A business cycle, also known as a boom-bust cycle, refers to the alternating periods of recession and recovery caused by changes in production and trade in a market economy. The term is often used together with the economic bubble, when prices soar far above their *intrinsic value, followed by a ‘burst’ when they plummet.
*Intrinsic value refers to the real value of a share, property, currency or option, rather that its book value or market value – its true worth.
It is the periodic, yet irregular, fluctuations (up and down movements) in economic activity, which can be measured by changes in real GDP and other macroeconomic factors.
Although they are periodic and are considered to be “cycles” it is important to note that the changes in economic activity are very unpredictable.
In this business cycle of a fictitious country’s economy, you can see moments when expansions reach their ‘peak’, then when they hit rock-bottom (troughs). During the expansion there are two periods, ‘recovery’ and later a faster period of growth known as a ‘boom’. When the boom is over, there comes the ‘bust’ – hence the term ‘boom & bust’.
A key component of the business cycle is a recession. If a country does not experience a recession, then it will not really have a business cycle, rather, just a prolonged period of economic expansion.
There are four main events that occur during a business cycle:
- Firstly there is contraction, which means that economic activity slows down.
- The economy keeps contracting until it reaches a trough (a low), at which point the contraction begins to show signs of an upcoming expansion.
- An expansion begins to occur, where economic activity starts to pick up at a rapid rate.
- Expansion reaches a high (known as a peak) and there are signs of the economy contracting again.
Economists Arthur F. Burns and Wesley C. Mitchell created the standard definition of what a business cycle is in 1946. The following was published in their book Measuring Business Cycles:
“Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.”
Artuhur F. Burns added:
“Business cycles are not merely fluctuations in aggregate economic activity. The critical feature that distinguishes them from the commercial convulsions of earlier centuries or from the seasonal and other short term variations of our own age is that the fluctuations are widely diffused over the economy – its industry, its commercial dealings, and its tangles of finance.”
“The economy of the western world is a system of closely interrelated parts. He who would understand business cycles must master the workings of an economic system organized largely in a network of free enterprises searching for profit. The problem of how business cycles come about is therefore inseparable from the problem of how a capitalist economy functions.”
Detecting where we are in the business cycle
Economists try and find out whether the economy is about to experience a cycle and determine where it is heading. This is important in planning the possible negative future economic events.
If economists believe that the economy is heading in a bad direction, then fiscal or monetary tools may be employed to try and steer it another way.
The theory of economic cycles traces back to Jean Charles Léonard de Sismondi’s 1819 Nouveaux Principes d’économie politique. His beliefs were in contrast to classical economics, an economic school of thought started by Adam Smith which denied the occurrence of business cycles.
However, Sismondi’s theories gained some traction when the first international economic crisis (ocurring during peacetime) happened in the Panic of 1825.
In 1817, Sismondi and his contemporary Robert Owen both shared their thoughts on business cycles in a Report to the Committee of the Association for the Relief of the Manufacturing Poor. In their report, the two economists stated that economic cycles are caused by overproduction of goods and underconsumption – caused by wealth inequality.
The two economists were for the intervention of government as a solution. However, their beliefs were not favored by classical economists.
Decades later Charles Dunoyer developed a theory of alternating cycles, which is thought to be heavily based on Sismondi’s theory or periodic crisis.
A graphical representation of business cycles:
Historical Business Cycles in the US:
Turning Point Date Peak
– June 2009 – Trough
– December 2007 – Peak
– November 2001 – Trough
– March 2001 – Peak
– March 1991 – Trough
– July 1990 – Peak
– November 1982 – Trough
– July 1981 – Peak
– July 1980 – Trough
– January 1980 – Peak
Video – Explanation of the Business Cycle