Business cycle
Business cycle
Economic changes are an example of the business cycle, a series of periods of expanding and contracting economic activity. The business cycle is measured by increases or decreases in real GDP.
Microeconomics and macroeconomics look at the economy through different lenses. While microeconomics examines the actions of individuals and single markets, macroeconomics examines the economy as a whole. Macroeconomists analyse the economy using national income accounting, statistical measures that track the income, spending, and output of a nation. The most important of those measures is gross domestic product (GDP), the market value of all final goods and services produced within a nation in a given time period.
To be included in GDP, a good or service has to fulfill three requirements. First, it has to be final rather than intermediate. For example, the fabric used to make a shirt is an intermediate good; the shirt itself is a final good. Second, the good or service must be produced during the time period, regardless of when it is sold. For example, cars made this year but sold next year would be counted in this year’s GDP. Finally, the good or service must be produced within the nation’s borders.
There are several different ways to calculate GDP, economists often use the expenditures approach. With this method, they group national spending on final goods and services according to the four sectors of the economy: spending by households, or consumption; spending by businesses, or investment; government spending; and total exports minus total imports, or net exports. Economists identify consumption with the letter C; investment with the letter I; government spending with the letter G; and net exports with the letter X. To calculate GDP, economists add the expenditures from all sectors together: C+I+G+X=GDP. Consumption includes all spending by households on durable goods, nondurable goods (goods that are used up relatively soon after purchase), and services. Investment, which measures what businesses spend, has two categories. One is fixed investment, which includes new construction and purchases of such capital goods as equipment, machinery, and tools. The other is inventory investment. This category, also called unconsumed output, is made up of the unsold goods that businesses keep on hand. Government spending includes all the expenditures on goods and services such as spending for defence, highways, and public education). Net exports, the final component of GDP, represents foreign trade (exports).
Economists use GDP to gauge how well a country’s economy is doing. When GDP is growing, an economy creates more jobs and more business opportunities. When GDP declines, jobs and more business opportunities become less plentiful. To get a clearer picture of a country’s economic health, economists calculate two forms of GDP - nominal and real. Nominal GDP- is stated in the price levels for the year in which the GDP was measured. Real GDP - is nominal GDP adjusted for changes in prices.
The cycle has four distinct stages: expansion (recovery), peak, contraction (recession), and trough.
1. Expansion (recovery) stage - is a period of economic growth, an increase in a nation’s real gross domestic product (GDP), jobs are relatively easy to find, so unemployment goes down, more and as resources become more scarce, their prices rise.
2. Peak phase- is the point at which real GDP is the highest and businesses become less profitable, as prices rise and resources tighten.
3. The contraction phase - is a period of economic activity, when resources become less scarce and prices tend to stabilise or fall and unemployment rises. While prices usually remain about the same or go down during the contraction phase, sometimes they go up (stagflation).
4. Trough phase - is the point at which real GDP and employment stop declining.
One way to understand business cycles is through the concepts of demand and supply. In this case the concepts apply not to a single product or business but to the economy as a whole. Aggregate demand is the total amount of goods and services that households, businesses, government, and foreign purchasers will buy at each and every price level. Aggregate supply is the total amount of goods and services that producers will provide at each and every price level.
When the quantity of aggregate demand equals the quantity of aggregate supply, the economy reaches macroeconomic equilibrium. It is an ideal situation.
Shifts in aggregate demand and aggregate supply indicate changes in the business cycle. There are four factors, which are especially important, that cause these shifts: decisions made by businesses, changes in interest rates, the expectations of consumers, and external shocks to the economy. These factors involve the “ripple effect,” the cause-and-effect interactions that ripple through the economy.
FACTOR 1. Business decisions When businesses decide to decrease or increase production, their decisions can have far-reaching effects. If enough businesses make similar decisions, it can lead to a change in the business cycle.
· Demand slump The single decision by the any industry businesses had numerous consequences. By itself, it might not be enough to change the business cycle for the entire country. But if enough businesses make similar decisions, a contraction in the business cycle might result.
· New technology New technology inevitably influences the business cycle. Businesses that use new technology while making goods, can make their products more cheaply. Other businesses may now be able to make new products with the more improved new technology. All of these businesses hire more workers to handle the increased production. The aggregate supply increases, and the economy experiences an expansion.
FACTOR 2. Changes in interest rates Rising interest rates, for example, make it more costly for consumers to borrow money to make purchases - from televisions to cars and houses. This decreased purchasing power lowers the level of aggregate demand and promotes a contraction in the economy. When interest rates fall, the opposite happens. Aggregate demand rises, promoting an expansion
FACTOR 3. Consumer expectations Consumers’ choices can bring about changes in aggregate demand. For example, when consumers are confident about the future and believe that they are economically secure, they tend to consume more, driving up aggregate demand and encouraging an economic expansion.
FACTOR 4. External issues A nation’s economy can also be strongly influenced by issues and events beyond its control or outside of its borders. Examples include natural disasters, oil embargo, etc.
Economists try to predict changes in the business cycle to help businesses and the government makes informed economic choices. They base their predictions on sets of economic indicators. Leading indicators are measures of economic performance that usually change six to nine months before real GDP changes. Examples include new building permits, orders for capital goods and consumer goods, consumer expectations, average manufacturing workweek, stock prices, and the money supply. Economists look for trends in these indicators that last several months before they predict a change. Coincident indicators are measures of economic performance that usually change at the same time as real GDP changes. These indicators include such items as employment, sales volume, and personal income. Lagging indicators are measures of economic performance that usually change after real GDP changes. Such indicators are useful for confirming the end of an expansion or contraction in the business cycle. They include the length of unemployment and the ratio of consumer credit to personal income.
There are various theories as to the change of the business cycle. Internal theories consider it to be self-generating, regular and indefinitely repeating. A peak is reached when people begin to consume less, for whatever reason. As far as back as the mid-nineteenth century, it was suggested that the business cycle results from people infecting one another with optimistic or pessimistic expectations. When economic times are good or when people feel good about the future, they spend, and run up debts. If interest rates rise too high, a lot of people find themselves paying more than they anticipated on their mortgage or rent, and so have to consume less. If people are worried about the possibility of losing their jobs in the near future they tend to save more. A country’s output, investment, unemployment, balance of payments and so on, all depend on millions of decisions by consumers and industrialists on whether to spend, borrow, or save.
Investment is closely linked to consumption and only takes place when demand and output are growing. Consequently, as soon as demand stops growing at the same rate, even at a very high level, investment will drop, probably leading to a downturn. Another theory is that sooner or later during every period of economic growth - when demand is strong, and prices can easily be put up, and profits are increasing - employees will begin to demand higher wages and salaries. As a result, employers will either reduce investment, or start to lay off workers, and a downswing will begin.
External theories, on the contrary, look for causes outside economic activity: scientific advances, natural disasters, elections or political shocks, demographic changes and so on. Joseph Schumpeter believed that the business cycle is caused by major technological inventions (railways, automobiles, electricity, microchips), which lead to periods of ‘creative destruction’. He suggested that there was a 56-year Kondratieff cycle, named after a Russian economist. A simpler theory is that, where there is no independent central bank, the business cycle is caused by governments beginning their periods of office with a couple of years of austerity programs followed by tax cuts and monetary expansion in the two years before the next election.