Business Cycle

AK Dash
IBS Hyderabad

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 What is Business Cycle
Most of the economies in the World have experienced altering period of
expansion or contraction of economic activity. A country may enjoy several
years of economic expansion and prosperity, with rapid increase in stock
prices (as in the 1990s) or housing prices (as in early 2000). The economy also
faces some down turn like 2001, 2007-08 and in 2019 COVID-19.
Consequently, firms profit falls, national output falls and unemployment rises
etc. .

Business cycles are economic wide fluctuations in national output, income and
employment usually lasting for a period of 2 to 10 years, marked by
widespread expansion or contraction in most of the sectors of the economy.
More clearly business cycles are irregular expansion and contractions in
economic activity. Economic fluctuations are the rise or fall of economic
activity relative to the long term growth trend of the economy.

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The business cycles are central concern in macro economics because business
cycle fluctuations- the ups and downs in overall economic activity are felt
through out the economy.

Two basic questions arises (a) what causes business fluctuations/ cycles (b)
how policy makers should respond to reduce cyclical fluctuations.

Economists were largely unable to answer these questions till 1930’s. In 1930
Keynes highlightened the importance of the forces of aggregate demand in
determining business cycles. Keynes emphasis that changes in aggregate
demand can have powerful impacts on the overall levels of output,
employment, prices in the short run.

The goal of business cycle research is to identify when the turning points will
occur. Aggregate economic activity isn’t measured directly by any single
variable. So, there is no single formula that tells economists when peak or
trough has been reached.

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 Causes of Business Cycles

The cyclic pattern that occurs in the economy is caused by many factors such
as internal and external factors. Internal factors are confined to country’s
boundary. And there are also external factors which may lead to a boom or
bust of an economy. So we can say due to internal or external factors business
cycle occurs.
Internal Factors
1. Changes in aggregate demand: Keynes believes that a change in
aggregate demand causes a change in the economic activities. When the
aggregate demand in an economy increases the firms start producing
more goods to meet the demand.There is more output,
more employment, more income, and higher profits. This will lead to a
boom in the economy.
On the other hand, if the aggregate demand falls, so does the economic
activity. This may lead to a bust, which if it continues for a longer period of
time may even lead to depression in the economy.

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2. Fluctuations in investment
It is one of the main causes of business cycles. The investments will fluctuate
due to many factors such as interest rate in the economy, entrepreneurial
profit, government policy etc.
An increase in investment, will lead to an increase in economic activities and
cause expansion. On the other hand, a decrease in investment, will have the
opposite effect and may cause a contraction .

3. Macroeconomic Policies
If government increases taxes and RBI increases interest rate significantly,
then there are chances of slowdown or a recession in the economy. Policy
implementation like demonetization slowed down the economy.
Recall how Zimbabwe, Venezuela economy entered into Hyper inflation.
Because of fatly leadership their economy entered the business cycle.

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 External Causes of Business Cycles
1. Wars: During war time, the economic resources are put to use to make
special goods like weapons, arms, and other such war goods. During war time
more priority is given to produce capital goods. During war time there is
increase in uncertainty and hence producer will produce less. This will lead to
a fall in income, employment, output. So, the economy will face a downturn
during war times.
On the contrary, once the war will over, Government focus is to rebuilt
infrastructure such as houses, roads, bridges, etc. This will help the economy
pick up.
2. Technology Shocks
Innovation of new technology boost to the economy. New technology
promote new investment, which increased employment, and subsequently
higher incomes . For example, the invention COVID-19 vaccine will promote
boost in the pharmaceutical industry. The countries who are giving more
priority to Artificial intelligence, Block chain, Big data will show expansion
phase. New technology enhances employment and brings more competitive.
3. Natural Factors
Natural disasters such as floods, droughts etc can cause damage to the crops
and huge losses to the agricultural sector and the economy as well. Shortage 6
of food will cause a surge in prices and high inflation.
 Features of Business Cycle
1. Aggregate economic activity:
Business Cycles are defined broadly as fluctuations of “aggregate economic
activity” rather than fluctuations in a single, specific economic variable.
Although real GDP may be the single variable that most closely measure the
aggregate economic activity
2. Expansions and contractions: Traditionally economists divide business
cycle into two phases expansion(boom) and contraction(recession). Peak and
trough are the turning points of the business cycle. As time passes, modern
economists added one more phase that is called recovery. Put it simply,
business cycle have 5 phases such as expansion, peak, contraction, though,
recovery.

The period of time during which aggregate economic activity grows is called
expansion or boom. After reaching the high point of expansion(peak), the
aggregate economic activity begins to decline.

