business cycle
- ️Fri Feb 20 2009
Business Cycles are the irregular fluctuations in aggregate economic activity observed in all developed market economies. Aggregate economic activity is measured by real gross domestic product (GDP), the sum weighted by market prices, of all goods and services produced in an economy. Comparisons of real GDP across years are adjusted for changes in the average price level (inflation). A business cycle contraction or recession is commonly defined as at least two successive three-month periods (quarters) in which real GDP falls. A business cycle then contains some period in which real GDP grows followed by at least half a year in which real GDP falls. Some business cycles are longer than others. As Table 1 shows, most contractions last for less than a year, with real GDP falling by 1 to 6 percent. Expansions are more variable, though most last from two to six years.
Business cycles date from at least colonial times. The data for the colonial period are limited; thus, it is more difficult to date cycles precisely. When the United States was primarily agricultural, fluctuations in climate exerted a strong influence on economic cycles. While business cycles are defined in terms of GDP, a number of other economic variables tend to move in concert with GDP. Aggregate consumption expenditures rise and fall with GDP. Investment does too, but it tends to rise much faster than GDP during expansions and to fall much faster in recessions. The trade balance increases as GDP falls and vice versa, and imports in particular tend to rise during expansions and fall during contractions. Interest rates, notably short-term interest rates, tend to rise in expansions and fall in contractions. The aggregate price level often moves up and down with GDP, as do profits.
Aggregate employment also rises during expansions and falls during contractions, usually fluctuating less than GDP. The unemployment rate rarely rises by more than 4 percent in a recession, in part because the average hours worked per worker rises and falls with the cycle. Also, firms tend to "hoard" some workers during recessions to obviate the need to rehire as the expansion begins. Consequently, output per worker falls during recessions.
Other economic variables sometimes move in concert with GDP. The "leading indicators," which tend to precede changes in GDP, include capacity utilization by industry, construction starts or construction plans, orders received for capital equipment, new business formation, new bond and equity issues, and business expectations. Studying these along with the aggregate variables, analysts attempt to forecast cycles, which is especially difficult when predicting the timing of turning points between expansion and contraction. While severe contractions affect every sector of the economy, milder contractions are observed only in some sectors, and employment continues to rise in about a quarter of industries.
Different Types of Cycles
Scholars in the early post–World War II period often distinguished "growth cycles," in which contractions were defined as a decline in the rate of GDP growth, from the less frequent business cycles, in which contractions were defined as decreases in GDP. Some held out hope that the business cycle could be replaced with less severe growth cycles.
While the chronology of business cycles produced by the National Bureau of Economic Research (NBER) (Table 1) is widely accepted, different definitions of the term "contraction" could easily combine or subdivide particular cycles. Indeed, the NBER does not adhere strictly to the definition of a recession as two successive quarters of GDP decline. Instead, a committee determines, by looking at movements in variables, when turning points have occurred. Some scholars have criticized this committee's decisions.
Economists from time to time have hypothesized the existence of at least three other economic cycles, including a shorter Kitchin or inventory cycle, identified by Joseph Kitchin in 1923, of about forty months in length; a Kuznets cycle, suggested by Simon Kuznets in 1958, of fifteen to twenty-five years in duration; and a Kondratiev or Long Wave cycle, popularized by Nikolai Kondratiev in 1922, of fifty to sixty years in duration. However, none of these is accepted as widely as the business cycle, which bears a strong similarity to the cycle identified by Clément Juglar in the 1860s.
Debate regarding Long Waves has been intense. If these exist, only a handful would have occurred in the modern era, and the major wars complicate interpretation of the historical record. Moreover, explaining fairly regular fluctuations of a half-century duration is arguably a more difficult theoretical task than explaining business cycles. Analyzing the same variables, most scholars of Long Waves emphasize the interplay among technological and economic phenomena. While the existence of fairly regular Long Waves is disputed both empirically and theoretically, the historical record clearly shows periods of more than one business cycle in length in which economic growth and employment were high, such as the 1950s and 1960s, and other periods of more than a business cycle in length in which economic growth was sluggish at best and unemployment was high, such as the 1930s or the 1970s and 1980s. Such periods likely require a different type of explanation. An understanding of the causes of economic growth in general should in turn inform the understanding of business cycles, because fluctuations would not likely be seen in a world without growth.
