What are Business Cycles?

It is a simple fact that the evolution of economic activity does not follow a straight line in a market economy, it fluctuates. Periods of prosperity and rapid economic growth are followed by periods of economic contraction or slower growth in preparation again for faster growth. This cyclical movement of general economic activity is not periodic. It embodies what is described as the business cycle, or more closely defined as the fluctuation of economic activity around a growth trend. A time-honoured definition of the business cycle is found in that of Burns & Mitchell (1947):

In each phase of the business cycle, we find the co-movement of macro-economic magnitudes (e.g. expenditure by households, the government and business; production across a range of sectors, inflation, interest rates, credit extension, money supply, etc.). The key fact of the business cycle is that different recessionary periods in the economy have more in common compared to the expansion phases surrounding them (see Boldin, 1994: 98). It is through the study of the co-movement of various economic variables in each phase of the business cycle that we can get to understanding the business cycle.

It is important to realise that the business cycle as such is ‘invisible’. A vast literature has developed around the identification of turning points in the business cycle, as well as methods in providing real-time (and forward-looking) information on business cycles.

The student of the business cycle is particularly interested in the drivers of the re-current deviations of the level of economic activity from its underlying growth trend. Comprehensive statistical techniques can be applied in isolating the cyclical components of economic time series, which are then analysed in determining a reference series representing the (‘invisible’) business cycle. Zarnowitz (1992: 183-190) warns that it is difficult to isolate cyclicality from the trend growth elements of an economic time series; according to him they are interdependent.

The practice of business cycle analysis is very involved with identifying how much of the fluctuation of economic activity (e.g. GDP) is explained by trend changes (typically on the supply-side of the economy) and/or the business cycle (typically driven by changes in expenditure – on the demand-side of the economy).

Both elements need to be explored in order to arrive at an understanding of the drivers of (trend) growth and the propagation of cyclical movements in improving our comprehension of business cycles. This knowledge allows the economic policy maker, the business executive and the investor (and household!) to optimize economic decisions.

One has to accept that the business cycle phenomenon in modern economies is a very complex. Attempts at explaining the business cycle often only address partial elements. This was particularly the case in the pre-industrial era (see Achuthan & Banerji, 2004: 17-36). However, business cycle research has come a long way.

A more accurate handle on the course of the business cycle limits financial losses in business decision-making. It can also assist with limiting economic welfare losses associated with sub-optimal economic policy decision-making.

References

1. Achuthan, L & Banerji, A (2004): Beating the Business Cycle, Currency Doubleday: New York.
2. Boldin, MD (1994): Dating turning points in the business cycle, The Journal of Business, vol. 67, No. 1: 97-131
3. Zarnowitz, V (1992): Business Cycles: Theory, History, Indicators, and Forecasting, University of Chicago Press, Chicago.