Business Cycles and Their Characteristics - Online Tutor, Practice Problems & Exam Prep

The business cycle consists of fluctuations in real GDP, characterized by periods of expansion and recession. During expansions, GDP and employment rise, while interest rates and wages increase. Conversely, recessions see GDP and employment decline, leading to higher unemployment and lower inflation. Key factors influencing these cycles include irregular innovation, productivity changes, monetary policy, and political events. Understanding the relationship between unemployment and inflation is crucial, as they move in opposite directions. Notably, a "jobless recovery" can occur when economic growth resumes but unemployment remains high.

Business Cycle Characteristics

Alright. Let's talk in a little more detail about the business cycle. So remember, the business cycle is where we're tracking fluctuations in specifically real GDP. Remember, when we talk about real GDP, that's adjusting for inflation because we want to see, without the effect of inflation, how real GDP is flowing over time. We're going to see periods of increase and decrease and like we saw on that graph of the business cycle, it's going to look something like this. So, we're going to have GDP here and time on this axis over here. Right? And we saw that the business cycle kind of looks something like this where we're increasing for some time, then we top out, start decreasing, bottom out, and increase. Something like that, right? Where it goes up and down, up and down.

So, what we talk about... We've mentioned these before but let's go through them real quick. We've got the recession, right? The recession is when we're going down, when the economy is in a downturn. So, we see that GDP is decreasing and during this period of GDP decreasing, the jobs are going away as well. So, we also see that employment is decreasing. So, GDP and employment are decreasing during a recession. There are fewer jobs available and less production happening. Firms aren't investing as much, and we call these contractions of the economy, right? Recession, contraction. They mean the same thing and then eventually, we're going to bottom out. We're going to hit the bottom in a trough. So, this trough is the bottom and that's the point where the economy turns from this recession into an expansion. Right? So, we're going to start growing again, and this expansion, well, it's the opposite of the recession. In the recession, we're decreasing GDP and employment. Well, now GDP and employment are now increasing again. Alright? And another term for expansion is recovery. Right? We're recovering from this recession. We're on the upturn.

So, that's the expansion and then eventually, we're going to hit the top, right? We're going to peak and that's the top of the business cycle and this is the point where the economy turns now from the expansion back into a recession. So, on our little graph here, let's point out our peaks and our troughs. So, we've got right here, what do we have right here at this point right here? Is that a peak or a trough in our business cycle? That one's a trough, right? It's the very bottom before it turns into an expansion. Here's another one right here, trough. And on the other side here, these top points are peaks. Peak right there and a peak right there. Right? So, we're going to keep seeing that. That's how the business cycle goes. Expansion to a peak, through a recession, to a trough, expansion, right? And it's going to keep going through that as a cycle.