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 Features of Business Cycle Continues…

On the contrary, the period of time during which aggregate economic activity
is falling is called contraction(or recession). During a contraction, the
economy’s output decreases. A milder contraction is called a recession.
Recession is traditionally defined as a decline in total output (real GDP) at
least two consecutive quarter, or at least six months. A recession means
output declines for at least two consecutive quarters, a recession is not so
designated until at least six months after it begins. If a contraction is so severe
then it is called as depression. Depression refers to a sharp reduction in the
nation’s total production lasting more than a year and accompanied by high
unemployment. In otherward, a recession that is large in both scale and
duration is called depression.

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 Features of Business Cycle Continues…
3. Business cycle fluctuations are recurrent but not periodic
The business cycle fluctuations are not periodic in that it does not occur at
regular, predictable intervals and does not last for a fixed or predetermined
length of time. Although the business cycle is not periodic, it is recurrent.
That is, the standard pattern of contraction-trough-expansion-peak reoccurs
again and again in industrial economies.
4. Business cycle fluctuations are persistence
It means that once a recession or expansion begins, it usually last for a while.
The tendency for decline in economic activity to be followed by further
declines, and for the growth in economic activity to be followed by more
growth is called persistence.

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Aggregate Economic Activity (Real GDP)
Phases of Business Cycle

Peak

Long
term
Growth
Trend

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Note: Business cycles are temporary deviations from the economy’s normal growth path.
 Phases of Business Cycle Continues..

In exhibit 1, the straight line shows the long term growth trend in real GDP
which is upward slopping. Economic fluctuations reflects movements around
this growth trend. A contraction begins after the previous expansion has
reached a peak, or high point and continues until the economy reaches a
trough, or low point. The period between peak and trough is a contraction,
and the period between a trough and subsequent peak is an expansion. Note
that expansion last longer than contraction. The longest expansion on record
lasted to 1 years from March 1991 to March 2001 in the US economy.

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 Phases of Business Cycle Continues..
 Expansion/Boom-A period of fast economic growth. Output is high due to
increased demand. High output is produced by employing more people as a result
unemployment is low. A boom occurs when national output is rising at a rate faster
than the trend rate of growth.
 Peak- the point at which recession begins, the highest point in real GDP before a
recession. In other words, time when aggregate economic activity stops rising and
begins falling
 Recession (contraction): The downturn of a business cycle. In other words period
when economic activity is falling (at least two consecutive quarters).
 Trough: the lowest point of real GDP at the end of a recession. In other words,
time when aggregate economic activity stops falling and begins rising.
 Recovery: A period when the economy starts to experience renewed growth after a
recession.
Turning point-peaks or trough. A peak is the high point following a period of economic
expansion. A trough is the low point following a period of economic decline.
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 In a boom, what happens to ….
 Economic Growth?
 Consumer spending?
 Employment?
 Business confidence index?
 Consumer confidence index?

In a Recession, what happens to ….

 Economic Growth?
 Consumer spending?
 Employment?
 Business confidence index?
 Consumer confidence index?
 Government spending

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 Business Cycle Facts
Two characteristics of cyclical behavior of macro economic variables are
important for business cycle facts.

Characteristics of Cyclical behavior of macro economic variables

1. Direction 2. Timing
Direction

The first is the direction in which a macro economic variables moves, relative
to the direction of aggregate economic activity.

Procyclical: An economic variable that moves in the same direction as

aggregate economic activity (up in expansion, down in contraction) is
procyclical. For example, industrial production, Consumption, business fixed
investment, Government expenditure, employment, average labour
productivity, money supply, stock price.

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Countercyclical: A variable that moves in the opposite direction to aggregate
economic activity (ups in contractions, down in expansion) is countercyclical.
Note: Unemployment is the only counter cyclical variable. Most of the
variables are procyclical in nature.

Acyclical: A variable that do not display a clear pattern over the business cycle
are acyclical. For example real interest rate.

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Timing
The second characteristics is the timing of the variables turning points (peak
and trough) relative to the aggregate economic activity(Business cycle peak
and trough)

Leading Variable: An economic variable is a leading variable if it tends to

move in advance as compared to aggregate economic activity. In other words,
the peak and trough in a leading variable occur before the corresponding peak
and trough of the aggregate economic activity.

