Causes of business cycle

21 September 2019 by Tejvan Pettinger

The business or trade cycle relates to the volatility of economic growth, and the
different periods the economy goes through (e.g. boom and bust). There are
many different factors that cause the economic cycle – such as interest rates,
confidence, the credit cycle and the multiplier effect. Some economists also point
to supply side explanations, such as technological shocks.

This graph shows quarterly economic growth in the UK 1979 to 1995. It shows
two recessions 1980 and 1990/92, and the periods of recovery and boom. The
stats are quarterly figures.

In the UK, the average rate of economic growth is about 2.5%, and therefore we
say that the UK long-run trend rate of economic growth is around 2.5%.
However, the actual growth rate can vary from this average, as it passes through
different stages of the business cycle.
 Graph showing the UK economy cycle – including three recessions of 1981,
1991 and 2009.

For example, in the late 1980s, we experienced rapid economic growth of over
4% a year. However, this growth proved unsustainable leading to inflation and
then a recession in the early 1990s.

Phases of the business cycle

1. Economic growth – when real output increases.

2. Economic boom – fast economic growth which tends to be inflationary and
unsustainable.
3. Economic downturn – when the growth rate falls and the economy heads
towards recession
4. Recession – when there is a period of negative economic growth, and real
output falls.
Causes of the business cycle

1. Interest rates. Changes in the interest rate affect consumer spending and
economic growth. For example, if interest rates are cut, this reduces
borrowing costs and therefore increases disposable income for
consumers; this leads to higher spending and economic growth. However,
if the Central Bank increase interest rates to reduce inflation, this will tend
to reduce consumer spending and investment, leading to an economic
downturn and recession. See: Interest rate cycle.
 High-interest rates in 1991-92 were a major factor in the recession of
that year. The cut in interest rates post 1992, helped the economy to
recover.
2. Changes in house prices
A rise in house prices creates a positive wealth effect and leads to higher
consumer spending. A fall in house prices causes lower consumer
spending and bank losses. (house prices and consumer spending) In the
late 1980s, the boom in house prices caused an economic boom. The drop
in house prices in the early 1990s was a significant factor in causing the
recession of 1991-92.
3. Consumer and business confidence.

Fall in confidence in
May 2008, contributed to the deepest recession for a considerable time.
People are easily influenced by external events. If there is a succession of
bad economic news, this tends to discourage people from spending and
investing, making a small downturn into a bigger recession. But, when the
economy recovers this can cause a positive bandwagon effect. Economic
growth encourages consumers to borrow and banks to lend. This causes
higher economic growth. Confidence is an important factor in causing the
business cycle.

4. Multiplier effect. The multiplier effect states that a fall in injections may
cause a bigger final fall in real GDP. For example, if the government cut
public investment, there would be a fall in aggregate demand and a rise in
unemployment. However, those who lost their jobs would also spend less,
leading to even lower demand in the economy. Alternatively, an injection of
investment could have a positive multiplier effect.
5. Accelerator effect. This states that investment depends on the rate of
change of economic growth. If the growth rate falls, firms reduce
investment because they don’t expect output to rise as quickly.
 Drop in business investment caused by lower growth and credit crunch
made the recession deeper.
This theory suggests investment is quite volatile and small changes in the
rate of growth have a big effect on investment levels. This contributes to a
more volatile business cycle.