So, although each business cycle is different, what we're going to notice is that each one is different, especially in terms of length. Sometimes, the recessions are long; sometimes, the recessions are short. The expansions can last a very long time or a very short time in between them, but however, what we see is that there are general characteristics that are the same when we analyze all of our business cycles. So, let's go through some of these general characteristics. Let's start here with the expansion phase. So, throughout the expansion phase, what we see is that there's an increase in interest rates while firms are investing, they're spending more, and the interest rates continue to increase throughout that expansion. So, as those interest rates increase, we also see increases in wages. So, the workers are making more money and the price levels are going up as well. So, everything's going up. Interest rates are up, wages are up, price levels are up. However, one thing that starts to happen towards the end of the expansion is that these wages increase faster than the price level. So, what does that do? Well, the wages to the firms, this is an expense while the price level that's the revenue of the firm. Right? That's the money they're bringing in, but the expenses are going up faster than the revenue. So it leads to lower profit. It leads to lower profit for the firms and this is as the expansion nears the end of the expansion. This is where this starts to happen because throughout the expansion, those wages are increasing, but the price levels don't keep up with the wages throughout the expansion which eventually leads us to turn around. So, another thing that happens during this expansion phase is there's a lot of spending going on. Not only from the firms investing but also from the household spending, the increased wages that they earn, they increase their spending as well. And to finance this spending, maybe they're buying new cars, new houses, well, they take on debt, right? The households and firm debt increases during the expansion phase, which eventually they're going to have to pay back, right? So eventually, this increase in debt leads to a reduction in spending because they're going to have interest to pay back as well as the principal. So, that's going to reduce their spending over time as well, right? When they have to finally pay that back. So, that's what happens during the expansion. We see everything going up. Interest rates, wages, prices, everything's going up and then eventually that debt starts to pile up and we have a decrease in spending. So, what the first thing that kind of ticks when we have a recession is that we see a decrease in spending specifically on capital goods. So, capital goods remember, this is firms investing, firm's investment where they're not building factories, not buying machinery, right? They're not looking into the future as much because they've had all this spending, they piled on this debt and they're not able to purchase much more in the capital goods category as that recession begins. So, we start to see lower firm investment and this lower investment less spending leads to higher unemployment. There's not as much expansion going on. They're not growing their business as much and we see that they're not hiring as much leading to more unemployment and then the higher the unemployment, well, now not only do the firms have less money, but the households have less money, right? If they're not employed, they're not making money. So, it further decreases spending leading to a deeper recession, right? So towards the beginning of the recession, we see a decrease in capital goods leading to unemployment, leading to further decrease in spending from the households and then the recession, it bottoms out finally. There's going to be a turnaround at some point and we basically see this happen. It eventually turns around, right? At the end of the recession. So, what generally causes that is that these debts are repaid, right? They were taking on a lot of debt and they finally repay, the debt that was owed which allows an increase in spending again, right? So, a lot of the issue with recession with the business cycle with the recessions is generally a decrease in spending, right? When there's less spending going on, well, it doesn't allow firms to invest, it doesn't allow firms to hire people, right? So the spending is a key factor in these business cycles. So, just like we saw during the expansion interest rates going up, well, during the recession, interest rates were also declining and at these lower interest rates, guess what? People are able to borrow and spend again, especially the firms. Again, the focus here on capital goods being the investment firm investment allowing for the expansion to happen again, right? The recession ends, firms are investing again allowing for another expansion of the economy. Cool? So those are some general characteristics that we see during the expansion and recession. Okay? So, what we've got here at the bottom of the page, we've got one more thing to look at and this is just what the recessions have looked like in the past 60 years or so in the US economy. So notice, we've got here on the left. We've got the peaks which is the top and the trough the bottom of the economy here, the bottom of the business cycle, and everything in between. Well, that is our recession, right? So notice how each recession has been a little different, some lasted short, somewhere 8 months, 6 months and we've had long ones 10, 12, 11, 16, 18 months down here. This last recession on our chart December 2007 through June 2009, well, this one we term as the Great Recession that just happened just a few years ago and this was when we had the problems in the real estate market that led to more and more problems with all sorts of debt and professors love to talk about the great recession. We're going to have more videos about the great recession throughout these chapters and how it relates to macroeconomics. So, it's just good to know that this one definitely comes up quite a bit in this class just because it was so long and obviously so recent. Cool? So, let's pause here and on the next page, we'll discuss a few more things about the business cycle, all right? Let's do that now.

Causes of Business Cycles

So why do we go through business cycles? Why aren't we just constantly growing? Why is there growth and then recession and then growth again? Why doesn't it happen smoothly? Well, it's because events happen rather sporadically, spontaneously. We get shocks to the standard flow of things that cause unexpected booms and severe recessions in the market. The main idea here is that these events occur spontaneously. When we experience a shock in the market, it's going to cause an unexpected growth or recession.

The first factor is irregular innovation. There are going to be big inventions and revolutionary technologies that cause economic booms, like when we had the railroad, automobiles, or most recently the internet. When these technologies were created, there was a sudden expansion in our economy that was unprecedented. After one of these inventions, there's unprecedented expansion, but eventually, our economy will absorb this new technology. All that expansion that happened when the railroad was built has now fueled new growth in the logistics business. However, this logistics business will eventually cap out. The transportation of people from East to West is going to reach its peak and will be absorbed by the economy. Thus, that expansion must eventually end. Growth is going to slow down from that new technology until a new technology emerges. These ideas occur sporadically; it's not like every 5 years we have a new revolutionary idea. We can't plan on it like that; it just happens all of a sudden.

Another factor is changes in productivity, similar to irregular innovation. Changes in productivity can be caused by new technologies, an increased availability of resources or even human capital. For example, a new public education system could lead to more human capital, leading to higher productivity, which could lead to unexpected booms and busts. Likewise, the discovery of a new oil deposit and the subsequent decrease in oil prices, allows more businesses to invest and use oil to boost the economy. Any kind of shock like this in the availability of a key resource can lead to a shock in the economy.

Another shock to the economy comes from monetary factors. This is more controlled because it involves monetary policy by the Federal Reserve. This policy is generally aimed at fixing a recession or helping the economy in some way through changes like printing money or buying and selling bonds.