Variables that predict or lead to, a recession or recovery; examples include

consumer confidence index, producer confidence index, average labour
productivity, money supply, stock prices, residential investment. In the early
stage of a recession, business slow down, orders for machinery and computer
slips, and the stock market, anticipating lower profit, turns down. Consumer
confidence in the economy also begins to sag, so households spends less. All
these signs are called leading economic indicator because they usually predict
, or lead to, a downturn. Likewise, if leading indicators are showing upwards
trends it is the indication of economy recovery. 16
Lagging Variable: A lagging variable is one whose peaks and throughs tend
to occur latter as compared to aggregate economic activity. In other words, a
variables that follow the changes in overall economic activity. Eg. Inflation,
interest rate

Coincident Variable: A coincident variable is one whose peaks and trough

occurs at about the same time as the corresponding aggregate economic
activity peak and trough. Examples includes employment, personal income, and
industrial production

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 Business Cycle Theories
1. Exogenous vs. internal theories(factors): Exogenous theories believes that the
sources of business cycle is due to fluctuations of factors out side the economy
system-in wars, revolutions, and elections, oil prices, gold discoveries, migrations,
discovery of new inland and resources, technological innovations etc. By contrast,
internal theories look within the economy system itself that generates business cycles.
2. Demand-Induced cycles: One important sources of business fluctuations is shocks
to aggregate demand. How increase or decrease in aggregate demand creates business
cycle.

3. Monetary theories attribute business fluctuations to the expansion and contraction

of money and credit (M. Friedmam). Under this approach, monetary factors are the
primary sources of fluctuations in aggregate demand.
4. Political theories of business cycle attribute fluctuations to politicians who
manipulate economic policies in order to be re elected (W. Nordhaus, E. Tufte).
Historically presidential elections are sensitive.

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 Business Cycle Theories Continues..

5. Real business cycle proponents holds that innovations or productivity

shocks in one sector can spread to the rest of the economy and cause
recessions and booms (J. Schumpeter). In classical approach, cycles are
caused primarily by shocks to aggregate supply and not by changes in
aggregate demand.

6. Supply shocks occur when business fluctuations are caused by shifts in

aggregate supply (R. J. Gordon). During the oil crises of the 1970s, when
sharp increase in oil price contracted aggregate supply, increased inflation,
and lowered output and employment.

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 Measuring Unemployment

Unemployment: The person who is looking for a job but not getting the job
and are not in the labour force. The unemployment rate is the most widely
reported measure of the nations economic health. In India, the employment
and unemployment data are given by national sample survey (NSS)

Unemployment rate: the number of unemployed as a percentage of the labour

force

Labour Force: Consists of the people in the adult population who are either
working or looking for work.

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 Why there always are unemployed People

Even when the economy is growing vigorously and many new jobs are being
created, some people remain unemployed. Why is unemployment apparently
a permanent feature of the economy?. Due to the presence of frictional and
structural unemployment, the unemployment rate never reaches zero.

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 Frictional Unemployment
The labour market is characterised by a great deal of searching by both
workers and firm. Unemployed workers search for suitable jobs, and the firm
with vacancies search for suitable workers. If all workers were identical and
all jobs were identical, these searches would be short and easy. Unemployed
workers would simply have to find firms that had vacancies and they would
immediately be hired. The problem, of course, is that neither jobs nor workers
are identical. Workers vary in their talents, skills, experiences, goals,
geographic location (and willingness to move), and amount of time and
energy they are willing to commit to their job. Similarly jobs very in the skills
and experience required, working conditions, locations, hours and pay.
Because of these differences, an unemployed workers may search for several
weeks or more before finding a suitable job; Similarly, a firm may search for
a considerable time before it is able to hire a suitable worker. The
unemployment that arises as workers search for suitable jobs and firms search
for suitable workers is called frictional unemployment. Because the economy
is dynamic, with jobs continuously being created and destroyed and workers
continuously entering and existing the labour force, there is always some
frictional unemployment as workers are matched with appropriate job.
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 Structural Unemployment
Why job vacancies and unemployment coexist is that unemployed workers often do
not have the skills in demand or do not live where their skills are demanded.
Unemployment arising from a mismatch of skills (demand and supply) or
geographic location is called structural unemployment. Structural unemployment
occurs because changes in tastes, technology and competition reduce the demand for
certain skills and increases the demand for other skills. ATMS replaced banks
tellers, and office technology is replacing clerical staff. Because of email, voice
email, cell phones and other wireless devices, the number of secretaries, typists and
administrative assistants lost their jobs. Structural unemployment occurs due to
changes in the structure of the economy.