6. Lending/finance cycle. Up until the 2008 recession, less emphasis had

been placed on the state of the financial system. However, the credit
crunch of 2008 was the primary cause of the 2008/09 recession. A boom in
credit and lending (especially sub-prime mortgages in US) was a factor in
promoting economic growth during the 2000s. But, when banks became
over-stretched and needed to call in loans, the financial system was short
of liquidity. After the credit crunch, more attention has been given to
theories of financial instability. For example, H. Minsky ‘Financial instability
hypothesis‘ as a cause of business cycles.
7. Inventory cycle. Some argue that there is a natural inventory cycle. For
example, there are some ‘luxury’ goods we buy every five years or so.
When the economy is doing well, people buy these luxury items causing
faster economic growth. But, in a downturn, people delay buying luxury
goods, and so we get a bigger economic downturn.
8. Real business cycle theories. Real business cycle theories – e.g.
Kydland and Prescott (1982) – emphasise supply-side causes of the
 business cycle. For example, periods of technological change can go in
cycles, leading to variations in rates of growth. Real business cycle
theories tend to assume rates of unemployment reflects changes in
people’s willingness to work. See more at Real Business Cycle models
Causes of recessions

The business cycle can go into recession for a variety of reasons, such as:

Falling house prices causing negative wealth effect and lower consumer
spending
 Credit crunch causing an increase in the cost of borrowing and shortage of
funds
 Volatile stock markets and money markets undermining business and
investment confidence.
 Higher interest rates – causing lower spending and investment.
 Tight fiscal policy – higher taxes and lower spending.
 Appreciation in the exchange rate.
 See: causes of recessions
Examples of business cycles

In the post-war economy, there appeared to be a simple trade-off between

unemployment and inflation, shown by the Phillips curve. There were several
economic booms, followed by an economic downturn.
In the late 1980s, there was a classic boom and bust, with economic growth
exceeding the long-term trend rate and causing inflation. Eventually, the
government tried to reduce inflation, and the boom turned into a recession.
See: Lawson Boom and Bust
The end of the business cycle?
 A
long period of economic expansion from 1992 to 2007, combined with low
inflation. But, credit crunch caused a dramatic drop in GDP.
During the great moderation (1992-2007), some economists hoped we had seen
the end of the business cycle because we experienced a long period of economic
expansion without inflation. However, in 2008, the global credit crunch pushed
the world economy into recession, showing the business cycle hadn’t ended. For
further reading see Financial instability hypothesis – why economic stability can
cause financial instability.
Impact of business cycle on economy

 A volatile business cycle is considered bad for the economy. A period of

economic boom (rapid growth in GDP) invariably leads to inflation with
various economic costs. This inflationary growth tends to be unsustainable
and leads to a bust (recession).
 The biggest problem of the business cycle is that a recession represents a
large wastage of resources. A prolonged period of unemployment can also
lead to a loss of labour productivity as workers get discouraged and leave
the labour force altogether.
  The uncertainty created by a volatile business cycle tends to cause lower
investment, and this can lead to lower long-term economic growth.
 However, other economists, such as J.Schumpeter argue that the creative
destruction of capitalism can be a good thing. In a recession, inefficient
firms go out of business and it acts as an incentive to cut cuts.
Moderation of business cycle

 Monetary authorities tend to try and minimise fluctuations in the business

cycle. They seek to avoid an inflationary boom and also avoid a recession.
In the UK, the primary tool to smooth the business cycle is the use
of interest rates. The government may also use fiscal policy. In a
recession, the government could try increasing government spending and
cutting tax.
 However, the effectiveness of monetary and fiscal policy depends on a few
factors; Central Banks are not always able to overcome a recession. For
example, cutting interest rates in 2008 and 2009 was insufficient to end the
recession and return to normal growth. This was because the recession
was very deep and banks reluctant to lend.
Is the business cycle inevitable?

Some economists argue that the business cycle is an essential part of an

economy. Even downturns have their role to play as it tends to ‘shake-up’ the
economy and weed out ‘inefficient’ firms and creating greater incentives to cut
costs and be efficient. However, this view is controversial, and other economists
argue that in a recession, even ‘good efficient’ firms can go out of business
leading to a permanent loss of productive capacity.

Economic Booms
Definition of an economic boom
A boom is a period of rapid economic expansion resulting in higher GDP, lower
unemployment, a higher inflation rate and rising asset prices.

