—the GDP—an evaluation is made of the whole economy.
A more detailed definition of a recession is the one used by the National Bureau of Economic Research (NBER), a nonprofit organization regarded as the official agency for the measurement of business cycles. According to the NBER, a recession is “a period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy.”
Using this definition, the NBER has identified nine complete business cycles during the period from 1945 to 1991. The average duration of these business cycles, measured from trough to previous trough—that is, from the end of one recession to the end of the previous recession—is 53 months. During these cycles the average contraction lasted 18 months, and the average expansion lasted 35 months. For the current business cycle an expansion began in March 1991 and ended in March 2001. This expansion covering 120 months was the longest in United States economic history. As of November 2002, the NBER had not declared an official end to the recession that began in March 2001.
Besides differing in length, business cycles differ considerably in degree, especially in the severity of contractions. The most significant contraction in American economic history occurred during the 1930s. This contraction was so severe that it became known as the Great Depression. The NBER marks August 1929 as the start of the Great Depression with an initial contraction that lasted for 43 months. During this downturn the unemployment rate rose from about 3 percent to 25 percent while the production of goods and services fell by 30 percent. A very modest recovery began in March 1933, but the economy experienced another contraction that began in 1937 and lasted for another 13 months. A true economic recovery did not begin until 1941.
CAUSES OF BUSINESS CYCLES
A variety of explanations have been offered for business cycles. The Austrian American economist Joseph Schumpeter published his innovation theory in the late 1930s. He related upswings in the business cycle to new inventions, which stimulate investment in capital-goods industries. Because new inventions develop unevenly, business conditions alternate between expansion and contraction, according to Schumpeter’s theory.
In the early 1960s American economist Milton Friedman offered another explanation of the business cycle, known as a monetarist theory. In a careful review of American economic history Friedman and his collaborator Anna Schwartz found that turning points in the growth rate of the money supply (the total amount of money circulating in the economy) preceded business cycle turning points. They also found that the sources of the changes in the money supply’s growth rate—for example, the spread of commercial banking and the output of gold during the 19th century—were independent of the changes in economic activity. This finding indicated that the money supply was the primary cause of changes in business conditions.
Some business cycle analysts, including statistician Edward Tufte, have argued that politics plays a major role in the business cycle. These analysts believe that elected officials manipulate monetary and fiscal policies in an effort to win reelection. According to this viewpoint, as a presidential election approaches, officeholders seek to stimulate the economy with reductions in taxes, increases in government spending, and decreases in interest rates. The elected officials do this because they believe voters, enjoying the favorable economic conditions, will reward them by reelecting them to office. But in the process they may be stimulating an expansion that cannot be sustained and so may lead soon to a contraction.
Still another explanation for business cycles, advanced by American economist Robert E. Lucas, Jr., and others, examines misperceptions about the movements of wages and prices. In this view producers mistakenly perceive an overall increase in the level of prices in the economy as increased demand for their products. They respond by expanding production and employment within their firms. If enough firms make the same mistake, overall business activity will accelerate, followed by a contraction when the firms realize that they were mistaken in perceiving a growing demand.
A fifth explanation for business cycles is known as real business cycle theory and was developed in the 1980s by American economist Edward C. Prescott and others. It looks beyond political, monetary, and perception considerations to “real” factors, such as significant changes in technology and productivity.
Some business cycle analysts believe that there is no single consistent cause of business cycles. Instead they study what might be called shocks to the economy—a positive shock promoting a business expansion and a negative shock pushing the economy into recession. World War II (1939-1945) might be considered a positive economic shock that ended the Great Depression, whereas the events leading up to the 1991 Persian Gulf War represented a negative shock that explained the recession of 1990-1991. Other negative shocks might include agricultural failures associated with droughts. Discoveries of precious resources such as oil or gold would represent positive shocks. So these economists view the history of business cycles as a history of alternating positive and negative shocks.
REGULATING THE BUSINESS CYCLE
Because of the severity of the Great Depression, action was taken during the 1930s to both promote recovery and to reduce the likelihood and severity of future business downturns. Legislation known as New Deal programs created federal unemployment insurance, the Social Security system, the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission (SEC).
Unemployment insurance provides workers with income when they are laid off. Social Security furnishes some income to retired or disabled persons. These two programs thus provide greater income stability because people retain some purchasing power even when they are no longer working. The FDIC gives consumers confidence in their financial institutions and helps prevent a repeat of the massive withdrawals of funds or bank panic that led to the collapse of several thousand banks during the Great Depression. The SEC helps prevent financial fraud by requiring corporations that publicly trade their stock to report accurate financial information.
Other aspects of New Deal legislation also helped promote economic stability. The New Deal’s National Industrial Recovery Act of 1933 enabled workers to bargain collectively in trade unions. Although not as powerful as they once were, labor unions help prevent spiraling wage declines that have worsened previous downturns. Similarly, government support of crop prices shields farmers from disastrous loss of income. Whether or not these changes represent all or part of the explanation, the fact remains that since the Great Depression all economic contractions have been significantly less severe.
Beyond these structural changes, the government can also engage in direct intervention to counter a recession. Two main counter-cyclical policy options are available: monetary policy and fiscal policy. Economists disagree on the effectiveness of these options.
Monetary policy involves control of the money supply and interest rates by a central bank. In the United States the central bank is known as the Federal Reserve System, or simply the Fed. These controls determine the amount of credit available to businesses and consumers and the cost of that credit. By reducing the rate of money supply growth and allowing interest rates to rise, the Fed reduces the amount of available credit and increases the cost of borrowing in order to slow an economic expansion. This practice is known as contractionary monetary policy. Alternatively, expansionary monetary policy involves increasing the rate of growth in the money supply and lowering interest rates. In this fashion the Fed increases the availability of credit and lowers the cost of borrowing in an effort to stimulate the economy.
Fiscal policy consists of changes in government spending or taxation or both. If the government seeks to constrain an economic expansion by engaging in contractionary fiscal policy, it can lower its purchases of goods and services, reduce the amount of money it spends on social services and subsidies, or increase taxes. Expansionary fiscal policy involves the opposite actions—namely, increases in purchases of goods and services, increases in social service spending and subsidies, or reductions in taxes—in an effort to stimulate production and employment.
In discussing the relative merits of monetary and fiscal policies as counter-cyclical tools, economists often argue over which policy to pursue. Some economists note that changes in monetary policy can be implemented quickly whereas changes in fiscal policy take much longer. The Fed’s Open Market Committee, for example, makes decisions regarding the money supply and interest rates. All that is needed to change monetary policy is a vote by this committee. Fiscal policy, on the other hand, typically requires the approval of both the legislative and executive branches of the federal government. For example, a lowering of taxes needs approval from both the U.S. House of Representatives and Senate as well as the approval of the U.S. president, approvals that sometimes may take longer than a year to secure.
However, many economists also note that it takes fiscal policy less time than monetary policy to have an impact on the economy once a specific action has been implemented. For example, a fiscal-policy reduction in the personal income tax will show up immediately in higher take-home pay for workers. By contrast, consumers and business firms may take awhile before they modify their spending in response to a monetary-policy change, such as a reduction in interest rates. For example, not everyone goes out to buy a new car just because the interest rate on car loans has decreased.
Recognition of the delays involved with both monetary and fiscal policies has led some economists to conclude that policy actions may actually contribute to economic instability and make the business cycle worse. According to these economists, the best strategy for monetary policy is the provision of steady growth in the money supply and credit, and the best strategy for fiscal policy is efficient and effective tax and spending programs.
