Business Cycle

BUSINESS CYCLE

A business cycle refers to the ups and downs of the general level of economic activity for a country. Such changes are normally visible in key macroeconomic measures such as gross domestic product (GDP), real income, employment, industrial output, and wholesale-retail sales. The upward movement in economic activity is referred to as the expansion phase and the downward movement as the contraction phase of the cycle. The turning points of the cycle are called the peak, which is at the end of the expansion phase, and the trough, which is at the end of the contraction phase.

Much attention is paid to the timing of these turning points and the duration of the phases. The expansion phase of the business cycle starts with a short period of recovery before becoming a full-blown expansion. Similarly, a period of recession occurs at the start of the contraction phase. Thus the cycle is generally referred to as

Business cycle expansions and contractions
Business cycle reference dates		Duration in months
Trough	Peak	Contraction (trough from previous peak)	Expansion (trough to peak)	Cycle
				Trough from previous trough	Peak from previous peak
1 31 cycles
2 15 cycles
3 26 cycles
4 13 cycles
Notes:
1) Figures printed in bold italic are the wartime expansions (Civil War, World Wars I and II, Korean war and Vietnam war), the postwar contractors, and the full cycles that induce the wartime expansions.
2) The determination that the last contraction ended in November 2001 is the most recent decision of the Business Cycle Dating Committee of the National Bureau of Economic Research.
source: National Bureau of Economic Research, Inc., 1050 Massachusetts Avenue, Cambridge MA 02133.
December 1854	June 1857	—	30	—	—
December 1858	October 1860	18	22	48	40
June 1861	April 1865	8	46	30	54
December 1867	June 1869	32	18	78	50
December 1870	October 1873	18	34	36	52
March 1879	March 1882	65	36	99	101
May 1885	March 1887	38	22	74	60
April 1888	July 1890	13	27	35	40
May 1891	January 1893	10	20	37	30
June 1894	December 1895	17	18	37	35
June 1897	June 1899	18	24	36	42
December 1900	September 1902	18	21	42	39
August 1904	May 1907	23	33	44	56
June 1908	January 1910	13	19	46	32
January 1912	January 1913	24	12	43	36
December 1914	August 1918	23	44	35	67
March 1919	January 1920	7	10	51	17
July 1921	May 1923	18	22	28	40
July 1924	October 1926	14	27	36	41
November 1927	August 1929	13	21	40	34
March 1933	May 1937	43	50	64	93
June 1938	February 1945	13	80	63	93
October 1945	November 1948	8	37	88	45
October 1949	July 1953	11	45	48	56
May 1954	August 1957	10	39	55	49
April 1958	April 1960	8	24	47	32
February 1961	December 1969	10	106	34	116
November 1970	November 1973	11	36	117	47
March 1975	January 1980	16	58	52	74
July 1980	July 1981	6	12	64	18
November 1982	July 1990	16	92	28	108
March 1991	March 2001	8	120	100	128
November 2001		8	—	—	—
Average, all cycles:
1854–2001 (32 cycles)		17	38	55	156
1854–1919 (16 cycles)		22	27	48	249
1919–1945 (6 cycles)		18	35	53	53
1945–2001 (10 cycles)		10	57	67	67
Average, peacetime cycles:
1854–2001 (27 cycles)		18	33	51	352
1954–1919 (14 cycles)		22	24	46	447
1919–1945 (5 cycles)		20	26	46	45
1945–2001 (8 cycles)		10	52	63	63

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consisting of four phases: recovery, expansion, recession, and contraction.

THE PHASES OF A CYCLE

The transition from phase to phase is described in terms of the rate of growth of the economy. During the recovery phase, the economy turns into a positive growth period with an increasing rate of growth. During the expansion period, the economy continues to grow, but gradually at a decreasing rate. After the peak is reached, the rate of growth will turn negative, causing the economic activity to decline and the economy to slip into recession. The recession phase is marked by a rapidly declining economy from its peak. The rate of decline slows down as the cycle approaches its trough and the economy passes through the contraction phase. A severe contraction is referred to as a depression, the type that occurred in 1930s. During the Great Depression, the output fell by almost 50 percent and employment by 22 percent. All the recessions since then have been shorter in duration and less severe.

LENGTH OF BUSINESS CYCLES

The time taken to complete a cycle can vary from cycle to cycle, with the time usually measured from peak to peak or trough to trough. Considerable variability of the duration of business cycles has been observed in the past. Between 1854 and 1982, there were 30 business cycles with an average length from trough to trough of 46 months and standard deviation of 16 months. The average length of the expansion in these cycles was 27 months with a standard deviation of 11 months, and the average contraction was 19 months with a standard deviation of 13. Though they varied greatly in duration and scope, all of them had some common features. They were national or international in scope; they affected output, employment, retail sales, construction, and other macroeconomic variables; and they lasted for years, with upward movement longer than downward movement.

