Economic Cycles in Business

Business cycles can be described as collective periods of expansion and contraction in the national economic activity of countries that organize their work principally in private business enterprises. The cycles can vary in the length of time that they last, the height or depth to which the economic activity moves during the cycle, and how broadly the national economy as a whole is affected. In the United States, peacetime expansions have historically averaged from approximately eighteen months to three years, with contractions generally lasting from one to two years, making the total cycle about two and one-half to five years in length from beginning to end. Of course, considerable deviations around these averages have occurred, and each cycle necessarily has its own unique characteristics. However, business-cycle expansions typically have been longer and contractions significantly shorter after World War II than before it, with the contractions also being less severe.

Economic pundits have presented a number of possible explanations for this change in cycles after World War II. For instance, spending for services has increased, and such spending generally doesn't vary greatly within a given cycle. The size of government is larger as well, and government employment is relatively stable during a cyclical time span. Better methods of inventory control have also contributed to the reduced severity of contractions. Additionally, a variant of the typical business cycle in this post-WWII era has been labeled by some as a growth recession, which can be explained as a period of sluggish growth not marked by an actual downturn in overall economic activity. Such periods occurred from 1965 to 1967 and again from 1984 to 1985.

Characteristics

In order to recognize and understand business cyclical movements, they must first be differentiated from several other types of economic movements: long-term growth trends; seasonal fluctuations (economic variations within a year due to weather or other seasonal factors, such as holidays; and irregular or random economic movements, which are characterized, for example, by labor strikes or natural disasters (hurricanes, earthquakes, etc.).

Numerous comprehensive studies of U.S. cyclical history have identified the following repetitive characteristics of business cycles:

  • Most – but not all – industries and sectors of the economy are affected by business cycles (agriculture and the extraction of natural resources are two notable exceptions).
  • Durable producer- and consumer goods are affected more than nondurable goods and services.
  • Private investment expenditures have larger percentage fluctuations during a cycle than consumer spending.
  • Production fluctuates more than sales, resulting in still greater movement in inventories.
  • Profits have cyclical movements that closely mirror the business cycle, but profit fluctuations are much greater than those of wages and salaries, dividends and interest payments, and rental income.
  • Industrial prices fluctuate more than retail prices.
  • Short-term interest rates have relatively large movements that conform to cyclical changes. Reversal points in long-term interest rates lag behind short-term rate turns and have smaller amplitudes; as a result, near cyclical peaks, short rates tend to exceed long rates.

Additionally, certain timing indications with respect to cyclical peaks and troughs have also been observed:

  • In the months preceding a cyclical peak, certain activities begin to decline, such as new business startups, commercial and industrial construction contracts, and new orders for machinery and equipment.
  • Profit margins decline before actual profits do (this occurrence, in conjunction with stock prices, tends to direct cyclical downturns).
  • Monetary accumulations show little cyclical conformity and more random fluctuations, thus limiting their usefulness as either a forecasting or governmental policy tool.

Causes

Prior to the severe contraction period that ran from 1929 until 1932 (the beginning years of the commonly-called Great Depression), very little attention was paid to business cycles – which were believed to be short, mild, and essentially self-correcting. The severity of that particular contraction initiated many studies of the cycle. Although no one theory of the causes of business cycles has as yet to be generally accepted, several explanations have been offered by economists.

The explanation most commonly used to illustrate the causes of a cyclical downturn is briefly summarized here: a long and complex chain of production exists for both long- and short-lived goods. This chain also produces a stream of consumer income that supports the demand for the output produced. However, an interruption in final demand (for whatever the reason) will reduce income, which will reduce demand even further, and lead to curtailed production and an economic contraction. Some reasons for a temporary reduction in demand might be that consumers already have a plentiful stock of durable goods such as automobiles, or a business already possessing excessive inventories or plant capacity. Moreover, wages and prices habitually do not respond quickly to changes in the supply or demand for goods and services, and may not adjust enough to avoid disproportionate unemployment. A downward cycle results, which will correct after the excesses in the system are worked off.

The cycle, although temporary, can be harmful to the country's welfare, making government action an appealing means to temper the adverse effects. Activity by the Federal Reserve can influence the economy's supply of money and credit and the level of interest rates. Fiscal policy includes the influence on the private sector of federal spending, receipts, and the budget surplus or deficit. Either or both of these policy tools have been used to offset the effects of contractions or overheated expansions.

Other explanations of the cycle disagree with the desirability of government action to offset cyclical changes. They assert that changes in the money supply of the economy are the causes of cyclical fluctuations; thus, a steady rate of growth in the supply of money and no monetary policy shifts are the best ways to significantly check cyclical fluctuations.

In the 1980s, another school of thought argued that changes in the economy are typically more permanent than temporary and are due to things such as technological adjustments and transformations or shocks (for example, wars or changes in the price of oil). This mindset it questions the desirability of any government intervention designed to affect employment and economic output.

In spite of the alternative views, government action – through monetary and fiscal policy changes – to offset cyclical fluctuations is still the method of choice among most economists, politicians, and private citizens. At present, however, the use of fiscal policy to counter a cyclical downturn is limited due to the enormous size of the federal deficit and the efforts undertaken to reduce it. Therefore, Federal Reserve monetary policy is the primary countercyclical force presently available. Yet monetary policy is also constrained by concerns over inflation, the position of the dollar in the Foreign Exchange marketplace, and by the limited tools (mostly working on short-term interest rates) at the Fed's disposal.

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