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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:
18542001 (32 cycles) 17 38 55 156
18541919 (16 cycles) 22 27 48 249
19191945 (6 cycles) 18 35 53 53
19452001 (10 cycles) 10 57 67 67
Average, peacetime cycles:
18542001 (27 cycles) 18 33 51 352
19541919 (14 cycles) 22 24 46 447
19191945 (5 cycles) 20 26 46 45
19452001 (8 cycles) 10 52 63 63

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 (18741948), 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 (18841963), 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 (18831950), 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 cyclenew 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 (18511926), 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 unstablewhich 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 (18831946). 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


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 groupsleading, 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

bibliography

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Blanchard, Olivier (2000). What do we know about macroeconomics that Fisher and Wicksell did not? (National Bureau of Economic Research Working Paper No. W7550). New York: National Bureau of Economic Research.

Burns, Arthur, and Mitchell, Wesley C. (1946). Measuring business cycles. New York: National Bureau of Economic Research.

Clark, J. M. (1917). Business acceleration and the law of demand: A technical factor in economic cycles. Journal of Political Economy, 25, 217235.

Conference Board. (2001). Business cycle indicators handbook. New York: Author.

Hicks, J. R. (1958). The trade cycle. London: Oxford University Press.

King, Robert, and Plosser, Charles (1984). Money, credit and prices in a real business cycle. American Economic Review, 74 (3), 363380.

King, Robert, and Rebelo, Sergio (2000). Resuscitating real business cycles (National Bureau of Economic Research Working Paper No. W7534). New York: National Bureau of Economic Research.

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Lucas, Robert E. (1981). Studies in business cycle theory. Cambridge, MA: MIT Press.

Lucas, Robert E., and Sargent, Thomas J. (Eds.) (1981). Rational expectations and econometric practice. Minneapolis: University of Minnesota Press.

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Anand Shetty

David A. Bowers

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Simon Kuznets

Simon Kuznets

American economist, researcher, and author, Simon Kuznets (1901-1985) won the Nobel Prize in 1971 for pioneering the use of a nation's gross national product to analyze economic growth.

Simon Kuznets was born in Kharkov, Russia, in 1901. At an early age he and his family emigrated from Russia to the United States. Kuznets and his family settled in New York City, where he attended school. He received his bachelor's degree from Columbia University in 1923. He also attended Columbia University to do his graduate work, completing his master's degree in 1924 and his doctorate in 1926. His doctoral dissertation was entitled "Cyclical Fluctuations in Retail and Wholesale Trade." This work, in principle, set the stage for many of his future research efforts. In 1929 he married Edith Handler. They raised two children.

Kuznets' fields of specialization were economic growth, economic development, and economic planning theory and policy; the economics of technological change; and demographic economics. He taught in all of these areas and did research in them as well. He was especially interested in researching the relationship of population size and population traits to the process of long-term economic growth. His research was not restricted to the experience of the United States; quite to the contrary, he was interested in and did extensive analysis of the national income and growth data of a number of industrialized nations. In addition, Kuznets did a significant amount of research on secular movements in production levels and prices.

He was employed at the rank of professor in the Economics Department at the University of Pennsylvania from 1936 until 1954. He then joined the Economics Department at Johns Hopkins University as a full professor from 1954 until 1960. From 1960 until 1971, he was professor of economics at Harvard University and then professor of economics emeritus there until his death in 1985.

Kuznets was well known for his analysis involving national income data. Indeed, Kuznets was the intellectual "father" of modern methods of national income accounting. He was credited with having developed the basic format for studying both national income and product accounts and the composition of such accounts. In the process of his pioneering work on national income and related data, many important contributions to economic policy and economic understanding were developed. For example, digging back to the year 1870 Kuznets estimated national income and the components of national income for the United States for both the latter part of the 19th century and the early part of the 20th century. As a result, his studies involved him in a number of important national economic policy issues and debates. In point of fact, his involvement in such issues and debates won him recognition in a wide variety of economics textbooks.

One of the main issues in which Kuznets' studies played an important role involved the relationship among the levels of aggregate consumer spending, aggregate consumer saving, and aggregate household disposable income. For instance, the relationship between the level of aggregate consumer spending and the level of aggregate disposable income is critical to the effectiveness of public economic policy and to the formulation of public economic policy. Kuznets found that the proportion of per capita income that is saved had not significantly changed since the year 1870.

