Phases of the Business Cycle

Figure Phases of the Business Cycle shows a simplified picture of a typical business cycle. It shows that economies go through periods of increasing and decreasing real GDP, but that over time they generally move in the direction of increasing levels of real GDP. A sustained period in which real GDP is rising is an expansion; a sustained period in which real GDP is falling is a recession.

Figure Phases of the Business Cycle

The cycle begins at a peak and continues through a recession, a trough, and an expansion. A new cycle begins at the next peak. Here, the first peak occurs at time t ₁, the trough at time t ₂, and the next peak at time t ₃. Notice that there is a tendency for real GDP to rise over time.

At time t ₁ an expansion ends and real GDP turns downward. The point at which an expansion ends and a recession begins is called the peak of the business cycle. Real GDP then falls during a period of recession. Eventually it starts upward again (at time t ₂). The point at which a recession ends and an expansion begins is called the trough of the business cycle. The expansion continues until another peak is reached at time t ₃.

The business cycle or trade cycle is a permanent feature of market economies: gross domestic product (GDP) fluctuates as booms and recessions succeed each other. During a 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 a 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. A serious, long-lasting recession is called a depression. Not all recessions lead to a depression – there might just be a mild slowdown in the economy (seen as a reduction in GDP – gross domestic product).

There are various theories explaining the causes of the business cycle. Internal (or endogenous) theories consider it to be self-generating, regular, and indefinitely repeating. A peak is reached when (or just before) people begin to consume less, for whatever reason. 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. When economic times are good or when people feel good about the future, they spend, and run up debts. If interest rates rise too high, a lot of people find themselves paying more than they anticipated on their mortgage or rent, and so have to consume less. If people are worried about the possibility of losing their jobs in the near future, they tend to save more. A country’s output, investment, unemployment, 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 a very high level, investment will drop, probably leading to a downturn. 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 and salaries. As a 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’. He suggested that there was 56-year Kondratieff cycle, named after a Russian economist. A simpler theory is that, where there is no independent central bank, the business cycle is caused by the fact that governments begin their periods of office with a couple of years of austerity programmes followed by tax cuts and monetary expansion in the two years before the next election.

 

Key concepts

1. Nominal gross domestic product (GDP) is the total value of final goods and services for a particular period valued in terms of prices for that period.

2. Real gross domestic product (real GDP) is a measure of the value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of price changes.

3. The economy follows a path of expansion, then contraction, then expansion again. These fluctuations make up the business cycle.

4. The point at which an expansion becomes a recession is called the peak of a business cycle; the point at which a recession becomes an expansion is called the trough.

5. Over time, the general trend for most economies is one of rising real GDP.

Unit 1.2 Economic Growth

Learning objectives

1. Define economic growth and explain it using the production possibilities model and the concept of potential output.

2. Calculate the percentage rate of growth of output per capita.

Defining Economic Growth

Real GDP is widely used to measure economic growth rates. Governments closely follow changes in the numbers of real GDP over a 12-month period. A percentage change in real GDP in one year compared with the real GDP in the previous year gives an idea whether the economy is growing or shrinking. So an annual economic growth rate equals the difference between the real GDP in year 2 and year 1 divided by the real GDP in year 1.

Economic growth =  * 100%, where Yt is real GDP of the current year; Y(t-1) is real GDP of the previous year. It can be a positive or a negative number.

But this measure does not take into account possible cyclical implications. It is more desirable to analyze rate of economi9c growth over a long term, actually, comparing the years in which the economy was working at its potential output level with full employment. In other words, economic growth is a long-run process that occurs as an economy’s potential output increases. Changes in real GDP from quarter to quarter or even from year to year are short-run fluctuations that occur as aggregate demand and short-run aggregate supply change. Regardless of media reports stating that the economy grew at a certain rate in the last quarter or that it is expected to grow at a particular rate during the next year, short-run changes in real GDP say little about economic growth. In the long run, economic activity moves toward its level of potential output.

Economic growth is the process through which an economy achieves an outward shift in its production possibilities curve. How does a shift in the production possibilities curve relate to a change in potential output? To produce its potential level of output, an economy must operate on its production possibilities curve. An increase in potential output thus implies an outward shift in the production possibilities curve. In the framework of the macroeconomic model of aggregate demand and aggregate supply, we show economic growth as a shift to the right in the LRAS curve.

There are three key points about economic growth to keep in mind:

1. Growth is a process. It is not a single event; rather, it is an unfolding series of events.

2. We define growth in terms of the economy’s ability to produce goods and services, as indicated by its level of potential output.

3. Growth suggests that the economy’s ability to produce goods and services is rising.

The use of actual values of real GDP to measure growth can give misleading results. Here, an economy’s potential output grows at a steady rate of 2.5% per year, with actual values of real GDP fluctuating about that trend. If we measure growth in the first 10 years as the annual rate of change between beginning and ending values of real GDP, we get a growth rate of 3.5%. The rate for the second decade is 0.5%. Growth estimates based on changes in real GDP are affected by cyclical changes that do not represent economic growth.

By measuring economic growth as the rate of increase in potential output, we avoid such problems. One way to do this is to select years in which the economy was operating at the natural level of employment and then to compute the annual rate of change between those years. The result is an estimate of the rate at which potential output increased over the period in question. For the economy shown in Figure Cyclical Change Versus Growth, for example, we see that real GDP equaled its potential in years 5 and 15. Real GDP in year 5 was $1,131, and real GDP in year 15 was $1,448. The annual rate of change between these two years was 2.8%. If we have estimates of potential output, of course, we can simply compute annual rates of change between any two years.