- business cycle
a recurrent fluctuation in the total business activity of a country.[1920-25]
* * *Periodic fluctuation in the rate of economic activity, as measured by levels of employment, prices, and production.Economists have long debated why periods of prosperity are eventually followed by economic crises (stock-market crashes, bankruptcies, unemployment, etc.). Some have identified recurring 8-to-10-year cycles in market economies; longer cycles have also been proposed, notably by Nikolay Kondratev. Apart from random shocks to the economy, such as wars and technological changes, the main influences on the level of economic activity are investment and consumption. An increase in investment, as when a factory is built, leads to consumption because the workers employed to build the factory have wages to spend. Conversely, increases in consumer demand cause new factories to be built to satisfy the demand. Eventually the economy reaches its full capacity, and, with little free capital and no new demand, the process reverses itself and contraction ensues. Natural fluctuations in agricultural markets, psychological factors such as a bandwagon mentality, and changes in the money supply have all been proposed as explanations for initial changes in investment and consumption. After World War II many governments used monetary policy to moderate the business cycle, aiming to prevent the extremes of inflation and depression by stimulating the national economy in slack times and restraining it during expansions. See also productivity.
* * *Introductionperiodic fluctuations in the general rate of economic activity, as measured by the levels of employment, prices, and production. Figure 1—>, for example, shows changes in wholesale prices in four Western industrialized countries over the period from 1790 to 1940. As can be seen, the movements are not, strictly speaking, cyclic, and although some regularities are apparent, they are not exactly wavelike. For these reasons, some economists prefer the term business fluctuation over business cycle.There are many types of economic fluctuation. Because of the complexity of economic phenomena, it may be that there are as many types of fluctuation or cycle as there are economic variables. There are daily cycles in commuter traffic or the consumption of electricity, to cite only two examples. Almost every aspect of economic life displays seasonal variations: sales of coal or ice, deposits in savings banks, monetary circulation, agricultural production, purchases of clothing, travel, housing, entertainment, and so on. As one lengthens the span of observation, one finds new kinds of fluctuation, such as the hog cycle and the wheat cycle, the inventory cycle, and the construction cycle. Finally, there are movements of general economic activity that extend over periods of years.Statistical studies of cyclesModern economic history has recorded a number of periods of difficult times, often called depressions, during which the business economy was marked by sudden stock market declines, commercial bankruptcies, bank failures, and mounting unemployment. Such crises were once looked upon as pathological incidents or catastrophes in economic life, rather than as a normal part of it. The notion of a “cycle” implies a different view. The following examples represent some of the attempts theorists have made to explain and predict business cycles.The Juglar cycleThe first authority to explore economic cycles as periodically recurring phenomena was the French physician and statistician Clément Juglar (Juglar, Clément), who in 1860 identified cycles based on a periodicity of roughly 8 to 11 years. Scholars who developed Juglar's approach further distinguished three phases, or periods, of a typical cycle: prosperity, crisis, and liquidation. Subsequent analysis designated the years 1825, 1836, 1847, 1857, 1866, 1873, 1882, 1890, 1900, 1907, 1913, 1920, and 1929 as initial years of a downswing (i.e., the beginning of the “crisis” phase).The so-called Juglar cycle has often been regarded as the true, or major, economic cycle, but several smaller cycles have also been identified. Close study of the interval between the peaks of the Juglar cycle suggests that partial setbacks occur during the expansion, or upswing, and that there are partial recoveries during the contraction, or downswing. According to this theory, the smaller cycles generally coincide with changes in business inventories, lasting an average of 40 months. Other small cycles result from changes in the demand for and supply of particular agricultural products such as hogs, cotton, and beef.Kondratieff wavesCycles of greater duration than the Juglar cycle have also been studied. For example, the construction industry was found to have cycles of 17 to 18 years in the United States and 20 to 22 years in England. Measuring longer-term business cycles involves the study of long waves, or so-called Kondratieff cycles, which were named for the Russian economist Nikolay D. Kondratyev (Kondratyev, Nikolay D.). His examination of the major Western countries during the 150 years from 1790 to 1940 identified three periods characterized by slow expansions and contractions of economic activity, each averaging 50 years in length:1. 1792–1850 Expansion: 1792–1815 23 years Contraction: 1815–50 35 years2. 1850–96 Expansion: 1850–73 23 years Contraction: 1873–96 23 years3. 