Business Cycle

7. (ii) identify the different phases of business cycles and critically examine the main factors that led to the fluctuations in output

The Business Cycle is the periodic fluctuations in economic activity measured by changes in real GDP. The phases of the business cycle are known as boom, recession, trough, and recovery. While the fluctuations are, in practice, highly irregular, the most common illustration of the business cycle shows a standard periodic cycle. This is illustrated above. 

In the recovery phase we see economic expansion, with GDP increasing at a rising rate. This is largely driven by an increase in what is known as aggregate (total) demand in the economy, as households and businesses are encouraged to spend more. To meet the increase in demand by households firms increase their output and take on more workers so that unemployment falls. The newly employed workers spend their incomes on new goods and services and so household spending increases even more. Just as increasing demand for a good or service can result in an increase in its price, so can increasing aggregate demand in an economy lead to an increase in average prices. Thus, as an economy “booms” it is likely that inflationary pressure will build up and the rate of growth of GDP will fall as the economy nears its potential output. Economic policy makers are likely to react by trying to slow down the growth of the economy and this may cause a fall in total demand. This is the beginning of the recession part of the cycle.

A recession is defined as two consecutive quarters of negative GDP growth, that is, falling GDP. (Please note that a decrease in GDP, where the economy actually gets smaller, is not the same as a decrease in GDP growth, which is where the economy continues to grow, but at a slower rate.) During a recession, falling aggregate demand will lead firms to lay off workers, so unemployment rises. If more people are unemployed, there will be even less spending. Low levels of demand result in lower rates of inflation, or even deflation.

At some point the contraction will come to an end. This is known as the trough. Output cannot continue to fall for ever as there will always be some people with jobs to maintain a given level of consumption, foreigners will demand exports, governments will continue to spend by running budget deficits, and people will be able to use savings to finance their consumption. Additionally, the low demand for money for investment will result in lower interest rates. Thus, aggregate demand will pick up, the economy will enter the recovery phase, and the cycle will repeat itself.

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