Booms usually suggest the economy is overheating creating a positive output

gap and inflationary pressures.
A boom suggests the economy is growing at a faster rate than the long-run trend
rate of economic growth.
Economic booms tend to be unsustainable and are often followed by a bust – an
economic recession or downturn. Hence the phrase “Boom and Bust”.

Monetary policy tries to avoid boom and busts by moderating the economic cycle
– e.g. if growth is too fast, the Central bank will increase interest rates to
moderate inflationary pressures.

Potential causes of economic booms

1. Expansionary monetary policy. If the economy is growing close to the long-

run trend rate and monetary policy is loosened (cut in interest rates). This
will further increase demand in the economy. The lower costs of borrowing
will encourage investment and consumer spending. This will cause a
further rise in aggregate demand. Lower interest rates will also make it
more attractive to take out a mortgage and buy a house.
2. Expansionary fiscal policy. If the economy is getting close to full capacity
and the government cut taxes – financed by higher borrowing, then this will
have the effect of boosting consumer spending and aggregate demand.
3. Confidence. If consumers and firms are confident – then they are more
likely to borrow to finance investment and spending. This can cause a fall
 in the savings ratio and encourage a higher percentage of income to be
spent.
4. Rising asset prices. Rising asset prices, such as housing and stocks
create a positive wealth effect. This increases confidence and also the
ability to remortgage to gain equity withdrawal. Higher growth, rising prices
and high confidence also causes a feedback loop to put upward pressure
on asset prices to continue to rise. This enthusiasm for buying assets
which are rising in value – can become divorced from an underlying
valuation. It is something economists can refer to as irrational exuberance.

Economic Boom of the 1980s

The 1980s was another period of relatively fast growth ( Sometimes known as
the Lawson boom). Towards the end of the 1980s, UK growth started to exceed
its long-term trend rate (typically around 2.5%). Quarterly growth of 1% means
annualise growth of 4%. In this period of economic boom, the UK saw
 A rapid rise in house prices
 In
the late 1980s there was a deterioration in the current account due to boom in
consumer spending and imports.

 Widening of current account deficit (if domestic demand rises faster than
domestic supply – the economy will tend to import more goods from
overseas.)
 Fall in the savings ratio
 Rise in the inflation rate
As economic growth increased, we also saw a rise in inflation.

An economic boom can be shown using a simple AD/AS diagram

AD increasing faster than LRAS

The same principle can be shown with an increase in AD as the economy
reaches the full employment level (Y2)

(N
ote for students – both diagrams illustrate an economic boom)
Examples of Economic booms
 Turkey boom
 The Lawson Boom of the 1980s
Economic boom of the 2000s

U
S house prices boomed in the mid-2000s

The economic boom of the 2000s was a little different.

 Inflation remained low. Economic growth wasn’t excessive. We didn’t have

a traditional macroeconomic boom.
 However, there was a boom in financial lending, borrowing and a boom in
house prices. When the credit bubble burst – it harmed the economy.
Economic Boom of the 1920s in the US
In the US, the 1920s saw an economic boom. This was an era of rising
production, economies of scale from the Assembly line (e.g. Ford Motor Cars). 
However, although there was an increase in productive capacity towards the end
of the 1920s, demand and asset prices started to grow faster than economic
fundamentals, and share prices soared on the back of borrowing. This financial
bubble burst on Black Thursday in the Wall Street Crash of 1929.   See also
– what caused The Wall Street Crash of 1929
Economic Boom in China and India

Not all economic booms have to come to an abrupt end. For example, the
Chinese economy has experienced over 20 years of rapid economic expansion.
The Indian economy has also experienced a period of rapid growth. In their
cases, they have been able to maintain a high rate of growth because they have
substantial scope for efficiency gains. But, their booms may not last forever.
There are concerns over unsustainable borrowing in China.
An economic boom in the US in 2018/19?
When the US economy was getting close to full capacity in 2018, the Trump
administration announced a large tax cut – financed by higher borrowing. In
theory, this will cause a further rise in spending – will this create an inflationary
boom?