1896–1940 Expansion: 1896–1920 24 years Contraction: 1920–40 20 yearsOnly these three Kondratieff waves have been observed. Some students of business cycles have analyzed them by statistical methods, in the hope of finding regularities that are not immediately apparent. One speculative theory has held that the larger cycles were built up from smaller ones. Thus, two seasonal cycles would produce a two-year cycle, two of which would produce a four-year cycle; two four-year cycles would become an eight-year, or Juglar, cycle, and so on. The hypothesis is not widely accepted.Patterns of economic depression and upswingCycles of varying lengths are closely bound up with economic growth. In 19th-century Germany, for example, upswings in total economic activity were associated with the growth of the railroad, metallurgy, textile, and building industries. Periodic crises (such as those outlined above in the discussion of the Juglar cycle (business cycle)) brought slowdowns in growth. The crisis of 1873 led to a wave of financial and industrial bankruptcies; recovery started in 1877, when iron production ceased to fall, and by 1880 a new upswing was under way. The recession of 1882 was less severe than the previous one, but a slump that began in 1890 led to a serious depression, with complaints of overproduction.The year 1890 was one of financial crisis also in England and the United States. The British (United Kingdom) banking house of Baring Brothers failed, partly because of a revolution in Argentina. English pig-iron production fell from 8.3 million tons in 1889 to 6.7 million tons in 1892, and unemployment increased. That depression might have been less severe but for the international financial crisis, especially intense in the United States, where in 1893 a stock market panic led to widespread bank failures.The recession of 1900 was followed by an unusually vigorous upsurge in almost all the Western economies. U.S. (United States) pig-iron production increased by more than 150 percent during the expansion, which lasted until 1907; building permits more than doubled; and freight traffic rose by more than 50 percent. Prices rose more and more rapidly as the U.S. economy approached full employment.Deviations from cycle patternsCycles are compounded of many elements. Historical fluctuations in economic activity cannot be explained entirely in terms of combinations of cycles and subcycles; there is always some factor left over, some element that does not fit the pattern of other fluctuations. It is possible, for example, to analyze a particular fluctuation into three principal components: a long component or trend; a very short, seasonal component; and an intermediate component, or Juglar cycle. But these components cannot be found exactly recombined in another fluctuation because of a residual element in the original fluctuation that does not have a cyclical form. If the residual is small, it might be attributed to errors of calculation or of measurement. On a more sophisticated statistical level, a residual element can be treated as “random movement.” If the random element is always present, it becomes an essential element of the analysis to be dealt with in terms of probability.For practical purposes, it would be useful to know the typical shape of a cycle and how to recognize its peak and trough. A great amount of work has been done in what may be called the morphology of cycles. In the United States, Arthur F. Burns and Wesley C. Mitchell (Mitchell, Wesley C.) based such studies on the assumption that at any specific time there are as many cycles as there are forms of economic activity or variables to be studied, and they tried to measure these in relation to a “reference cycle,” which they artificially constructed as a standard of comparison. The object in such studies was to describe the shape of each specific cycle, to analyze its phases, to measure its duration and velocity, and to measure the amplitude or size of the cycle.In studying various cycles, it has been possible to construct “lead and lag indicators”—that is, statistical series with cyclical turning points consistently leading or lagging behind the turns in general business activity. Researchers using these methods have identified a number of series, each of which reaches its turning point 2 to 10 months before the turns in general business activity, as well as another group of series, each of which follows the turns in business by 2 to 7 months. Examples of leading series include published data for new business orders, labour productivity, consumer demand, residential building contracts, stock market indices, and changes in business inventory. These and other leading indicators are widely used in economic forecasting.Dynamic analyses of cyclesCoincident with the Great Depression—one of the most severe economic downturns in modern times—the British economist John Maynard Keynes (Keynes, John Maynard) put forth a large body of economic theory that examined the relationship between investment and consumption. According to Keynes and other economists associated with his views, any new expenditure—e.g., on building a road or a factory—generates several times as much income as the expenditure itself. This is so because those who are paid to build the road or factory will spend more of what they receive; their expenditures will thus become income for others, who will in their turn spend most of what they receive. Every new act of investment will, thus, have a stimulating effect on aggregate income. This relationship is known as the investment multiplier (multiplier). Of itself, it cannot produce cyclical movements in the economy; it merely provides a positive impulse in an upward direction.To the relationship between investment and consumption must be added that between consumer demand and investment. An increase in demand for refrigerators, for example, may eventually require increased