Business Cycle

What It Means

The U.S. economy has grown tremendously since the eighteenth century. This growth has not, however, been a constant march toward higher levels of production and income; rather, it has been cyclical. Periods of economic expansion are followed by periods of economic contraction (during which the economy slows down, and fewer goods and services are sold), the slowdown reaches its low point, and then expansion begins again. This pattern of expansion and contraction, common to all capitalist economies (economies in which businesses are mostly owned by private individuals, not the government), is called the business cycle.

The term business cycle can be used to refer to the overall pattern of fluctuations as well as to an individual period of expansion and contraction. In the second case a business cycle would consist of the period between two economic peaks.

The period between economic peaks can last many years, as with the Great Depression of the 1930s. Since then economic downturns have been less severe. One recession (a milder form of downturn than a depression) in the United States, for instance, officially spanned only March to November 2001.

A contracting economy brings trauma in the form of job losses for ordinary people, but economists generally agree that business cycles are inherent parts of capitalist economies and cannot be prevented. Governments attempt to soften the effects of business cycles by using fiscal policy (decisions about taxes and government spending) and monetary policy (alterations in a country’s money supply) to manage the economy and promote stability. Many economists believe that the knowledgeable use of these tools for controlling the economy explains why downturns since the Great Depression have been generally less severe than they were before it.

When Did It Begin

Because business cycles are believed to be a characteristic of all capitalist economies, their existence can probably be dated to the rise of capitalism in Europe during the sixteenth through eighteenth centuries. Capitalism, in which profit-seeking individuals are the main force driving the economy, replaced the feudal system, in which the small number of people who owned land were the possessors of all wealth. Although business cycles may have been one source of economic instability for early capitalists, economists did not begin to understand them in any detail until much later.

In the eighteenth and nineteenth centuries the dominant school of economic thought was classical economics, which grew out of the ideas that Scottish philosopher Adam Smith (1723–90) presented in his 1776 masterwork, An Inquiry into the Nature and Causes of the Wealth of Nations. Classical economists believed that free markets (in which businesses are not controlled by the government) regulated themselves and benefited everyone in a society more than alternate systems of organizing business and wealth did. They argued that those economies experiencing difficulties were simply unhealthy. In the late nineteenth century economists began to recognize that all free-market economies fluctuated over time and that these fluctuations were not necessarily signs that the economy was operating wrongly. A detailed understanding of business cycles, however, did not come until the twentieth century.

The American economist Wesley Mitchell (1874–1948) pioneered the measurement and analysis of business cycles as they are understood today. In 1920 he founded the National Bureau of Economic Research (NBER), a nonprofit group devoted to studying business cycles. Mitchell’s views were presented most fully in the book Measuring Business Cycles (1946), coauthored by economist Arthur Burns (1904–87). Mitchell and Burns pointed out the ways in which various economic indicators (statistics representing important factors in the economy) moved together to bring about larger economic fluctuations. For instance, output (the total value of goods and services a country produces in a specific period of time) generally moves in combination with prices and the employment rate (which measures how many people have jobs; it is given as a percentage of everyone in a country who wants to work). By looking at these indicators, Burns and Mitchell showed, a government might be able to assess and manage business cycles. The NBER continues to provide the most authoritative word on the measurement of business cycles in the United States. It is extremely influential among government policymakers and within the business community.

More Detailed Information

An individual business cycle (the period between two economic peaks) consists of four phases: peak, recession, trough, and recovery. It is difficult for the NBER or anyone else who studies business cycles to know for certain which phase the economy is currently in or to predict when it will reach the next phase. This is because the actual economy is enormously complex, made up of countless individual transactions whose importance is not always immediately clear. The economy is, however, always in one of the above four phases, and economists keep a close watch on the indicators that are linked to each phase.

The economic indicator that is usually considered the most important one for analyzing business cycles is called gross domestic product (GDP). The GDP is a measure of the monetary value of all the goods and services produced in a country. When GDP is rising, the economy is in an upswing. During a downturn GDP falls, meaning fewer goods and services are being produced. When this happens, fewer workers are needed, so falling GDP is usually accompanied by higher rates of unemployment (the number of people who want to work but do not have jobs). When the economy recovers, more people get jobs, and unemployment rates generally fall. Therefore, employment is also one of the important indicators used to determine what phase of the business cycle an economy is in.

At a peak in the business cycle, GDP is at its highest level since the previous peak. This means that the economy is generating as large an amount of goods and services as it can produce. Businesses are using all of their resources as efficiently as possible, and as many people have jobs as the economy can provide; this level of employment is called full employment. Full employment does not mean zero percent unemployment. In the early twenty-first century an unemployment rate of about 4 to 5 percent was seen as full employment.

After the peak in a business cycle comes a period of decline called a recession. Most economic observers consider a recession to be in effect once the GDP has dropped for at least two consecutive quarters (three-month periods into which the economic year is divided). Along with falling GDP, business profits tend to decline, and unemployment rises. During a recession businesses as a whole produce less than they are capable of producing.

The trough is that portion of the cycle when GDP is at its lowest level. Businesses have more unused resources than at any time since the previous trough, and unemployment is usually at its high point. Although recession and trough are two separate phases of the business cycle, the total length of the recession includes both. The economy is not officially out of a recession until it is out of the trough.

After it bottoms out, the economy enters a period of recovery. GDP is rising, businesses are using more of their capabilities, and more people are employed. The economy remains on an upswing, also called an expansion, until it peaks. Then the whole process is repeated.

This sounds like a neat and organized pattern, and the word cycle may seem to suggest regularity. In reality, the length of each phase and cycle can vary dramatically. For instance, the recession of 2001 (from peak through trough of the business cycle) officially lasted only eight months. By contrast, the trough during the Great Depression did not come until 1933, four years after the economy’s peak in 1929. The intensity of the phases also varies from business cycle to business cycle. During a U.S. recession that lasted from July 1990 to March 1991, the country’s economic output fell by less than 1 percent. During the Great Depression, by contrast, output fell by almost 25 percent.

Recent Trends

The Great Depression radically changed the way governments and economists monitor the economy. Using data such as the information that the NBER provides and analyzes, governments now intervene in the hope of softening the intensity of business-cycle fluctuations. The U.S. government has two tools for influencing the economy. The first is fiscal policy (taxation and spending programs), which the president and Congress are largely responsible for crafting. The U.S. central bank, the Federal Reserve System (commonly called the Fed), is entrusted with the other tool: the crafting of the nation’s monetary policy, or control over the money supply.

Today monetary policy is by far the more influential of the two government tools for controlling the economy. The reasons for this are complex, but they include the fact that the other tool, fiscal policy, can be inefficient because it usually takes Congress and the president some time (perhaps years) to approve and enact new measures. By that time the economic situation may have already changed.

The effects of monetary policy on the economy, however, can be dramatic. For instance, the recession of 1981–82 is widely believed to have been initiated by the Federal Reserve. The Fed, concerned about runaway inflation (the general rising of prices) during the 1970s, drastically restricted the money supply. This resulted in very high interest rates (the fees charged by institutions that lend money), which meant that businesses did not take out loans to expand their operations. GDP dropped, unemployment rose, and the economy went into recession. After the recession ended, the economy went into a period of strong growth.