Chapter Three

Economic Performance and Business

Cycle

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3.1.Definitions and Concepts of Business Cycle
 Economies follow cycles of economic activity: Periods of
expansion are followed by periods of contraction.

 Output and employment increase during periods of expansion

and decrease during periods of contraction.

 For example, if current GDP is larger than last year’s GDP, the
economy is said to be expanding (getting bigger), vice versa.

 This pattern of real GDP rising and then falling is called a

business cycle or trade cycle. This pattern, however, is not
regular.
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3.1.Definitions and Concepts of Business Cycle
 The duration of business cycles and the rate at which real GDP
rises or falls vary considerably

 A business cycle represents fluctuations in the level of economic

activity (output or real GDP ) over time around the economy’s
short-term trend rate of growth.

 It is the on-going downward and upward movement of GDP or

fluctuations in aggregate output.

 In the business cycle, aggregate output (GDP) fluctuates around

its long-run average trend.
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 Cont’d…
 During the business cycle, other macroeconomic variables such
as unemployment, price, aggregate demand, etc. also fluctuate
with output.

 When businesses are increasing production, and they need more

employees.

 As a result, more people are hired, there is more money to spend,

and businesses make more profits and can focus on growth.

 It can be characterized as form of actual real output fluctuations

around potential output of the economy (i.e. the trend).
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 Characteristics of the Business Cycle
 The economic cycle means alternating periods of growth & decline
in real output.

 In this case, there is changing in employment, investments, profits

and other variables.

 The business cycle may have a growth trend, in that case we are
talking about an expansion, or fall trend, when talking about a
contraction.

 Situation when the output does not decrease, or grow, and therefore
has a zero change, is called stagnation.

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 Phase of business cycle
 Business cycle has four phases: the Peak, the Contraction, the
Trough, and the Expansion phase.

 Peak: It is a period when aggregate demand reaches a peak and

output grows faster than its long-term trend. As output grows faster
than its potential trend, it becomes unsustainable.

When the economic cycle peaks(Boom):

 The economy stops growing (reached the top)
 GDP reaches its maximum
 Businesses can’t produce any more or hire more people
 Employment rises rapidly
 Aggregate demand is high
 It is followed by contraction phase 6
 Phase of business cycle
 Contraction: During this phase the AD falls and it is accompanied by
a decline in economic activity and rising unemployment. These factors
lead to a recession.

 Producers do not notice the decrease in demand instantly and go on

producing, which creates a situation of excess supply in the market.

 All positive economic indicators such as income, output, wages, etc.,

consequently start to fall.

 Generally, during a period of contraction:

Unemployment increases
prices tend to fall
People are pessimistic and stop spending money 7
 Phase of business cycle
 Trough is the turning point at which a recession ends and an
expansion begins.

 In this stage, the economy’s growth rate becomes negative saturation

point.

 There is further decline economy until the prices of factors, and

demand and supply of goods and services, contract to reach their
lowest point.

 There is extensive depletion of national income and expenditure.

 During a trough:
 Economy “bottoms-out”(reaches lowest point)
 High unemployment and low spending 8
 Phase of business cycle
 A prolonged contraction is called a recession typically lasts b/n 2 and
18 months. A recession of more than one year is called a depression.
 For example: world great depression of 43 months, from August
1929 to March 1933.

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 Phase of business cycle
 Expansion: It represents the phase after a trough if AD increases. It
results in an expansion in output and falling unemployment.

 It the period in the business cycle from a trough up to a peak during

which output and employment grow.

 During this phase, there is an increase in +ve economic indicators

like employment, income, output, wages, profits, demand, and
supply of goods and services.

 During a period of expansion:

Wages increase and unemployment decreases
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People are optimistic and spending more money
 Phase of business cycle
Rising demand for goods and services
Businesses start to grow and make profits
Easy to get a bank loan etc.

 These phases of a business cycle are often collectively referred to as

a ‘boom-bust’ cycle.

 The contraction phase of a business cycles leads to recession.