investment in the facilities for producing them. This relationship, known as the accelerator, implies that an increase in national income will stimulate investment. As with the multiplier, it cannot of itself explain cyclical movements; it merely accounts for a fundamental instability that Keynesians thought they had observed.It can be shown, however, that the multiplier and accelerator in combination may produce very strong cyclical movements. Thus, when an increase in investment occurs, it raises income by some larger amount, depending on the value of the multiplier. That increase in income may in turn induce a further increase in investment. The new investment will stimulate a further multiplier process, producing additional income and investment. In theory, the interaction might continue until a point is reached at which such resources as labour and capital are being fully utilized. At that point—with no increase in employment and, therefore, no rise in consumer demand—the operation of the accelerator would cease. That halt in demand, plus the lack of new capital, would cause new investment to decline and workers to be laid off. The process thus would go into reverse. The fluctuations in national income could take various forms, depending on the characteristics of the economy and the way in which the population allocated its income between consumption and savings. Such spending habits, of course, affect both the levels of consumer demand and capital investment. This theoretical analysis does not explain actual economic fluctuations; it is merely an aid to understanding them. See also Keynesian economics.The analysis can be made more realistic by taking into account three other factors. First, one may assume that although the economy has an inherent tendency to swing very widely, there are limits beyond which it cannot go. The upper limit of the swings would be the point at which full employment or full capacity is reached; the lower limit is more difficult to define, but it would be established when the forces that make for long-term economic growth begin to operate. Thus, the upswing of a cycle stops when it meets the upper limit; and the downswing stops at the lower limit, resulting in continuous cyclical movements with an overall upward trend—a pattern corresponding to the one found in history.The occurrence of a time lag—the inevitable delay between every decision to invest and the outcome of that investment—provides a second reason for expecting cyclical fluctuations to occur in any economic process. This phenomenon is illustrated, for example, in the relation between the action of a thermostat and the temperature of a room. A fall in room temperature causes the thermostat to turn on the heater, but there is a lag in time until the room warms up sufficiently to cause the thermostat to turn the heat off, whereupon the temperature begins to fall again. The shape of the curve of the temperature cycle will depend on the responsiveness of the thermostat and on the time required to raise the temperature of the room. By making various adjustments, it is possible to minimize the cycle, but it can never be eliminated entirely.In economic life, there are many such lags between the decision to invest and the completion of the project: between the farmer's decision to raise hogs and the arrival of pork chops at the store, for example, or between prices at the time of a decision and prices at the time the transaction is completed.Random shocks, or what economists call exogenous factors, constitute the third type of phenomena affecting business cycles. These are such external disturbances to the system as weather changes, unexpected discoveries, political changes, wars, and so on. It is possible for such external impulses to cause cyclical motions within the system, in much the same way that striking a rocking horse with a stick will cause the horse to rock back and forth. The length of the cycle will be determined by the internal relationships of the system, but its intensity is governed by the external impulse.Theories of economic fluctuationMany explanations of the reasons for economic fluctuation have been advanced throughout history. Even the most rudimentary explanation of cycles must isolate the forces and relationships that tend to produce these recurrent movements. The more comprehensive theories must in addition explain why, during downturns, (1) employment falls and unemployment increases and (2) investment declines by a much greater percent than output.Agricultural (agricultural economics) and climatic theoriesPerhaps the oldest theories of the business cycle are those that link their cause to fluctuations of the harvest. Since crops depend upon soil, climate, and other natural factors that in turn may be affected by biological or meteorological cycles, such cycles will transmit their effects through the harvests to the rest of the economy. The 19th-century British economist William Stanley Jevons (Jevons, William Stanley) thought he had found the key to such a process in the behaviour of sunspots, which seemed to display a 10-year cycle. His naïve explanation could not long withstand critical examination. It attracted a certain interest, however, for suggesting a causal factor that was completely detached from the economic system and one that could not be influenced by it in turn. Agricultural theories made sense in the 19th century and earlier, when agricultural products represented between 40 and 60 percent of the output of advanced economies. By the turn of the 21st century, however, agriculture's contribution to the outputs of advanced economies had fallen to 5 percent or