To many analysts, Kuznets' finding of a proportional relationship between the level of aggregate consumer spending and the level of aggregate disposable income was seemingly at odds with Keynesian theory and Keynesian policy analysis. In point of fact, the findings by Kuznets essentially related to the long run, whereas the theory of Keynes related essentially to the short run. The findings by Kuznets and the theories of Keynes actually supplemented each other. Indeed, the findings by Kuznets provided a most suitable format for the study of long-term economic growth. Among other things, Kuznets' findings helped to shape the evolution of modern theories of both macroeconomic growth and development and regional economic growth and development.

The work by Kuznets on national income accounting led to a myriad of other contributions. For example, Kuznets was apparently the first economist to observe a 15 to 25 year long business cycle involving business construction. As a result, Kuznets was able to contribute substantively to the study and the theory of business cycles in industrialized nations. In addition, Kuznets had several insightful observations to make regarding the components of the national income and product accounts. For instance, national defense expenditures are classified as "regrettable necessities."

Kuznets received recognition and honors on many occasions. For example, he was voted in as the president of the prestigious American Economic Association in 1954. In itself, this is an honor of enormous proportions, for only an economist of true distinction is ever awarded such recognition.

In 1971 Kuznets received the Nobel Prize for his empirically founded interpretation of economic growth. Kuznets' receipt of this honor is an example of a prize awarded for inductive analysis rather than deductive analysis. In point of fact, Kuznets' greatest strength had been to reveal new facts and new relationships about the real world. He was able to find "new truths" about the real world with the aid of common sense and rational thinking and with a minimum of the elegant, formal economic models with which most economic researchers are so enamored. An example of a "new truth" derived by Kuznets is his celebrated "law" of the relationship between long-term economic growth in a society and the distribution of income in that society.

In certain respects, the Nobel Prize to Simon Kuznets may be regarded as an award for interdisciplinary research. In integrating techniques from economic analysis, statistics, and history, Kuznets attempted to give quantitative precision to fields of study that were supposed to be pertinent to the understanding of the processes of economic development and social development. He was a pathbreaker in the integrated use of technology, population, marketing, and industrial structure.

Further Reading

The work of Simon Kuznets is perhaps best represented in his two-volume work entitled National Income and Its Composition, 1919-1938 (1941). Kuznets also examined long-term economic growth in 14 Western industrial nations in his book Modern Economic Growth: Rate, Structure, and Spread (1966). □

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business cycle

business cycle Recurring economic cycles, involving a period of above-average growth (expansionist phase), followed by one of lower than average growth (recession), then one of negative growth (depression). Modern economists generally assume that the ‘normal’, ‘classic’, or ‘Juglar’ cycle lasts approximately five years, but there is no consensus as to its causes, indeed there are some who have argued that the fluctuations themselves are random rather than uniform in character. The Russian-born American development economist Simon Kuznets also identified a longer economic cycle (‘Kuznets cycle’) lasting some fifteen to twenty years. So-called Kondratieff cycles (named after the Russian economist who developed the idea in the 1920s) consist of ‘long wave’ cycles of boom and recession averaging half a century or so, fuelled by major technological and industrial advances, such as the advent of steam power. These cycles are often linked to developments in the world-system (see, for example, Christopher Chase-Dunn and and Peter Grimes , ‘World-Systems Analysis’, Annual Review of Sociology, 1995
).

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Kuznets, Simon

Simon Kuznets (kŏŏznĕts´, kŭz´nĕts), 1901–85, American economist, b. Kharkiv, Russia (now in Ukraine), grad. Columbia (B.S., 1923; M.A., 1924; Ph.D., 1926). He emigrated to the United States in 1922. After serving as a fellow on the Social Science Research Council (1925–27), he worked for the National Bureau of Economic Research (1927–63), where he became involved in the study of business cycles. Kuznets taught at the Univ. of Pennsylvania (1930–54) and Johns Hopkins (1954–60); he joined the faculty of Harvard in 1960. Generally credited with having developed the Gross National Product as a measure of economic output, Kuznets was awarded the Nobel Memorial Prize in Economic Sciences in 1971. His National Income and Its Composition, 1919 to 1938 (1941) is considered his major work. A prolific writer, Kuznets has also written National Income and Capital Formation (1938), National Product Since 1869 (1946), Economic Growth of Nations (1971), and numerous other books and scholarly articles.

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