Subject 1. The Business Cycle and its Phases

The business cycle is the fluctuations in the general level of economic activity as measured by such variables as the rate of unemployment and changes in real GDP. Periods of growth in real output and other aggregate measures of economic activity followed by periods of decline are distinguishing characteristics of business cycles. A complete business cycle is represented by A to G in the diagram below:

  • Peak

    When most businesses are operating at capacity level and real GDP is growing rapidly, a business peak or boom is present.

  • Contraction

    Aggregate business conditions are slow, real GDP grows at a slower rate or even declines, and the unemployment rate increases. This indicates that the economy begins the contraction, or recessionary, phase of a business cycle.

    • Firms start to cut hours and freeze hiring, followed by outright layoffs.
    • As final demand starts to fall off the downturn in investment spending usually occurs abruptly.
    • Inventories accumulate involuntarily, and firms cut production below even reduced sales levels to let their inventories decline. This eventually accelerates the economic downturn.

  • Trough

    The bottom of the contraction phase is referred to as the recessionary trough. When a contraction is prolonged and characterized by a sharp decline in economic activity, it is called a depression.

  • Expansion

    After the downturn reaches bottom and economic conditions begin to improve, the economy enters the expansion phase of the cycle. Here business sales rise, GDP grows rapidly, and the rate of unemployment declines.

    • Hiring new workers is a costly process. Firms will wait until it's clear that the economy is in this phase. They will then start full-time rehiring as overtime hours rise.
    • As inventories dwindle, businesses ultimately find themselves short of inventory. As a result, they start increasing inventory levels by producing output greater than sales, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate.
    • Changes in sales can result in magnified percentage changes in investment expenditures. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates.

      Orders for new equipment are early signals of recovery. Since it usually takes longer to plan and complete large construction projects than for equipment orders, construction projects may be less influenced by business cycles.

    The expansion eventually blossoms into another peak.

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