Wednesday, October 16, 2013

Business Cycles

Business Cycles

  • Business cycles are the normal fluctuations of the output of a country.
  • A country's GDP (under normal circumstances) grows over time, but not at a steady rate.
  • These fluctuations of the GDP around its steady trend growth line are called business cycles
  • The upswings and down swings of an economy are called business cycles.
  • Sometimes the pace of economic growth is rapid, called the expansionary phase, and sometimes the economy slows down called the contractionary phase.
  • From the diagram below we can see the phases of a business cycle


  • The steady growth line or trend line is the straight line in the middle.
  • The economy (or any economy) does not grow in that steady fashion.
  • Rather it grows in spurts, gathers momentum and grows even faster.
  • Then the reverse happens, and the economy slows down, and now it gathers momentum in the reverse direction, and slows faster and faster.
  • This is the real way an economy grows over time, not in a steady manner.
  • So the irregular ups and downs of an economy are called business cycles.
  • The phases of a business cycle are:
    1) Expansionary Phase:
  • In the business cycle diagram it is the phase when the economy is moving up the cycle of growth, from a trough towards a peak.
  • During this phase there is growth observed all around the economy.
  • Every economic sector is growing.
  • Producers are producing more because people are buying /demanding more goods and services.
  • To produce more goods and services you need more people, so employment goes up.
  • These newly employed spend their money on food, clothing housing etc.
  • Thus the income in those sectors go up too.
  • As aggregate demand goes up, so do prices and profits.
  • So more investment is done in the economy.
  • Thus a positive momentum or a positive domino effect builds up and the economy grows faster and faster.
  • Income, employment, output all increase.
  • 2) Contractionary Phase:
  • The reverse of an expansionary phase happens here.
  • In the business cycle diagram it is the phase when the economy is moving downfrom a peak towards a trough.
  • During this phase there is contraction in economic activity observed all around the economy.
  • Every economic sector is reducing its output.
  • Producers are producing less because people are buying /demanding fewer goods and services.
  • To produce fewer goods and services you need fewer people, so employment goes down.
  • These newly unemployed spend less money on food, clothing housing etc.
  • Thus the income in those sectors go down too.
  • As aggregate demand goes down, so do prices and profits.
  • So private investment goes down too.
  • Thus a negative downward momentum or a negative domino effect builds up and the economy shrinks or contracts faster and faster.
  • Income, employment, output all tend to decrease.
  • 3) Peak:
  • This is the highest point an economy can reach.
  • It is the end of the expansionary phase.
  • Everything that happens in the expansionary phase, culminates at this point.
  • Beyond this point, the downturn starts.
  • 4) Trough:
  • This is the lowest point an economy can reach.
  • It is the end of the contractionary phase.
  • Everything that happens in the contractionary phase, culminates at this point.
  • Beyond this point, the upturn starts.
  • Length of a business cycle:
  • A business cycle is measured as the time period between two troughs or two peaks.
  • Related Concepts:
    Recession:
  • The technical definition is: It is decrease in real GDP over two consecutive quarters.
  • But if there is a significant contraction in economic activity all around, we generally call it a recession.
  • A trough in general would indicate a recession.
  • Depression:
  • A severe form of recession is a depression.
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