Question

4. Consider the situation where there has been a decline in real GDP growth rates, inflation, and employment rates. What part of the business cycle do you think the economy is currently in? what other indicators could you use to confirm this? – Word count 100

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Answer 1

A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural growth rate. It explains the expansion and contraction in economic activity that an economy experiences over time.

A business cycle is completed when it goes through a single boom and a single contraction in sequence. The time period to complete this sequence is called the length of the business cycle. A boom is characterized by a period of rapid economic growth whereas a period of relatively stagnated economic growth is a recession. These are measured in terms of the growth of the real GDP, which is inflation adjusted.

Stages of the Business Cycle

In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves about the line. Below is a more detailed description of each stage in the business cycle:

1 Expansion

The first stage in the business cycle is expansion. In this stage, there is an increase in positive economic indicators such as employment, income, output, wages, profits, demand, and supply of goods and services. Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment is high. This process continues until economic conditions become favorable for expansion.

2 Peak

The economy then reaches a saturation point, or peak, which is the second stage of the business cycle. The maximum limit of growth is attained. The economic indicators do not grow further and are at their highest. Prices are at their peak. This stage marks the reversal in the trend of economic growth. Consumers tend to restructure their budget at this point.

3 Recession

The recession is the stage that follows the peak phase. The demand for goods and services starts declining rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive economic indicators such as income, output, wages, etc. consequently start to fall.

4 Depression

There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as this falls below the steady growth line, the stage is called depression.

5 Trough

In the depression stage, the economy’s growth rate becomes negative. There is further decline until the prices of factors, as well as the demand and supply of goods and services, reach their lowest. The economy eventually reaches the trough. This is the lowest it can go. It is the negative saturation point for an economy. There is extensive depletion of national income and expenditure.

6 Recovery

After this stage, the economy comes to the stage of recovery. In this phase, there is a turnaround from the trough and the economy starts recovering from the negative growth rate. Demand starts to pick up due to the lowest prices and consequently, supply starts reacting, too. The economy develops a positive attitude towards investment and employment and hence, production starts increasing.

Employment also begins to rise and due to the accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced by producers, leading to new investment in the production process.

Recovery continues until the economy returns to steady growth levels. It completes one full business cycle of boom and contraction. The extreme points are the peak and the trough.

The Business cycle is in the recession stage if there is a decline in the real GDP rate, inflation and employment rates. If this gets worse it will enter into the depression stage.

A recession is defined as a decline in real GDP for two consecutive quarters. An economy is in an official recession after six months of falling national income. A recession will typically lead to higher unemployment, a decline in confidence, falling house prices, decline in investment and lower inflation.

The ability to know whether you’re in a recession is important for policymakers. As soon as you know a recession is occurring or likely to occur, the Central Bank can cut interest rates, and the government may wish to pursue expansionary fiscal policy. The sooner you know the better because monetary and fiscal policy can itself have a time lag.

Consumer confidence is an indicator of whether people are optimistic or pessimistic about the economic future. This is often a reflection of the economic situation. If consumers see people being made unemployed, or if it is difficult to get bank loans or house prices falling, they will have negative confidence. In this situation, they will spend less – leading to lower aggregate demand and this will tend to cause negative economic growth.

A fall in stock markets could be an indication of a decline in economic sentiment. However, the stock market is a poor guide to economic forecasting. For example, in 2002-04, the stock market has a long decline – despite good economic growth