Business Cycle

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The Economic Cycle

The economic cycle is the natural fluctuation of the economy between recovery and recession.

Recession

A recession is defined as “two or more consecutive quarters of negative real GDP growth”.
In the trough, the prices of factors of production, such as labour and land, have fallen so far that some entrepreneurs think the only way is up. So some entrepreneurs think the economy has ‘bottomed out’ and it is the best time to buy and invest.
This starts the recovery process...

Recovery

Eventually, this recovery gathers momentum and turns into a full expansion:
As investment increases, real GDP grows. Unemployment falls as jobs are created and workers are needed to produce goods and services.
So incomes rise and consumption rises too, creating a further need for investment and workers. As consumers buy more things like houses, house prices also begin to rise.
As profits rise, so do firm’s share prices. Animal spirits (confidence) are rising with these variables too.

Boom

During a boom:
- Workers are working over-time and wages are rising.
- Inwards migration may rise attracted by the work.
- Demand for luxury goods is high.
- Demand for imports is high – raw materials to produce other goods and luxury goods from abroad to consume e.g. holidays abroad.
Eventually, factories can't keep up with demand and so there are delays in deliveries. Workers keep working overtime, extra staff are hired.
The government gets more tax revenue and is spending less on benefits, so the fiscal deficit reduces.

Stagnation

Once the boom is in full flow, eventually it starts to become unsustainable. People start to worry that house prices and share prices are too high. They no longer reflect the real value of these assets but instead are speculative bubbles (over optimistic hype).
Some firms have over-invested as a result and returns on their investment starts to be below forecast. Suddenly, some entrepreneurs get cold feet and start to worry. They might start to put off investment projects. Some workers may be told to take shorter shifts.

Return to recession

If prices start to fall significantly, firms profits will fall as demand collapses. Now, workers will be fired and unemployment will rise. Government spending on welfare will rise while tax revenue from firms and consumers will fall.
Consumers may try to save money for a rainy day, reducing consumption further.
As firms profits fall, some make losses and go bankrupt. This means some banks have made loans that don’t get repaid. This harms confidence and reduces aggregate demand. Firms will need fewer workers and will reduce investment further.
And the cycle repeats.

There is no fixed length to booms and busts – and governments aim to reduce the volatility of the economic cycle to try to generate sustainable and stable economic growth. Some possible causes of recessions are:

Global financial crisis

A global financial crisis e.g. 2008, could cause a boom to turn into a recession.

Trading partners

A recession in a main trading partner e.g. a recession in the EU would cause exports to fall from the UK, which could trigger a change from slowdown to recession.