less.Psychological (psychology) theoriesA number of writers have explored mass psychology and its consequences for economic behaviour. Individuals are strongly influenced by the beliefs of the group or groups to which they belong. There are times when the general mood is optimistic and others when it is pessimistic. British economist Arthur C. Pigou (Pigou, Arthur Cecil), in his Industrial Fluctuations (1927), put forward a theory of what he called “noncompensated errors.” He pointed out that, if individuals behave in a completely autonomous way, their errors in expectations will tend to offset each other. But if they imitate each other, their errors will accumulate, eventually acquiring a global magnitude that may have powerful economic effects. This “follow-the-crowd” tendency is a factor in the ups and downs of the stock market, in financial booms and crashes, and in the behaviour of investors. One can say, however, that this psychological factor is not enough to explain economic fluctuations; rather, moods of optimism and pessimism themselves are probably rooted in economic factors.Political theoriesSome observers have maintained that economic fluctuations result from political events. Even the imposition of a tax or an import restriction may have some dynamic effect upon the economy. In the United States, for example, some economists have speculated that incumbent political leaders pressure the chairman of the Federal Reserve System to loosen monetary policy in advance of an election as a means of fostering prosperity. It remains to be determined whether such political factors are capable of producing cyclical movements.Technological theoriesEver since the start of the Industrial Revolution at the end of the 18th century, technical innovations have followed each other without end but not without pause. For example, cycles of rapid growth and measured accommodation took place after the introduction of the steam engine, the development of petroleum-based energy sources, the harnessing of electric power, and the invention of the computer and the creation of the Internet. It is possible that, if a rhythm could be found in these waves of change, the same rhythm might be responsible for corresponding movements in the economy. But it is equally possible that the technical innovations themselves have been dictated by the prior needs of the economy.Demographic theoriesEven changes in population have been postulated as a cause of economic fluctuations. There are, undeniably, cyclical movements of population; it is possible to find fluctuations in the rates of marriage, birth, mortality, and migration, but the extent to which such fluctuations may be associated with changes in economic conditions is not clear.Underconsumption theoriesIn an expanding economy, production tends to grow more rapidly than consumption. The disparity results from the unequal distribution of income: the rich do not consume all their income, while the poor do not have sufficient income to meet their consumption needs. This imbalance between output and sales has led to theories that the business cycle is caused by overproduction or underconsumption. But the basic, underlying cause is society's inadequate provision for an even flow of savings (saving) out of the excess of production over consumption. In other words, saving is out of step with the requirements of the economy; it is improperly distributed over time.Investment theoriesThe fact that changes in the supply of savings, or loanable funds, are not closely coordinated with changes in the rest of the economy lies at the heart of the theories that link investment imbalance to the business cycle. Savings accumulate when there is no immediate outlet for them in the form of new investment opportunities. When times become more favourable, these savings are invested in new industrial projects, and a wave of investment occurs that sweeps the rest of the economy along with it. The new investment creates new income, which in turn acts as a further stimulus to investment. In 1894 an early observer of this phenomenon, the Russian economist Mikhayl Tugan-Baranovsky, published a study of industrial crises in England in which he maintained that the cycle of investment continues until all capital funds have been used up. Bank credit expands as the cycle progresses. Disproportions then begin to develop among the various branches of production as well as between production and consumption in general. These imbalances lead to a new period of stagnation and depression.Monetary theoriesSome writers have ascribed economic fluctuations to the quantity of money in circulation. Changes in the money supply do not always conform to underlying economic changes, and it is not difficult to see how this lack of coordination could produce disturbances in the economic system. Thus, an increase in the total quantity of money could cause an increase in economic activity.The banking (bank) system, with its ability to expand the supply of credit in an economic expansion and to contract the supply of credit in time of recession, may in this way amplify small economic fluctuations into major cycles of prosperity and depression. Theorists such as the Swedish economist Knut Wicksell (Wicksell, Knut) emphasized the influence of the rate of interest: if the rate fixed by the banking system does not correspond to the “natural” interest rate dictated by the requirements of the economy, the disparity may of itself induce an expansion or contraction in economic activity.Rational expectations theoriesIn the early 1970s the American economist Robert Lucas (Lucas, Robert E., Jr.) developed what came to be known as