The business cycle is the periodic but irregular up-anddown movement in economic activity, measured by fluctuations in real gross domestic product (GDP) and other macroeconomic variables. A business cycle is typically characterized by four phases—recession, recovery, growth, and decline—that repeat themselves over time.
Economists note, however, that complete business cycles vary in length. The duration of business cycles can be anywhere from about two to twelve years, with most cycles averaging six years in length. Some business analysts use the business cycle model and terminology to study and explain fluctuations in business inventory and other individual elements of corporate operations. But the term “business cycle” is still primarily associated with larger (industry-wide, regional, national, or even international) business trends.
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Stages Of A Business Cycle
Recession A recession—also sometimes referred to as a trough—is a period of reduced economic activity in which levels of buying, selling, production, and employment typically diminish. This is the most unwelcome stage of the business cycle for business owners and consumers alike.
A particularly severe recession is known as a depression.
Recovery Also known as an upturn, the recovery stage of the business cycle is the point at which the economy “troughs” out and starts working its way up to better financial footing.
Growth Economic growth is in essence a period of sustained expansion. Hallmarks of this part of the business cycle include increased consumer confidence, which translates into higher levels of business activity. Because the economy tends to operate at or near full capacity during periods of prosperity, growth periods are generally accompanied by inflationary pressures.
Decline Also referred to as a contraction or downturn, a decline basically marks the end of the period of growth in the business cycle. Declines are characterized by decreased levels of consumer purchases (especially of durable goods) and, subsequently, reduced production by businesses.
Factors That Shape Business Cycles
For centuries, economists in both the United States and Europe regarded economic downturns as “diseases” that had to be treated; it followed, then, that economies characterized by growth and affluence were regarded as “healthy” economies. By the end of the 19th century, however, many economists had begun to recognize that economies were cyclical by their very nature, and studies increasingly turned to determining which factors were primarily responsible for shaping the direction and disposition of national, regional, and industry-specific economies. Today, economists, corporate executives, and business owners cite several factors as particularly important in shaping the complexion of business environments.
Volatility of Investment Spending Variations in investment spending is one of the important factors in business cycles. Investment spending is considered the most volatile component of the aggregate or total demand (it varies much more from year to year than the largest component of the aggregate demand, the consumption spending), and empirical studies by economists have revealed that the volatility of the investment component is an important factor in explaining business cycles in the United States. According to these studies, increases in investment spur a subsequent increase in aggregate demand, leading to economic expansion. Decreases in investment have the opposite effect. Indeed, economists can point to several points in American history in which the importance of investment spending was made quite evident. The Great Depression, for instance, was caused by a collapse in investment spending in the aftermath of the stock market crash of 1929. Similarly, the prosperity of the late 1950s was attributed to a capital goods boom.
There are several reasons for the volatility that can often be seen in investment spending. One generic reason is the pace at which investment accelerates in response to upward trends in sales. This linkage, which is called the acceleration principle by economists, can be briefly explained as follows. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. As a result, changes in sales result in magnified percentage changes in investment expenditures. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates. In more concrete terms, the response of the investment spending is related to the rate at which sales are increasing. In general, if an increase in sales is expanding, investment spending rises, and if an increase in sales has peaked and is beginning to slow, investment spending falls. Thus, the pace of investment spending is influenced by changes in the rate of sales.
Momentum Many economists cite a certain “follow-theleader” mentality in consumer spending. In situations where consumer confidence is high and people adopt more free-spending habits, other customers are deemed to be more likely to increase their spending as well. Conversely, downturns in spending tend to be imitated as well.
Technological Innovations Technological innovations can have an acute impact on business cycles. Indeed, technological breakthroughs in communication, transportation, manufacturing, and other operational areas can have a ripple effect throughout an industry or an economy. Technological innovations may relate to production and use of a new product or production of an existing product using a new process. The video imaging and personal computer industries, for instance, have undergone immense technological innovations in recent years, and the latter industry in particular has had a pronounced impact on the business operations of countless organizations. However, technological innovations— and consequent increases in investment—take place at irregular intervals. Fluctuating investments, due to variations in the pace of technological innovations, lead to business fluctuations in the economy.
There are many reasons why the pace of technological innovation varies. Major innovations do not occur every day. Nor do they take place at a constant rate.
Chance factors greatly influence the timing of major innovations, as well as the number of innovations in a particular year. Economists consider the variations in technological innovation as random (with no systematic pattern). Thus, irregularity in the pace of innovations in new products or processes becomes a source of business fluctuations.
Variations in Inventories Variations in inventories— expansion and contraction in the level of inventories of goods kept by businesses—also contribute to business cycles. Inventories are the stocks of goods firms keep on hand to meet demand for their products. How do variations in the level of inventories trigger changes in a business cycle? Usually, during a business downturn, firms let their inventories decline. As inventories dwindle, businesses eventually use down their inventories to the point where they are short. This, in turn, starts an increase in inventory levels as companies begin to produce more than is sold, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate. However, as the rate of increase in sales slows, firms begin to cut back on their inventory accumulation. The subsequent reduction in inventory investment dampens the economic expansion, and eventually causes an economic downturn. The process then repeats itself all over again. It should be noted that while variations in inventory levels impact overall rates of economic growth, the resulting business cycles are not really long. The business cycles generated by fluctuations in inventories are called minor or short business cycles. These periods, which usually last about two to four years, are sometimes also called inventory cycles.
