The concept and phases of the business cycle

The business cycle refers to the fluctuations in an economy's actual output growth around its long-term trend growth in productive potential. It is also known as the trade cycle or economic cycle. Over time, most economies experience gradual increases in trend real gross domestic product (GDP) due to factors such as advancements in education and technology.

Phases of the business cycle

The business cycle typically consists of four distinct phases:

1. Upturn (expansion) - The economy expands rapidly, with high levels of optimism leading to increased consumption and investment, alongside rising employment.
2. Peak - The highest point of the cycle, acting as a turning point where a positive output gap emerges, and high aggregate demand can trigger inflation and balance of payments issues.
3. Downturn - Economic growth slows or becomes negative, with falling optimism resulting in higher saving rates, failures among high-risk businesses, and reduced net investment.
4. Trough - The lowest point, characterised by insufficient aggregate demand, which may lead to a recession or depression, along with a negative output gap.

Output gaps and their relation to the business cycle

An output gap measures the difference between an economy's actual output and its potential output based on trend growth. These gaps occur during different phases of the business cycle and highlight imbalances in economic activity.

Types of output gaps

• Positive output gap - Occurs at the peak of the cycle when actual output exceeds potential output due to excessive aggregate demand, often causing inflationary pressures.
• Negative output gap - Appears at the trough when actual output falls below potential output, typically due to weak demand, leading to underutilised resources and higher unemployment.

Output gaps illustrate how the business cycle deviates from sustainable trend growth.

Explanations for business cycles

Business cycles can be explained by changes in either aggregate demand or aggregate supply, which cause swings in economic activity.

Fluctuations in aggregate demand

Variations in aggregate demand can drive business cycles through several mechanisms:

• Business confidence - Optimism boosts investment, leading to multiplied increases in GDP, while pessimism reduces spending and deepens downturns.
• Multiplier and accelerator effects - The interaction between these can cause significant rises or falls in demand.
• Money supply changes - If money supply grows faster than output, it can stimulate investment and consumption, fuelling expansions.
• Political influences - Governments may expand fiscal policy before elections to boost the economy, followed by contractions afterward, creating cyclical patterns.

Fluctuations in aggregate supply

Shifts in aggregate supply, often from supply-side shocks, can also trigger business cycles by altering productive capacity:

• Positive shocks - Improvements like technological breakthroughs (e.g., developments in artificial intelligence) expand capacity and support growth phases.
• Negative shocks - Events such as spikes in resource prices (e.g., a surge in energy costs) or natural disasters (e.g., widespread flooding damaging infrastructure) reduce supply, leading to downturns.
• Historical example - The 2020 COVID-19 pandemic caused a global recession, with many economies facing negative growth due to supply disruptions and lockdowns.

The role of automatic stabilisers in the business cycle

Automatic stabilisers are built-in economic mechanisms that help moderate the business cycle without direct government intervention. They counteract fluctuations by dampening booms and cushioning recessions, resulting in a smoother overall cycle.

How automatic stabilisers function

• During booms - Progressive taxation increases government revenue as incomes rise, which curbs excessive consumption and investment.
• During recessions - Welfare benefits automatically rise as more people require support, boosting spending and limiting the decline in aggregate demand.

These countercyclical effects reduce the amplitude of business cycle fluctuations, promoting greater economic stability.