Table 1 Table 1 The fact that growth rates are higher in some periods than others poses difficulties for the empirical evaluation of business cycles. Ascertaining the severity of the business cycle requires knowing the growth rate around which cyclical fluctuations occur. But observation of a change in GDP from one year to the next conflates the effect of the trend growth rate and the effect of the cycle. Thus, analysts use complex and controversial statistical techniques to distinguish trends from cycles. This task would increase in complexity if economists accepted the existence of more than one type of cycle.
Table 1
| U.S. Business Cycle Expansions and Contractions | |||||
| *30 cycles | |||||
| **15 cycles | |||||
| SOURCE: National Bureau of Economic Research Website (http://www.nber.org/cycles.html) | |||||
| Reference Dates | Duration in Months | ||||
| Trough | Peak | Contraction | Expansion | Cycle | |
| Trough from | Trough | Trough from | Peak from | ||
| Previous Peak | to Peak | Previous Trough | Previous Peak | ||
| 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 |
| Average | |||||
| 1854–1991 (31 cycles) | 18 | 35 | 53 | 53* | |
| 1854–1919 (16 cycles) | 22 | 27 | 48 | 49** | |
| 1919–1945 (6 cycles) | 18 | 35 | 53 | 53 | |
| 1945–1991 (9 cycles) | 11 | 50 | 61 | 61 |
The existence of natural seasonal fluctuations in economic activity, associated with climatic changes and the bunching of purchases around holidays such as Christmas, adds another complication. Economists prefer to look at "seasonally adjusted" figures when evaluating economic performance. Has the change from month to month been greater or less than is usually observed between those two months? But as the economy evolves, so does the desirable seasonal adjustment.
Causes of Business Cycles
Economists have long debated the causes of business cycles, especially since the Great Depression. At that time, macroeconomics, the study of aggregate economic activity, emerged. Economists increasingly have recognized, however, that an understanding of business cycles requires microeconomic foundations, that is, an under-standing of how the interaction of individuals and firms in the markets for goods and services, finance, and labor generates business cycles.
Theories of business cycles can be divided into two broad categories. The first argues that cycles are exogenous or due to a variety of shocks. These shocks stimulate either economic expansion or contraction. The second argues that cycles are endogenous or self-generated by the market economy. Theoretical debates often have an ideological tinge influenced by scholarly attitudes toward the market economy and the desirability of government interference. Nevertheless, after decades of often heated debate, economists widely recognize that one right answer is not likely. Different forces have differential impacts on different cycles, and both exogenous and endogenous arguments have some explanatory power.
Exogenous theories emphasize a variety of shocks. Some speak of political shocks; for instance, politicians may encourage economic expansion just before elections. Shocks to the prices of important raw materials, such as oil, are often mentioned at least with respect to particular cycles.
More commonly, scholars argue that increases in the money supply encourage expansions and that central banks, fearing inflation, then restrict the money supply and trigger a contraction. To be sure, the supply of money does tend to rise and fall through cycles, but the debate concerns whether this is in large part a result of or a cause of cycles. Central banks, such as the Federal Reserve Bank, are not the sole influences on the money supply, which is affected also by the level of economic activity and the behavior of individual banks.
During the Great Depression and again later, some economists pointed to technological shocks. If, as seems to be the case, innovation does not occur evenly through time, then investment, consumption, and employment decisions would be expected to vary through time as a result. One problem that plagues this analysis is the difficulty of measuring innovation. Moreover, different innovations likely have different effects on different sectors. The development of new products likely has a positive effect on employment, while the development of better ways of producing existing products likely has a negative effect on employment.
Theories of business cycles must grapple with two opposing questions: Why is economic activity not stable, and how is complete chaos avoided (why do both contractions and expansions always end)? The common presupposition is that equilibrating mechanisms take the economy back toward the trend growth rate but are sluggish in operation. Examples of equilibrating mechanisms include the tendency of firms to increase production as inventories fall, the tendency of people to buy more as prices fall, or the tendency of firms to hire more as wages fall. Another rarely discussed possibility is that shocks of opposing effects may hit the economy. Most of the time these shocks are roughly balanced, and thus cycles are not too severe. Occasionally, as during the Great Depression, shocks are unbalanced and produce lengthy expansions or contractions.
