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Business Cycle

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Business Cycle

You may have heard in the news that some countries' economy is going through a decline. You may have also heard that some country's economy is experiencing a rapid rise or that it is one of the best performing economies in the world. All these things characterize the business cycle. When an economy experiences a rise or decline in economic activity, it is said to be going through a business cycle. However, simply stating this would be an oversimplification. Let's dig deeper into the topic of business cycles. Keep on reading to find out more!

Business cycle definition

First, we will provide the definition of a business cycle. Business cycles refer to short-term fluctuations in the level of economic activity in a given economy. An economy may experience long-term growth where its national output or GDP increases. However, while this economic growth happens, it is often interrupted momentarily by a series of business cycles where economic activity rises or declines.

Business cycles refer to short-term fluctuations in the level of economic activity in a given economy.

Let's look at it this way. The economy is eventually (in the long run) going to grow, either negatively or positively. While this growth is being achieved, the economy goes through some ups and downs. We call these ups and downs business cycles. Let's look at a simple example.

Between year 1 and year 2, the economy of a country grows by 5%. However, within this one-year period, this country's economy experienced different downward and upward changes in output, employment, and income.

The downward and upward changes described above characterize the business cycle. It is important not to rely on duration in understanding business cycles; business cycles can be anywhere from 6 months to 10 years. Look at business cycles as periods of fluctuations!

Types of the business cycle

The types of business cycles include cycles caused by exogenous factors and those caused by internal factors. These types exist due to the circumstances that lead to fluctuations in economic activity.

There are two types of the business cycle: cycles caused by exogenous factors and those caused by internal factors.

Exogenous factors refer to those factors that are not inherent to the economic system. Examples of such factors include climate change, discoveries of rare resources, wars, and even migrations.

Exogenous factors refer to those factors that are not inherent to the economic system.

These occur outside the economic system in the sense that they are mainly external factors that cause the economic system to respond in a certain way, which then results in a business cycle. Let's look at an example.

The discovery of crude oil in a country results in the creation of oil refineries in that country as it becomes an exporter of oil.

The scenario described above clearly shows a sudden increase in economic activity as a whole new economic activity has been added.

Internal factors, on the other hand, refer to factors that are within the economic system. The simplest example of this is an increase in interest rate, which reduces aggregate demand. This is because an increase in interest rates makes it more expensive to borrow money or get a mortgage, and this makes consumers spend less.

Internal factors refer to factors that are within the economic system.

Business cycle diagram

Here, we will look at the business cycle diagram. To do this, we must introduce the phases of a business cycle. There are four phases of a business cycle. These include the peak, recession, trough, and expansion. Let's look at each of these.

The peak refers to the period where economic activity has reached a momentary maximum. At a peak, the economy has achieved or almost achieved full employment, and its actual output is near or equal to its potential output. The economy typically experiences an increase in price level during a peak.

A recession follows a peak. During a recession, there is a rapid decline in the national output, income, and employment. Here, there is a contraction of economic activity. In other words, economic activity shrinks, and certain sectors reduce in size. Recessions are characterized by high levels of unemployment as businesses shrink and cut down their number of employees.

After a recession is a trough, which is when economic activity has reached its lowest. This means that there can only be a rise in economic activity after a trough. If the economic activity goes further down, then it was not a trough, to begin with. Here, national output, income, and employment are at their lowest for the cycle.

An expansion is the next movement of economic activity after the trough. It is a rise in economic activity as the national output, income, and employment all begin to rise towards full employment. In this phase, spending may increase rapidly and outpace the production in the economy. This results in a rapid increase in the price level, which is referred to as inflation.

Read our article on Inflation for more on this.

From the four phases described above, we can then draw the business cycle diagram. The business cycle diagram graphically depicts the phases of the business cycle. Take a look at Figure 1.

The business cycle diagram is the graphical representation of the phases of the business cycle.

Business Cycle Causes

A series of factors are considered to be possible causes of business cycles by economists. These include irregular innovation, changes in productivity, monetary factors, political events, and financial instability. Let's look at these in turn.

  1. Irregular Innovation - When new technological discoveries are made, new economic activities emerge. Examples of such innovations include the inventions of the computer, the telephone, and the internet, which are all significant advancements in communication. The inventions of the steam engine or airplanes are also factors that are bound to cause a fluctuation in economic activity. For instance, the invention of planes meant that a new business segment had been created in the transportation industry. Such a scenario will lead to an increase in investment and consumption and, with it, cause business cycle fluctuations.
  2. Changes in Productivity - This refers to an increase in the output per unit of input. Such changes will cause an increase in economic output since the economy is producing more. Changes in productivity may occur as a result of rapid changes in the availability of resources or rapid changes in technology. For instance, if an industry acquires newer, cheaper technology that helps it to increase its output to twice the previous quantity, this change is likely to cause a fluctuation in the business cycle.
  3. Monetary Factors - This is directly related to the printing of money. As the country's central bank prints more money than expected, inflation occurs as a result. This is because, as more money is printed, households have more money to spend. As the printed money was unexpected, there was not enough supply of goods and services to match this new demand. This will cause businesses to raise the prices of their goods and services. The opposite of all this happens if the central bank suddenly reduces the quantity of money it prints.
  4. Political Events - Political events, such as wars, or even a change in government following an election, can cause a business cycle. For instance, a change in government could mean a change in policy or approach to government spending. If the new government chooses to unexpectedly print or spend more money than the previous government, then a fluctuation in economic activity occurs.
  5. Financial Instability - Unexpected or rapid increases and decreases in the prices of assets can result in a loss or increase in the confidence of consumers and businesses. If consumers lose confidence, there will be a significant unexpected decline in the demand for assets, which will cause a fluctuation in economic activity.