SPECIFIC CYCLES

It is sometimes useful to speak of the cycles of specific time series; that is, the interest rate cycle, the inventory cycle, the construction cycle, and so forth. Given the diversity of general economic cycles, one can find turns in the general level of economic activity in which individual sectors of the economy do, at least for a time, appear to be independent of the rest of the economy. The most frequently mentioned individual cycles are the inventory cycle, the building or construction cycle, and the agricultural cycle. The standard business cycle is sometimes referred to as the inventory cycle, and some business cycle theorists explain the severity of turns in the economy by the coincidence of timing in the individual cycles.

DATING OF BUSINESS CYCLES

The idea of the timing of individual time series relative to the general level of business implies specific dates for the business cycle. How does one establish the peaks and troughs for the business cycle? To say whether something leads or lags the business cycle, one must have some frame of reference; hence, the business cycle is referred to as the reference cycle and its peaks and troughs as reference turning points. (See Table 1.)

For the United States, the reference turning points are established by the National Bureau of Economic Research (NBER), a nonprofit research organization. This organization, originally under the guidance of Wesley Clair Mitchell (1874–1948), pioneered business cycle research in the late 1920s. In the early twenty-first century the NBER's decisions regarding the reference cycle are often viewed as infallible, although they are actually quite subjective. No single time series or group of time series is decreed to be "the" reference cycle. A committee of professional business cycle analysts convened by the NBER establishes the official peaks and troughs in accordance with the following definition:

Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge in the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximately their own. (Burns and Mitchell, 1946, p. 3)

With slight modification, this definition has been used since 1927. Although most of the definition is self-explanatory, it is not all that rigorous. It does not say something like, for example, if the total output of the economy (real GDP) falls at an annual rate of 1 percent for two consecutive quarters, a recession has begun. The definition does say unambiguously that business cycles are "recurrent but not periodic." The only real constraint in the definition is that if a business cycle is defined as, say, from peak to peak, one should not be able to find another cycle of equal amplitude between those two peaks. If so, one did it wrong.

The NBER's business cycle dating committee follows standard procedures by using economy-wide measures of economic activity. The primary measure it looks at is the real GDP, which it considers to be the single best measure of aggregate economic activity. It also looks at other measures such as real personal-transfer payments, employment, and industrial production. According to the dating committee, the decline of real GDP for two or more consecutive quarters is the criterion for determining the beginning of a recession. Table 1 provides the NBER's chronology of U.S. business cycles since 1854.

The most recent turning point identified by the NBER was November 2001, marking the end of the recession that started in March 2001 and inaugurating an expansion. As of December 2005, the U.S. economy continued to expand. The expansion that began in March 1991 and ended in March 2001, lasting exactly ten years, was the longest in the NBER's chronology. Notice from the table that all that is established with regard to "the" business cycle is the peak and trough of each cycle. This determination tells readers absolutely nothing about the rate of rise or fall in the general level of economic activity, nothing about the magnitude of the boom or the severity of the recession.

THEORIES OF THE BUSINESS CYCLE

The first lecture in an introductory economics course usually makes the point that the expenditures of one economic unit are the incomes of other economic units. This provides a fairly firm basis for expecting sympathetic movements in many sectors of the economy. A good theoretical basis and substantial empirical support exist for cumulative upward and downward movement in the economy. One sector's expansion is the basis for another sector's expansion, general prosperity lowers risk and makes credit more readily available, and so on; but the weakest part of business cycle theory and the toughest problem in forecasting is turning points. Why does the general upward or downward movement end? Sometimes it is obvious. When, for example, a war begins or ends with a commensurate and dramatic change in military expenditures, the cause of the beginning or end of an economic boom is fairly unambiguous.

Historically, however, only a small minority of the turning points are the result of specific, identifiable events such as wars, changes in population, and advances in technology. Even when exogenous events initiate a business cycle, what generates cumulative up-and-down movements in the economy is the internal mechanism of the economy responding to the external stimuli. A satisfactory theory of business cycle, therefore, must explain how cyclical movements are generated by the internal mechanism of the economy when affected by outside shocks. Many theories have been advanced over the years to explain these cumulative up-and-down movements.

One set of theories developed around the turn of the twentieth century focused on such factors as innovations, variations in funds flow, and overinvestment as the initiating causes of cyclical movements in the economy. Internal dynamics of the economy also played a key role in the various phases of the cycle in these theories. Theories developed during the interwar and immediate postwar period focused more on internal instability to explain how cyclical fluctuations in economic activity are created and sustained.

In 1917 an eminent American economist, J. M. Clark (1884–1963), published an article titled "Business Acceleration and the Law of Demand: A Technical Factor in Economic Cycles." His technical factor was the observation that with a fixed capital-output ratio, a small percentage change in final sales would give rise to a large percentage change in investment. Each innovation generates a temporary demand for the required investment goods. Once the initial investment has been made, the replacement market requires a lower rate of investment. This is referred to as the principle of acceleration. If it takes $10 worth of steel mills to produce $1 worth of steel per year, growth in demand for steel by $1 will temporarily generate $10 worth of demand for steel mills.