 A recession is a situation when the level of economic activity has

fallen for at least two consecutive quarters.
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 Phase of business cycle
 On other hand, recession is a period of significant decline in total
output, income, employment, and trade, usually lasting from six
months to a year

 A prolonged and severe recession results into economy depression

 Depression is a period of sustained trough in economy

accompanied by high unemployment levels and, usually falling
prices resulting from a collapse in domestic & international demand.

 The expansion phase is terminated by a peak of business cycle and

contraction by a trough. These points are called the turning points.

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 Phase of business cycle
If the economy is in a phase of expansion, but the actual real output is
below the potential output, we call this situation as a recovery.
 If it is a phase of expansion, where the actual real output is greater
than potential product, we are talking about a boom.

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Cont’d….

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 3.3. Causes of Business Cycles
 The possible factors that cause business cycles are grouped under
following categories: domestic economic factors, political factors,
and international economic factors,

 Domestic economic factors like change in demand, fluctuations in

investments, macroeconomic policies, and supply of money internal
causes of business cycles.

 Change in demand: Keynes economists believe that a change in

demand causes a change in the economic activities.

 When the demand in an economy increases the firms start producing

more goods to meet the demand.

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Cont….
 There is more output, more employment, more income, and higher
profits.

 This will lead to a boom in the economy. But excessive demand may
also cause inflation.

 On the other hand, if the demand falls, so does the economic activity.

 This may lead to a bust, which if it continues for a longer period of

time may even lead to depression in the economy.

 Also, changes in social trends, demographics, and consumer

behavior can affect businesses.

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Cont….
 Fluctuations in investments cause by current rate of interest,
entrepreneurial, profit expectation and income generation.

 An increase in investment will lead to an increase in economic

activities and cause expansion.

 If the economy is expanding, sales and profit keep rising, so companies

invest in new plants and equipment, creating new jobs and more
expansion.

 A decrease in investment will have the opposite effect and may cause a
trough or even depression.

 Low interest rates, companies make new investments, adding jobs.

 When interest rates climb, investment dries up and less job growth
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 The Circular Flow Diagram cont’d…
Cont….
 Political Factors: There is some correlation between volatility in
GDP and electoral cycles.

 Governments tend to adopt expansionary fiscal policy and easy

monetary policy, if it has control over monetary policy committee,
before elections.

 On the other hand, in the face of rising prices and growing budget
deficits, gov’ts tend to adopt contractionary fiscal policy and tight
monetary policy after elections.

 Expansionary fiscal policy along with easy monetary policy leads to

an economic boom.

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 The Circular Flow Diagram cont’d…
Cont….
 This results into increased output and an inflationary pressure in the
 economy, depending on the degree of spare capacity in the economy.

 On the other hand, contractionary policies may cause a slowdown in

the economy, leading to a recession.

 International Economic Factors: Globalization has increased the

interdependence b/n countries and there is international transmission
of volatility from one country to another.

 In an era of ever increasing financial integration, it has become more

and more difficult for a country to pursue an independent monetary
policy with respect to interest rates and exchange rates.

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 Cont….
 Greater product market integration leads to international
transmission of business cycles through exports and imports.

 Though these international factors do explain the transmission
mechanism, they fail to provide a convincing explanation of genesis
of a business cycle in the first place.

 Technological advancements can create new opportunities for

businesses or disrupt existing business models.

 i.e. Some exciting and new technology is always a boost to the

economy.

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 Cont…
Natural Factors: Natural disasters such as earthquakes, droughts,
hurricanes, floods, etc., can cause significant damage to infrastructure
and property, leading to a decrease in production and output.

 That means it can cause to damage the crops and huge losses to the
agricultural sector production.

 Shortage of food will cause a surge in prices and high inflation.

Capital goods may see a reduction in demand as well.

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The Circular Flow Diagram cont’d…
Cont….
 Population Expansion: If the population growth is out of
control that might be a problem for the economy.

 Basically if the population growth is higher than the economic

growth the total savings of an economy will start declining.

 Then the investments will reduce as well and the economy will face
depression or a slow down.

 Population growth can lead to increased demand for goods and

services, which can cause inflation if supply does not keep up with
demand.

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 End of Chapter
Three
Thank You for Your
Attention!

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