Fluctuations in Government Spending Variations in government spending are yet another source of business fluctuations. This may appear to be an unlikely source, as the government is widely considered to be a stabilizing force in the economy rather than a source of economic fluctuations or instability. Nevertheless, government spending has been a major destabilizing force on several occasions, especially during and after wars. Government spending increased by an enormous amount during World War II, leading to an economic expansion that continued for several years after the war. Government spending also increased, though to a smaller extent compared to World War II, during the Korean and Vietnam Wars. These also led to economic expansions. However, government spending not only contributes to economic expansions, but economic contractions as well. In fact, the recession of 1953-54 was caused by the reduction in government spending after the Korean War ended. More recently, the end of the Cold War resulted in a reduction in defense spending by the United States that had a pronounced impact on certain defense-dependent industries and geographic regions.
Politically Generated Business Cycles Many economists have hypothesized that business cycles are the result of the politically motivated use of macroeconomic policies (monetary and fiscal policies) that are designed to serve the interest of politicians running for re-election. The theory of political business cycles is predicated on the belief that elected officials (the president, members of Congress, governors, etc.) have a tendency to engineer expansionary macroeconomic policies in order to aid their re-election efforts.
Monetary Policies Variations in the nation’s monetary policies, independent of changes induced by political pressures, are an important influence in business cycles as well. Use of fiscal policy—increased government spending and/or tax cuts—is the most common way of boosting aggregate demand, causing an economic expansion. The Central Bank, in the case of the United States, the Federal Reserve Bank, has two legislated goals—price stability and full employment. Its role in monetary policy is a key to managing business cycles and has an important impact on consumer and investor confidence as well.
Fluctuations in Exports and Imports The difference between exports and imports is the net foreign demand for goods and services, also called net exports. Because net exports are a component of the aggregate demand in the economy, variations in exports and imports can lead to business fluctuations as well. There are many reasons for variations in exports and imports over time. Growth in the gross domestic product of an economy is the most important determinant of its demand for imported goods—as people’s incomes grow, their appetite for additional goods and services, including goods produced abroad, increases. The opposite holds when foreign economies are growing—growth in incomes in foreign countries also leads to an increased demand for imported goods by the residents of these countries. This, in turn, causes U.S. exports to grow. Currency exchange rates can also have a dramatic impact on international trade—and hence, domestic business cycles—as well.
Business Cycle Variants, Stagflation And The Jobless Recovery
Business cycles are difficult to anticipate accurately, in part because of the number of variables involved in large economic systems. Nonetheless, the importance of tracking and understanding business cycles has lead to a great deal of study of the subject and knowledge about the subject. It was as a result somewhat surprising when, in the 1970s, the nation found itself stuck in a period of seemingly contradictory economic conditions, slow economic growth and rising inflation. The condition was named stagflation and paralyzed the U.S. economy from the mid-1970s through the early 1980s.
Another somewhat unexpected business cycle phenomenon has occurred in the early 2000s. It is what has come to be known as the “jobless recovery.” According to the National Bureau of Economic Research’s Business Cycle Dating Committee, in a late 2003 report, “the most recent economic peak occurred in March 2001, ending a record-long expansion that began in 1991.
The most recent trough occurred in November 2001, inaugurating an expansion.” The problem with the expansion has been that it has not included a rise in employment or real personal income, something seen in all previous recoveries.
The reasons for the jobless recovery are not fully understood but are the cause of much debate within the economic and political circles. Within this debate there are four leading explanations that analysts have given for the jobless recovery. According to a study published in Economic Perspectives in the summer of 2004, these four explanations are:
- An imbalance in labor available by sector.
- The emergence of just-in-time hiring practices.
- The rising cost of health care benefits.
- Rapidly increasing productivity not being off-set by aggregate demand.
- Only time and further analysis will show which of these factors, or which combination of factors explains the advent of a jobless recovery. Neil Shister, editorial director of the World Trade summarizes a discussion of the jobless recovery this way, “The culprit is ourselves. We have become dramatically more productive.” This assessment suggests that much more will need to be understood about modern business cycles before we can again anticipate them and plan for their effects on the economy generally.
Keys To Successful Business Cycle Management
Small business owners can take several steps to help ensure that their establishments weather business cycles with a minimum of uncertainty and damage. The concept of cycle management is earning adherents who agree that strategies that work at the bottom of a cycle need to be adopted as much as those which work at the top of a cycle. While there is no definitive formula for every company, the approaches generally emphasize a longterm view focused on a company’s core strengths and stressing the need to plan with greater discretion at all times. Essentially, efforts are made to adjust a company’s operations in such a manner that it maintains an even keel through the ups and downs of a business cycle.
Specific tips for managing business cycle downturns include the following:
- Flexibility—Having a flexible business plan allows for development times that span the entire cycle and includes various recession-resistant funding structures.
- Long-term Planning—Consultants encourage small businesses to adopt a moderate stance in their longrange forecasting.
- Attention to Customers—This can be an especially important factor for businesses seeking to emerge from an economic downturn. Maintaining close relations and open communication with customers is a tough discipline to maintain in good times, but it is especially crucial coming out of bad times. Customers are the best gauges of when a company is likely to begin recovering from an economic slowdown.
- Objectivity—Small business owners need to maintain a high level of objectivity when riding business cycles. Operational decisions based on hopes and desires rather than a sober examination of the facts can devastate a business, especially in economic down periods.
- Study—Timing any action for an upturn is tricky.
The consequences of getting the timing wrong, of being early or late, can be serious. How, then, does a company strike the right balance between being early or late? Listening to economists, politicians, and media to get a sense of what is happening is useful.
The best route, however, is to avoid trying to predict the upturn. Instead, listen to your customers and know your own response-time requirements.