22. The business cycle

The business cycle or trade cycle is the fluctuation in the general level of economic activity, measured by the rate of unemployment and changes in GDP; it is a permanent feature of market economies: gross domestic product fluctuates as booms and recessions succeed each other. During a boom an economy expands to the point where it is working at full capacity, so that production, employment, prices, profits, investment and interest rates all tend to rise.

During a recession, the demand for goods and services declines and the economy begins to work at below its potential. Investment, output, employment, profits, commodity and share prices, and interest rates generally fall.

A serious, long-lasting recession is called a depression or a slump.

The highest point of the business cycle is called a peak, which is followed by a downturn or downswing or a period of contraction. The lowest point of the business cycle is called a trough, which is followed by a recovery or an upturn or upswing or a period of expansion.

Economists sometimes describe contraction as ‘negative growth’.

There are various theories as to the cause of the business cycle. Internal theories consider it to be self-generating, regular and repeating. A peak is reached when people begin to consume less. In 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 job in the near future they tend to save more. A country’s output, investment, unemployment, balance of payments depend on millions of decisions by consumers and industrialists on whether to spend, borrow or save.

Investment is closely linked to consumption, and takes place when demand and output are growing. As soon as the demand stops growing at the same rate, investment will drop, leading to a downturn.

Another theory is that sooner or later during every period of economic growth – when the demand is strong, profits are increasing – employees will begin to demand higher wages or salaries. As a result, employers will either reduce investment, or start to lay-off workers, and downsizing 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. There is a theory 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 programmes followed by tax cuts and monetary expansion in the two years before the next election.