Business cycle

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By: Michael Newman | Sep 30, 2009 | 1046 words | 102 views
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Market economies regularly experience periods of expansion and periods

of contraction. This rises and falls are the business cycle. The business cycle or trade
cycle is ? permanent feature of market economies: gross domestic product (GDP)
fluctuates as booms and recessions succeed each other.

During ? boom, an economy (or at least parts of it) expands to the point where it is
working at full capacity, so that production, employment, prices, profits, investment and
interest rates all tend to rise.

During ? recession, the demand for goods and services declines and the economy begins
to work at below its potential. Investment, output, employment, profits, commodity and
share prices, and interest rates generally fall. ? serious, long-lasting recession is called ?
depression or ? slump.

The highest point on the business cycle is called ? peak, which is followed by ? downturn
or downswing or ? period of contraction. The lowest point on the business cycle is
called ? trough, which is followed by ? recovery or an upturn or upswing or ? period of
expansion. Economists sometimes describe contraction as 'negative growth'.

There are various theories as to the cause of the business cycle. The traditional theory of
the business cycle is that it's caused by upturns and downturns in the behavior of
companies, in terms of mostly their investments and of their stocks, and on particular the
fact when demand pressure is very strong, that companies run at very high levels of
capacity, they’re using their plants to the full, and then they tend to invest perhaps
overmuch, and if demand weakens a little, people stop investment completely, that feeds
right back into the stock cycle, and pushes the economy down from a high level to a low
level, and it may stay at the low level until companies have to invest to replace
investment, rather than investing to increase capacity.

The standard classical theory of the economy suggests that economies naturally return to
an equilibrium level, where they make full use and efficient use of ?ll their resources. But
there are a number of very strong assumptions to make that model work. There has to be
perfect competition, there has to be ? lack of exogenous shocks from the world outside,
there has to be perfect information, so everybody knows exactly what’s going on in the
market at any one time, and the responses have to be very quick. We know that people
make a lot of mistakes in terms of information, they see the future incorrectly, and
they’re often surprised by developments in the external environment which they haven’t
seen.

Industrialists have to adjust their prices very quickly, wage-setters have to adjust their
prices very quickly.

Internal (or endogenous) theories consider business cycle to be self-generating, regular,

and indefinitely repeating. When economic times are good or when people feel good
about the future, they spend, and run up debts. ? peak is reached when (or just before)
people begin to consume less, for whatever reason. If interest rates rise too high, ? lot of
people find themselves paying more than they anticipated on their mortgage or rent, and
so have to consume less. As far back as the mid-nineteenth century, it was suggested that
the business cycle results from people infecting one another with optimistic or pessimistic
expectations. If people are worried about the possibility of losing their jobs in the near
future they tend to save more. ? country's output, investment, unemployment, balance of
payments, and so on, all depend on millions of decisions by consumers and industrialists
on whether to spend, borrow or save.

Investment is closely linked to consumption, and only takes place when demand and
output are growing. Consequently, as soon as demand stops growing at the same rate,
even at ? very high level, investment will drop, probably leading to ? downturn.

When people infect one another with pessimistic expectations, they think that the
economy will go into recession, therefore they invest and consume less and in this way
they can bring about a recession. If people reduce their investment and consumption still
further, the recession will continue and will get worse. This situation can be called a self-
fulfilling downturn. In order to change a situation, governments should change people’s
expectations. Governments should make people think that the economy would expand
and in this way change people’s expectations from self-fulfilling downturn self-fulfilling
upturn.

Another theory is that sooner or later during every period of economic growth - when
demand is strong, and prices can easily be put up, and profits are increasing - employees
will begin to demand higher wages or salaries. As ? result, employers will either reduce
investment, or start to lay off workers, and ? downswing will begin.

External (or exogenous) theories, on the contrary, look for causes outside economic
activity: scientific advances, natural disasters, elections or political shocks, demographic
changes, and so on. Joseph Schumpeter believed that the business cycle is caused by
major technological inventions (the steam engine, railways, automobiles, electricity,
microchips, and so on), which lead to periods of ‘creative destruction'. ?? suggested that
there was ? 56-year Kondratieff cycle, named after ? Russian economist. ? simpler theory
is that, where there is no independent central bank, the business cycle is caused by
governments beginning their periods of office with ? couple of years of austerity
programs followed by tax cuts and monetary expansion in the two years before the next
election.

The example of exogenous factors may be an event which happened not so long time
ago: the reunification of Germany in 1991. The shock of German reunification rised
interest rates and demand fell away sharply, because capacity was so strong, investment
also fell away strongly, so there were two or three years of strongly negative grows, that
was not a result of bad policy or any economical troubles, but was just concerned with
political event and it took three or four years to recover from that overinvestment cycle.

All the theories show that falls and rises in economic life usually happen due to the
expectations of people, who suppose some changes and react either optimistically or
pessimistically. All the factors may change people’s expectations and it’s hard to predict
how employees or employers, consumers or producers will behave in different situations.
That is why it’s hard to manage an economy on the state sca