the “Lucas critique” of both monetarist and Keynesian theories of the business cycle. Building on rational expectations concepts introduced by the American economist John Muth, Lucas observed that people tend to anticipate the consequences of any change in fiscal policy: they “behave rationally” by adjusting their actions to take advantage of new laws or regulations, inevitably weakening or undermining them. In some cases, these actions are significant enough to offset completely the outcome the government had hoped to achieve.Although he was criticized for overstating the connection between human behaviour and economic rationalism, Lucas influenced other 20th-century economists who asserted that business fluctuations resulted from underlying changes in the economy. Historically, according to their view, economic fluctuations have been marked by periods of innovation followed by slower periods during which the innovations were absorbed. Business cycles, therefore, serve as adjustments to underlying conditions—adjustments that are necessary if economic growth is to continue.Since the Great Depression, many governments have implemented anticyclical policies designed to offset regular business fluctuations. The increasing complexity and diversification of modern economies, however, have tended to reduce their dependence on any one sector, thereby limiting the possibility of boom-and-bust effects resulting from specific industries.Henri Guitton Ed.Additional ReadingGood introductions to the study of business cycles include Erik Lundberg (ed.), The Business Cycle in the Post-War World (1955, reprinted 1986); R.C.O. Matthews, The Business Cycle (1959, reissued 1967); Robert Aaron Gordon, Business Fluctuations, 2nd ed. (1961); Alvin Harvey Hansen, Business Cycles and National Income, expanded ed. (1964); and Henri Guitton, Fluctuations et croissance économiques, 3rd ed. (1970). Famous surveys of business-cycle theories are Joseph A. Schumpeter, Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process, 2 vol. (1939, reissued 2006); and Gottfried Haberler, Prosperity and Depression, 5th ed. (1964, reissued 1968). J. Tinbergen, Statistical Testing of Business-Cycle Theories, 2 vol. (1939, reissued 2 vol. in 1, 1968), attempts to verify by econometric analysis the theories surveyed in Haberler's work. The nontheoretical approach to business-cycle research is set forth in Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles (1946); and further developed in Geoffrey Hoyt Moore, Business Cycle Indicators, 2 vol. (1961). Important articles are collected in American Economic Association, Readings in Business Cycle Theory (1944, reprinted 1980), and Readings in Business Cycles (1965). History and politics are dealt with in Vivian Walsh and Harvey Gram, Classical and Neoclassical Theories of General Equilibrium; and James E. Alt and Kenneth A. Shepsle (eds.), Perspectives on Positive Political Economy (1990).The basic principles of macroeconomics, which include cyclical analysis, may be found in any contemporary textbook of economics. Two good introductions to this subject are George T. McCandless, Jr., Macroeconomic Theory (1991), neoclassical in approach; and Joseph Stiglitz, Economics, 4th ed. (2005), Keynesian-oriented. At the intermediate level, two competing alternative theories of national income are presented in Robert J. Barro and Vittorio Grilli, European Macroeconomics (1994), which applies the intertemporal equilibrium approach to macroeconomic analysis; and Rudiger Dornbusch, Stanley Fischer, and Richard Startz, Macroeconomics, 9th ed. (2004), which follows an IS-LM (an economic equilibrium model measuring trade-offs between the market for goods and bonds and the market for money) approach.More specialized or intensive treatments of macroeconomics are John Maynard Keynes, The General Theory of Employment, Interest, and Money, new ed. (2006), the classic theoretical work in the field; Seymour E. Harris (ed.), The New Economics: Keynes' Influence on Theory and Public Policy (1947, reprinted 1973), a collection of early essays on Keynes and his ideas, representing the thinking of its time; and Gardner Ackley, Macroeconomic Theory (1961; also published as Macroeconomics: Theory and Policy, 1978), an introductory text. Later evaluations by leading economists of the significance and influence of Keynesian ideas may be found in Roy F. Harrod, The Life of John Maynard Keynes (1951, reprinted 1990), offering insight into the genesis of Keynes's ideas; H.G. Johnson, “The General Theory After Twenty-five Years,” in The American Economic Review, 51:1-17 (1961), providing a retrospective survey from a monetarist point of view; Robert Lekachman (ed.), Keynes' General Theory: Reports of Three Decades (1964); Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (1968, reissued 1973), an interesting but difficult appraisal of the development of Keynesian ideas; and Herbert Stein, The Fiscal Revolution in America, 2nd rev. ed. (1996), examining the relationship between Keynesian thinking and governmental policies in the United States.Some important perspectives on economic strategies that have resulted in fluctuations are John Kenneth Galbraith, Economics and the Public Purpose (1973, reissued 1975), and Economics in Perspective: A Critical History (1987); Robert E. Lucas, Jr., “Understanding Business Cycles,” in Stabilization of the Domestic and International Economy, ed. by K. Brunner and A. Meltzer, vol. 5 of the Carnegie-Rochester Series on Public Policy, Amsterdam, North-Holland, 1977; and Douglass C. North, Institutions, Institutional Change, and Economic Performance (1990).Henri Guitton Ed.
* * *