Business cycle recession

A business cycle recession is one of the two main parts of the business cycle (the other being an expansion). It refers to the period in a business cycle where there is a rapid decline in the national output, income, and employment.

A recession refers to the period in a business cycle where there is a rapid decline in the national output, income, and employment.

Business activity contracts during this phase. A recession ends at the trough and is followed by an expansion.

Expansion business cycle

A business cycle expansion is one of the main parts of the business cycle alongside a recession. During an expansion, there is a rapid increase in the national output, income and, employment. Business activity expands during this phase. For instance, certain sectors employ more workers as there is room to increase production.

An expansion refers to the period in a business cycle where there is a rapid increase in the national output, income, and employment.

Business Cycle Employment increases during an expansion StudySmarterFig. 2 - Employment increases during an expansion

The Business Cycle in Action

Let's see what the business cycle looks like in real life. Here, we use the potential real GDP and actual real GDP of the United States. Take a look at Figure 3 below.

Business Cycle US Potential GDP and Actual Real GDP StudySmarterFig. 3 - U.S. Potential Real GDP and Actual Real GDP. Source: Congressional Budget Office1

Figure 3 above shows the ups and downs of the United States economy from 2001 to 2020. Reading from left to right, we see that there was a period when actual GDP was above the potential GDP (until 2010). After 2010, the actual GDP remained below the potential GDP through 2020. Where the actual real GDP falls above the potential real GDP line, there is a positive GDP gap. On the other hand, there is a negative GDP gap where the actual real GDP falls below the potential real GDP line.

You have reached the end of this article. You should read our explanations on the Business Cycle Graph and Inflation to understand more about related macroeconomic concepts.

Business Cycle - Key takeaways

  • Business cycles refer to short-term fluctuations in the level of economic activity in a given economy.
  • There are two types of business cycles: cycles caused by exogenous factors and those caused by internal factors.
  • The business cycle diagram is the graphical representation of the phases of the business cycle.
  • A recession refers to the period in a business cycle where there is a rapid decline in the national output, income, and employment.
  • An expansion refers to the period in a business cycle where there is a rapid increase in the national output, income, and employment.

References

  1. Congressional Budget Office, Budget and Economic Data, https://www.cbo.gov/system/files/2021-07/51118-2021-07-budgetprojections.xlsx

Frequently Asked Questions about Business Cycle

An example of a business cycle is an economy where the national economic output, income, and employment undergo a series of fluctuations.

The business cycle is caused by irregular innovation, changes in productivity, monetary factors, political events and financial instability.

The business cycle has 4 phases. These include the peak, recession, trough, and expansion.

The business cycle covers the short-term period and shows the fluctuations in economic activity within this period.

The business cycle is important because it helps economists study aggregate output in the short-term.

Final Business Cycle Quiz

Question

What is a business cycle?

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Answer

Business cycles refer to short-term fluctuations in the level of economic activity in a given economy.

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Question

Business cycles are caused by both exogenous and ___ factors.

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Answer

internal

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Question

What are exogenous factors?

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Answer

Exogenous factors refer to those factors that are not inherent to the economic system.

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What are internal factors?

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Answer

Internal factors refer to factors that are within the economic system.

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Question

What is a peak?

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Answer

A peak refers to the period where the economic activity has reached a momentary maximum.

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Question

A trough is not a phase of the business cycle.

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False

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Question

A recession comes after a trough.

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False

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Question

What is a recession?

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Answer

A recession refers to the period in a business cycle where there is a rapid decline in the national output, income and employment.

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Question

An expansion comes after a recession.

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True

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Question

A recession comes after an expansion.

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True

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Question

What is the business cycle diagram?

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Answer

The business cycle diagram is the graphical representation of the phases of the business cycle.

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Question

Changes in productivity can cause a business cycle.

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Answer

True

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Question

Employment decreases during an expansion.

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False

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Political events are not a possible cause of business cycles.

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False

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An expansion is likely to be followed by inflation.

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True

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Question

Define the business cycle.

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Answer

The business cycle refers to the short-term fluctuations in economic activity in an economy.

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Question

What is the business cycle graph?

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Answer

The business cycle graph is the graphical illustration of the short-term fluctuations in economic activity in a given economy.

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Question

Define potential output.

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Answer

Potential output refers to the level of output the economy can achieve if all economic resources are employed optimally.

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Define actual output.

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Answer

Actual output refers to the total output produced by the economy.

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Question

The trough comes between the expansion and the peak.

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False

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The business cycle has four phases.

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True

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Question

The phases of the business cycle include ____, ____, ____, and ____.

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Expansion, peak, contraction, trough.

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The business cycle graph shows real GDP

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False

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Real GDP is plotted on the horizontal axis of the business cycle graph.

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False

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Exogenous factors are factors that are not found within the economic system.

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Answer

True

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Question

The COVID-19 pandemic is not an exogenous factor.

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Answer

False

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Question

Define inflation.

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Answer

Inflation is the increase in the general price level in an economy.

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Question

The expansion phase often comes with inflation.

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Answer

True

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Question

The expansion phase is followed by a recovery.

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Answer

False

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Question

Inflation causes the currency to lose its purchasing power.

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Answer

True

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