Exogenous theories need only posit some set of shocks and usually some imperfect equilibrating mechanisms. Endogenous theories must argue both for equilibrating mechanisms and for nonequilibrating mechanisms that take the economy away from its trend growth rate. One early example was the general theory of John Maynard Keynes in 1936. Keynes noted that any expenditure has a multiplier effect, as the person receiving the money in turn spends it and so on. He also recognized an accelerator effect in that any attempt to increase output would require a much greater increase in the rate of investment. The multiplier-accelerator mechanism would cause any positive or negative growth impulse to be magnified and the economy to move further away from the trend growth rate. Writing during the Great Depression, Keynes was skeptical that any equilibrating mechanisms were strong enough always to reverse a contraction. Subsequently, the followers of Keynes stressed that inflexibility in wages and prices can cause an economy to move away from the trend growth rate.
A variety of other endogenous approaches is possible. Banks may naturally increase and decrease credit through time. Businesses may habitually overinvest as they fight for market share and then cut back in the face of over-capacity. Businesses may also saturate markets for consumer durables and inevitably experience a sudden drop in demand for such goods, which in turn induces them to reduce production.
Theories of business cycles strive to explain not only movements in GDP but in those variables that tend to move in concert with GDP. Some theories posit that unemployment is largely voluntary. Workers adjust work decisions in response to changes in real wages, or perhaps only to perceptions of such changes if they are fooled by changes in price levels. Other theories stress the involuntary nature of unemployment. During contractions many individuals cannot find work, at least not at anything approaching previously available wage rates. The evidence from unemployed individuals seems to support the latter position, though unemployment rates are constructed on surveys that tend not to ask the unemployed what sort of wage offer they seek.
All theories of business cycles face the problem of the role of expectations. No doubt expectations influence important economic variables, notably business investment and consumer durable purchase decisions. But how are expectations formed? Do they respond primarily to movements in economic variables, and if so, do they respond in a predictable fashion?
Effects of Business Cycles
As noted, business cycles affect variables such as employment, profits, hours of work, and often prices and wages. They thus have a significant impact on people's lives. In severe contractions a sizable proportion of the population loses its income. This was especially true before the creation of unemployment insurance and welfare, when the unemployed depended on charity. Unemployment in turn can affect a variety of noneconomic variables, including decisions regarding marriage and having children; mental health; attitudes toward the wider society, including the potential for civil disorder; and voting patterns, giving politicians a greater chance of reelection during times of economic expansion.
With the advantage of hindsight, economists know that all contractions end, and most end fairly quickly. It is thus all too easy to downplay the effects of cycles. Families may be unable to either borrow or save enough in advance to avoid serious hardship during a contraction, and fears of a future recession may cause families to forgo investments in houses and cars. Moreover, individuals who come of age during a serious recession may find their entire lives affected, as during the next expansion prospective employers may eschew those who have been long unemployed.
Changes in Business Cycles
Since business cycles involve an interaction among several economic and likely several noneconomic variables, some changes in the character of business cycles, including average duration, severity of fluctuations, or impact upon different sectors of the economy, should occur as an economy develops. Some have argued for the existence of a "new economy," in which the application of information technology would lessen the severity of cycles, yet most economists have been skeptical.
Considerable debate has focused on this question: Have business cycle fluctuations become less severe than they were before World War I? The debate has hinged primarily on the estimation of movements in GDP before such statistics were collected by the government. Most economists accept that business cycles involve longer expansions and shorter and shallower recessions than did those before World War I.
Most scholars attribute the longer expansions and shorter recessions primarily to government initiatives. The establishment of automatic stabilizers, such as unemployment insurance, have ensured that workers do not lose their entire incomes and thus their ability to spend when they lose their jobs in a recession. In addition, the government and the Federal Reserve have striven to adjust spending, taxation, and the money supply to reduce the severity of cycles. By putting more or less money in people's hands, they aim to increase or decrease the level of economic activity. Some economists worry that the government, due to a limited ability to predict cycles plus the time required to actually adjust spending or tax decisions, as often as not worsens cycles by, say, increasing spending after a contraction has already ended. Another concern is that taxpayers, faced with an increase in government debt, may reduce their own spending to save in anticipation of future tax increases. Nevertheless, substantial empirical evidence indicates that changes in government spending and taxation do affect the level of economic activity.