Political events also play a role. An unexpected war, peace, or act of terrorism can cause a shock to the economy, either stimulating a boom or leading to a bust. Finally, there is financial instability from market bubbles, like the one we saw in 2008 during the recession, which was in the real estate market. The burst of this huge bubble led to an unexpected decrease in real estate prices, spiraling into a major recession.

Let's pause here, and we'll continue with a conclusion about our discussion on business cycles in the next session.

Key Ideas of the Business Cycle

All right. One of the key things to remember about the business cycle, about our recessions and our expansions, is the connection to unemployment and inflation. All right? What we see is that during a recession, unemployment tends to increase, right? And that should come logically, right? Unemployment increases during the recession. There are no jobs available. So there's a lot of unemployment. Unemployment increases. So, what do you think happens during an expansion? Well, now businesses are spending, businesses are hiring, right? They are expanding their businesses. So, unemployment decreases during an expansion. And the key thing to remember is that they're opposites. Unemployment and inflation are opposites. So, they kind of go in opposite directions. So, during a recession, while unemployment is increasing, well, during a recession, inflation is decreasing, right? Because there's no one spending money, those price levels are dropping trying to sell inventories, trying to get rid of money, we see that price level start to drop again during a recession and guess what? What do you think happens during an expansion? Everyone's making more money, wages are going up, everything's going up, we've got an increase in inflation, right? Inflation increases during an expansion. Cool? So, that's a key thing to remember is this opposite effect of unemployment and inflation. Now, I think the easiest thing to remember is that unemployment during a recession, what do you think? Unemployment during a recession? I think that flows very logically. Unemployment during a recession is going to increase. There are no jobs available. So if you can remember that unemployment during a recession increases, well, you can remember everything else here because everything happens in opposites. Right? So, unemployment increasing during a recession. Well, you'll remember that inflation decreases because it's going to be the opposite. Okay? Unemployment and inflation, they tend to be opposites there. So, one more weird term that they like to bring up, and this actually happened during the latest recession, is a jobless recovery. So, this is where what seems to happen when we start to have a recovery and expansion. However, so we're going through a period of growth. So we're going through an expansion and this tends to happen right after a recession or we're going through an expansion. However, the unemployment rate is still rising and that's called a jobless recovery because we're starting to see growth again, where we're starting to see production grow again. However, there's still unemployment. The unemployment problem is not getting fixed and this happened during actually each of the last 3 recessions since 1990. So, when you go back up to the chart, there were jobless recoveries after each of the 3 last recessions since 1990. All right? So, that's about it here. These are some key facts to remember about the business cycle. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What are the main phases of the business cycle?

The business cycle consists of four main phases: expansion, peak, recession, and trough. During the expansion phase, real GDP and employment rise, interest rates and wages increase, and overall economic activity grows. The peak is the highest point of economic activity before a downturn. In the recession phase, real GDP and employment decline, leading to higher unemployment and lower inflation. The trough is the lowest point of economic activity before the economy begins to recover. Understanding these phases helps in analyzing economic trends and making informed decisions.

How do irregular innovations impact the business cycle?

Irregular innovations, such as revolutionary technologies or significant inventions, can cause sudden expansions in the economy. Examples include the advent of the railroad, automobiles, and the internet. These innovations lead to unprecedented economic growth as new industries and opportunities emerge. However, once the economy absorbs the new technology, the growth rate slows down until another innovation occurs. This sporadic nature of technological advancements contributes to the fluctuations observed in the business cycle.

What is a jobless recovery in the context of the business cycle?

A jobless recovery occurs when the economy begins to grow again after a recession, but the unemployment rate remains high. This means that while GDP and production are increasing, the job market does not immediately improve. This phenomenon was observed in the last three recessions since 1990. It highlights the lag between economic growth and employment recovery, indicating that other factors, such as technological changes or structural shifts in the economy, may be at play.

How do monetary factors influence the business cycle?

Monetary factors, controlled by the Federal Reserve, significantly influence the business cycle through monetary policy. By adjusting interest rates, controlling the money supply, and engaging in open market operations, the Fed can either stimulate or cool down the economy. For instance, lowering interest rates can encourage borrowing and spending, leading to economic expansion. Conversely, raising interest rates can reduce spending and investment, potentially leading to a recession. These actions aim to stabilize the economy and control inflation.

What is the relationship between unemployment and inflation during the business cycle?

Unemployment and inflation typically move in opposite directions during the business cycle. During a recession, unemployment increases as businesses cut back on hiring and production, leading to lower inflation due to decreased spending. Conversely, during an expansion, unemployment decreases as businesses hire more workers and increase production, leading to higher inflation as demand for goods and services rises. This inverse relationship is crucial for understanding economic conditions and making policy decisions.