Structural unemployment occurs for two primary reasons. First, unskilled or low
skilled workers often are unable to obtain desirable, long term jobs. The jobs
available to them typically offer relatively low wages and little chance for training
or advancement. The jobs held by low skilled workers often don’t last long. After a
few months of the jobs may end, or the workers may quit or be fired, thus entering
another spell of unemployment. Some workers with low skills level eventually get
enough training or experience to obtain more secure, long term jobs. Because of
factors such as inadequate education, discrimination and language barriers, however
some unskilled workers never make the transition to long term employment and 23
 Structural Unemployment Continues…
The second source of structural unemployment is the reallocation of labour
from industries that are shrinking, or regions that are depressed, to areas that
are growing. When industries find that their products are no longer in demand
or that they are no longer competitive, workers in these industries lose their
jobs. At the same time, some industries like health care, computer software
industries will be growing. To prevent unemployment, the workers who lose
jobs in declining industries be matched somehow with jobs in growing
industries. This matching may involve a long period of unemployment,
especially if workers need to relocate or be trained for a new job.

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 Natural Rate of Unemployment
Because of the combination of frictional and structural unemployment, an
economy’s unemployment rate is never zero, even when the economy is at its
full employment level. The rate of unemployment that prevails when output
and employment are at the full employment level is called natural rate of
unemployment. The natural rate of unemployment reflets unemployment
owing to frictional and structural causes. There is no single official measure
of the natural rate of unemployment.

When economists talk about “full employment” they do not mean zero
unemployment, but low unemployment , with estimates ranging from 4 to 6
%. Even when the economy is at full employment, there is some frictional
and structural unemployment.

Natural rate of unemployment corresponds to full employment output.

Unfortunately because, we cant be sure when the economy is at full
employment, we cant directly observe the natural rate and so must estimate it.

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 Cyclical Unemployment

As output declines during recession, firms reduce their demand for nearly all
resources, including labour. Cyclical unemployment increases during
recession and decreases during expansions. Cyclical unemployment, deals
with an economy’s business cycle. Cyclical unemployment is cause by job
losses during downturns and contractions in the business cycle. A general
lack of aggregate demand is one of the main factors that causes cyclical
unemployment. When there is a drop in consumer demand, business revenues
usually decline. Consequently, companies have to lay off workers to cut costs
and maintain their profit margins. For example, the U.S. economy faced
cyclical unemployment during the Great Recession.

The difference between the actual unemployment rate and the natural rate of
unemployment is called cyclical unemployment. Natural rate of
unemployment corresponds to full employment output. Cyclical
unemployment =u-u bar. Where u is the actual unemployment rate and u bar
is the natural rate of unemployment.
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 Seasonal Unemployment

Unemployment caused by seasonal changes in labour demand during the year

is called seasonal unemployment. Tourism in winter destinations such as
Shimla and Ooty melts in the heat of summer. The Christmas season in the
US increases the demand for sales clerks, postal workers and Santa cluses.
Those in seasonal jobs know their jobs dissapers in the off seasons. Policy
makers and economists are not that concerned about seasonal unemployment.

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 Voluntary Unemployment
Voluntary unemployment is a situation when a person is unemployed not due
to unavailability of jobs in the economy, but because of not being able to find
employment of his/her own choice.

Sometimes people reject employment opportunities if they do not receive

desired wages or if they are not offered the kind of work they wish to do.

Involuntary unemployment refers to the situation where people who are able
to work and are willing to work at the existing wage rate are not getting the
job.

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 Disguised Unemployment

 Disguised unemployment is unemployment that does not affect aggregate

economic output.
 It occurs when productivity is low and too many workers are filling too
few jobs

 Disguised unemployment is to say that people are employed but not in a

very efficient way.
 Disguised unemployment exists frequently in developing countries whose
large populations create a surplus in the labor force.
 Disguised, or hidden, unemployment can refer to any segment of the
population not employed at full capacity, but it is often not counted in
official unemployment statistics within the national economy.

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 Okun’s Law
Many short run output fluctuations results from changes in employment.
When employment falls and unemployment rises, the reduction in the number
of people working leads to a decline in the quantity of goods and services
produced.
The quantitative impact on aggregate output of a change in the
unemployment rate is described by Okun’s law, a rule of thumb (rather than a
‘law’). According to Okun’s Law, the gap between an economy’s full
employment output(potential output) and its actual level of output increases
by 2 percentage points for each percentage point the unemployment rate
increases.

𝑌−𝑌
− =2 (u- u )
𝑌
Y is actual output, Full employment output is Y, expressed as a percentage of
Y
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In Okuns law, actual output will deviate from potential output if there is
Thank You

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