Other possible explanations of increased economic stability include the lesser incidence of financial panics, which were an important component of nineteenth-century recessions, due in large part to deposit insurance, introduced in 1934; increased flexibility of wages and prices, important for equilibrating mechanisms; management of inventories so firms do not build them up at the start of a downturn, then slash production to compensate; increased importance of the service sector, which tends to be less volatile than industry because many goods are purchased irregularly; and increased business confidence that downturns will be short.
Analysis of Particular Cycles
The discussion above suggests that different theoretical approaches have different explanatory power with respect to particular cycles. No approach should be ignored in studying any cycle. An obvious danger is to ignore endogenous arguments in favor of unique exogenous shocks when analyzing a particular cycle. It is possible though that exogenous shocks loom larger in the more severe cycles that attract most historical attention.
Banking panics were a common characteristic of recessions as late as the Great Depression. The resulting bank failures surely exacerbated contractionary tendencies, for people could not spend money they had lost. The question is how great this contractionary tendency was relative to the size of particular recessions. Likewise, stock market crashes can have a contractionary impact; these dramatic events may receive more attention than warranted by their economic impact. More generally, changes in interest rates and money supply often are associated with cycles and are attributed an important causal role. The 1929 crash has often been blamed for inducing the Great Depression, although the crash of 1987 was not associated with a serious economic downturn.
Sudden increases in raw material prices, such as occurred with copper during the early days of electrification in 1907 or oil in the 1970s, likely played some role in inducing recessions. Electrification, the assembly line, the automobile, and the television are among a number of major technological innovations that almost certainly had some impact on the level of economic activity and employment. As prices of many products rose, consumers and investors reduced their purchases. Saturated markets for houses, cars, and other durables have been observed during contractions in the 1930s and the 1970s. New products usually, but not always, cause increased investment and employment, while new production processes generally cause employment to fall.
Since the Great Depression, governments have taken an active role in trying to affect economic activity by adjusting the level of taxes and spending. Central banks too have tried to affect economic activity through adjustments to the money supply or interest rates. Even before the Great Depression, major government expenditures, such as during war or for the development of transport infrastructure, would have had some expansionary effect. As noted above, economists debate whether governments thus alleviate cycles or instead make these worse by increasing spending during expansions or reducing spending in recessions.
Bibliography
Berry, Brian J. L. Long-Wave Rhythms in Economic Development and Political Behavior. Baltimore: Johns Hopkins University Press, 1991.
Burns, Arthur F., and Wesley C. Mitchell. Measuring Business Cycles. New York: National Bureau of Economic Research, 1946. A classic work by two leading scholars of business cycles of the time.
Diebold, Francis X., and Glenn D. Rudebusch. Business Cycles: Durations, Dynamics, and Forecasting. Princeton, N.J.: Princeton University Press, 1999. Discusses the statistical analysis of business cycles, and compares pre–World War I and post–World War II cycles.
Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867–1960. Princeton, N.J.: Princeton University Press, 1963. Classic argument for the importance of changes in monetary variables in generating cycles; unusually relies on examinations of particular cycles rather than on statistical analysis across several cycles.
Goldstein, Joshua S. Long Cycles: Prosperity and War in the Modern Age. New Haven, Conn.: Yale University Press, 1988.
Hall, Thomas E. Business Cycles: The Nature and Causes of Economic Fluctuations. New York: Praeger, 1990. A rare combination of a theoretical survey and application to selected twentieth-century cycles.
Keynes, John Maynard. The General Theory of Employment, Interest, and Money. London: Macmillan, 1936. Generally recognized as having spawned the field of macroeconomics.
National Bureau of Economic Research. "U.S. Business Cycle Expansions and Contractions." Available at http://www.nber.org/cycles.html.
Ralf, Kirsten. Business Cycles: Market Structure and Market Inter-action. New York: Physica-Verlag, 2000. Surveys modern theories, with an emphasis on microeconomic foundations.
Schumpeter, Joseph A. Business Cycles. New York: McGraw-Hill, 1939. Classic argument for the existence of four cycles of differing average durations.
Solomou, Solomos. Phases of Economic Growth, 1850–1973: Kondratieff Waves and Kuznets Swings. New York: Cambridge University Press, 1987. Argues for the existence of Kuznets cycles.
Zarnowitz, Victor. Business Cycles: Theory, History, Indicators, and Forecasting. Chicago: University of Chicago Press, 1992. Discussion of the evolution of the measurement of business cycles by a scholar long connected with the NBER.
—Rick Szostak