Business Cycles & the British Economy – What are business cycles

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Last updated: April 21, 2019

Business cycles, economic cycles or trade cycles as they are sometimes called, are defined by the Longman Dictionary of Business English, as “a cycle in time during which trade moves from a state of high activity (boom, prosperity) through a running-down period (contraction, downsizing, recession, slump, downturn) to a state of low activity (depression, stagnation, trough), then upward again when business improves (expansion, recovery, revival) until there is a return to high activity once more.

The whole cycle then begins again.” (Adam 1982 p.138)But what does this actually mean? In Fig. 1 below you can see a theoretical business cycle, which shows the trending and actual output or aggregate demand, of a country, over time.Aggregate demand is the sum of Consumer spending (C), Government spending (G), Investment (I) and Exports (X) (minus Imports (Z)); represented asC + G + I + (X-Z); and is a major indicator in the financial stability of a country.As you can see in Fig.1 the trending output increases steadily year on year, whilst the actual output fluctuates around it. The actual output curve reflects the business cycle at which point A marks a slump, B shows the economy in the recovery phase, C indicates the top of the boom period, D is the start of a recession and E shows another slump, after which the recovery starts again.

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The Implication to BusinessesFor businesses to survive it is imperative that they understand the nature of business cycles and the causal chains or knock-on effects that each stage creates. For example, when the economy enters a slump the following occurs:In a boom period the opposite happens and rises in aggregate demand fuel growth in the economy. To a business which is considering expanding, understanding this can mean the difference between prospering and going bankrupt.

What causes business cycles?There are several theories for what causes a business cycle and they are split into two categories:* External (Exogenous) Theories – these follow the ideology that business cycles are influenced by changes in external factors such as war, revolution, elections, gold discoveries, oil shortages, technology and scientific breakthroughs etc.* Internal (Endogenous) Theories – these look for triggers within the economic system itself, such as the massive consumer and business borrowing of the mid 1980’s or stock market crashes.Some of the main theories include:Monetary Theories – these argue that when the supply of money increases faster than output and interest rates are low, spending increases and the economy moves into a boom period, such as during the dot com era when wages skyrocketed.

However the higher demand increases demand for money, interest rates rise and investment and consumption fall causing a downturn in the economy.The Multiplier-Accelerator Theory – this says that if there is a rise in one sector of the economy it will impact another sector. For example, a rise in exports will increase National Income, by a multiple amount (the multiplier), this will cause investment to rise (the accelerator) which will lead to another multiple rise in National Income.

A ceiling is reached when shortages in labour or other resources are experienced, which causes income to grow more slowly and investment to fall leading to a downturn in the economy.Political (Stop-go) Cycles – governments that are keen to reduce inflation may initiate strict deflationary tactics which can cause a downturn in the economy. This would normally be done after an election and be reversed before the next election to stimulate the economy and win favour with voters.Equilibrium Business Cycle Theory – these argue that misconceptions about price and wage movements cause people to supply either too much or too little labour, such as workers holding out for higher wages after the skyrocketing salaries of the dot com boom. This leads to cycles of output and labour.

Demand and Supply-side Shocks – New Classical economists emphasise the impact of unanticipated shocks, such as the El Nino hurricane of 1998 damaged crops and infrastructure of Latin America, Asia and Africa which led to a downturn in economic activity.Tracking the EconomyUnderstanding business cycles is only half the battle, what businesses need to do is monitor the economy to check its position in the cycle and hopefully anticipate changes before they happen.This can be done by monitoring the elements which are affected by business cycles:* Aggregate Demand – which is measured as Gross Domestic Product (GDP)* Productivity – measured by the Producers Price Index* Unemployment* Consumer Spending – measured by the Retail Price Index* Government Spending* Investment and the strength of world marketsThe main indicator is the percentage changes of GDP from one year to the next, high changes indicate a growing economy, while low or negative changes suggest a slowing down or recession.

Inversely, high changes in the percentage of unemployment reflect hardship in the economy whilst low changes or stagnation indicate strength and prosperity.Business Cycles in BritainIf we look at the percentage change of GDP and Unemployment in the UK from 1980 to 2000 this becomes apparent, see Fig.3. In 1980 (Yr 1), there was a negative change in GDP and a rising change in unemployment, this marks the recession of 1980-81 which was the worst in Britain since the 1930’s.The recession hit the manufacturing industries such as steel, textiles and car makers the hardest and thousands of workers lost their jobs and yet other industries, such as financial services, prospered. In hindsight it was the first shift in working patterns away from traditional industries and into the service sector.The recession was a result of a long economic slowdown for Britain, which had not grown as fast as other European or Far East countries in the post war years. Cheap imports from abroad, coupled with high inflation at home, strong Trade Unions demanding higher wages from employers, the second oil crisis in ten years and a “newly elected Conservative Government, grappling with difficulty with its new monetarist strategy” caused a fall in aggregate demand, a fall in productivity, a rise in unemployment and a fall in income.

(Smith 1992 p.196)The recovery phase began in the middle of 1981 (Yr 2) and ran until 1984 (Yr 5) when the boom kicked in, this is shown in GDP by the steady growth rate year on year and the stagnating and falling unemployment.In 1989 (Yr 10) however the economy began to slow down and GDP fell, slowly at first and then more rapidly until 1991, as you can see, unemployment over the same period, rose at a similar rate.This marks the second recession in the UK, 1990-91 which Smith (1992 p.197) said “was largely due to errors in policy” as the Government was still trying to control inflation through a tight fiscal policy and refused to increase government spending to stimulate the economy.

Although to be fair there were also external factors such as the world-wide stock market crash of 1987 and the housing market crash of 1988, which undermined the massive public borrowing and business investment during the boom of the late 1980’s and the Gulf War of 1991.Despite these “massive negative shocks on the economy,” this second recession was not as severe as the first, and the recovery was far swifter for GDP and unemployment which returned to their pre-recession levels in only three years.However “consumer spending recovered only slowly” as people and businesses tried to reduce some of the debt they had accumulated. For many the recession proved fatal and they lost their homes and businesses.(Samuelson and Nordhaus 1995) (Begg 2001)In 1992 the cycle began again with a short sharp recovery to 1993 and an intense boom period which peaked in 1994 (Yr 15).

Between 1995 and 2000 the economy slowed down and both GDP and unemployment fluctuated slightly around a horizontal trend. This occurred despite the dot com boom and bust of the late 1990’s.Types of Business CycleBy analysing past data businesses are able to identify the type of business cycle that a country is in as well as the causes, this enables businesses to tailor their marketing mix to the environment. There are four types of business cycle:* The Kitchin Inventory Cycle – this lasts about 3 to5 years from peak to peak and is linked to changing stock levels.* The Juglar or Investment Cycle – this lasts about 7 to 11 years, peak to peak and relates to changes in net investment.* The Kuznets Cycle – this lasts about 15 to 25 years and is caused by fluctuations in activity in the construction and allied industries.* The Kondratieff Cycle – this lasts about 45 to 60 years and is called a long wave as it describes long-run fluctuations in economic activity.

It is argued that short waves or cycles, such as above, occur within long waves and that long waves are caused by external factors such as technological innovations, wars, revolutions and the discoveries of gold.

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