Another early business cycle theorist, Joseph Schumpeter (1883–1950), noted that nothing is constant over the business cycle and nothing ever really returns to its starting place. That is what makes each business cycle unique. The economy grows and changes with each cycle—new products, new firms, new consumers. As Schumpeter observed in 1939, "As a matter of history, it is to physiology and zoology, not to mechanics, that our science is indebted for an analogous distinction which is at the threshold of all clear thinking about economic matters" (p. 37). The economy grows and changes. He referred to this as the process of "creative destruction."

Schumpeter concluded that what most people consider "progress" is at the source of the problem. He believed that as entrepreneurs come up with new ways of doing things, this disturbs the equilibrium and creates fluctuations. Schumpeter distinguished between inventions, which may gather dust for years, and innovations, which are commercial applications of previous inventions. Inventions occur randomly through time. Innovations tend to be bunched, thereby creating cycles of economic activity.

Many business cycle theorists give a prominent role to the monetary system and interest rates. Early in the twentieth century, a Swedish economist, Knut Wicksell (1851–1926), argued that if the "natural" rate of interest rose above the "bank" rate of interest, the level of economic activity would begin to increase. In contemporary terms, the natural rate of interest is what businesses expect to earn on real investment. The bank rate is the return on financial assets in general and commercial bank loans in particular. The boom begins when, for whatever reason, the cost of borrowing falls significantly below expected returns on investment. This difference between the rate of return on real and financial assets generates a demand for bank loans by investors seeking to exploit the opportunity for profit. The economy booms.

At some point the bank rate will start to rise and/or the real rate will start to fall. When the expected rate of return on investment falls below the rate at which funds can be borrowed, the process will begin to reverse itself and the recession is on. As bank loans are paid off (or defaulted on), bank credit is reduced, and the economy slows accordingly.

Since the late twentieth century, business cycle theory has centered on the argument about the source of cyclical instability. The question of the root causes of ups and downs in the level of economic activity received a lot of attention in the 1980s and 1990s.

Figure 1 shows how the parties to the debate are divided up. First, there is the question of whether the private sector of the economy is inherently stable or unstable—which is to say, do the observed fluctuations originate in the government or private sector? On one side are what might be called classical economists, who are convinced that the economy is inherently stable. They contend that, historically, government policy has destabilized it in a perverse fashion. On the other side are what might be called Keynesians, named after the British economist John Maynard Keynes (1883–1946). Keynesians believe that psychological shifts in consumers' purchasing and savings preferences and in businesses' confidence are a substantial source of instability.

There is a whole body of literature on political business cycles. As economist William D. Nordhaus noted: "The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power" (1989, p. 1). The idea is that politicians in power will tend to follow policies to promote short-term prosperity around election time and allow recessions to occur at other times. The evidence that the state of the economy influences voting patterns is strong, as is the apparent desire of incumbent politicians to influence the economy; but it is difficult to make a case that the overwhelming determinant of the level and timing of business fluctuations is politically determined. At some points in modern history, politically determined policies were apparently a determining factor and at other times not.

With respect to the impact of governmental policies, there is a dispute as to the relative importance of monetary policy (controlling the money supply) and fiscal policy (government expenditures and taxes). Those who believe that monetary policies have had a generally destabilizing effect on the economy are known as monetarists. Most economists accept that fiscal policy, especially in wartime, has been a source of cyclical instability.

As noted above, it is the so-called Keynesian economists who believe that the private sector is inherently unstable. While noting the historical instability of investment in tangible assets, they have also emphasized shifts in liquidity preference (demand for money) as an independent source of instability. As a counter to the standard Keynesian position, there has arisen a school of thought emphasizing real business cycles. This school contends that nonmonetary variables in the private sector are a

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major source of cyclical instability and that the observed sympathetic movements between monetary variables and the level of economic activity result from a flow of causation from the latter to the former. The changes in real factors cause the monetary factors to change, not vice versa. In this way they are somewhat like Wicksell.

BUSINESS CYCLE INDICATORS

Changes in the magnitudes of certain economic series provide clues to the direction of changes in the cyclical behavior of economy. These series are identified, measured, and used for forecasting the turning points of the business cycle. Called economic indictors, they are divided into three groups—leading, lagging, and roughly coincidental. The leading indicators are those economic series that change direction in advance of the business cycle. The lagging indicators change direction after the overall economy has moved, while coincident indicators move in tandem with the aggregate economic activity. Basic economic indicators consist of 10 leading, 7 lagging, and 4 coincident series.

In order to smooth out the volatility of individual series in each group and to provide a single measure to represent the entire group, a composite index for each group (composite indicator) is constructed. The measures of basic indicators and the composites are calculated and published by the Conference Board, a not-for-profit organization.

see also Economics

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Anand Shetty

David A. Bowers