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Information > Financial Terms > This page Business Trade Cycle An
interval that embraces alternating periods of business prosperity and
depression. It is one of the
most significant phenomena of the capitalistic system and appears to be
an outgrowth of a system in which production requires considerable capital
investment and some lead time before consumption.
Business cycles are characterized by a series of phases that are
more-or-less predictable in occurrence but not necessarily in timing or
intensity. In the 1. Crisis.
This is the turning point or decisive moment that marks the collapse
of a period of prosperity, rising prices, increasing shortages, and considerable
speculation in the expectation that prices will rise faster.
Crisis is likely to be followed by panic, primarily a financial
phenomenon characterized by a collapse of the credit structure; a universal
demand for money payments; lack of confidence in the ability of debtors
to pay debts; and usually a series of important business, brokerage, and
banking failures, often brought about by the mounting accumulation of
inventories acquired at high prices and financed on credit.
Because of the sudden demand for cash, banks are the storm centers
of the panic. If important
bank failures occur, bank runs, even on sound banks, are likely to ensue,
placing a great strain upon the banking system.
Interest rates may rise to entice depositors to leave their funds
with financial intermediaries. 2. Emergency
liquidation.
Following the crisis (and panic, if one occurs) comes a period
emergency liquidation. During
the previous period of prosperity and high demand, production boomed,
eventually leading to an overall accumulation of high-priced inventories.
When the crisis ends the period of high prices, businesses are
eager to unload these inventories before prices decline, and they place
goods on the market for whatever they will bring.
This tendency is exacerbated by high rates of interest, which makes
holding inventories expensive in a flat or falling market. 3. Depression.
This is a period of low prices and drastic curtailment of production,
resulting in widespread unemployment, reduction or elimination of profits,
overcapacity in production facilities, many business failures, and a general
reluctance or inability to use credit or to make new capital investment
or spend on consumption. Interest
rates drop in nominal terms but may remain high in real terms. 4. Readjustment.
When the bottom of the price movement has been struck, the period
of readjustment begins. It
is characterized by an irregular and uneven process of price stabilization
and readjustment of supply/demand relationships.
Business becomes "leaner and meaner" - inefficient businesses have
been eliminated, production costs are lower, and competition is sharper.
Survivors tend to accumulate liquidity rather than other assets.
Interest rates are low in real terms. 5. Recuperation
or revival.
The period of readjustment blends so imperceptibly into the recuperative
phase that the latter is not easy to detect.
By this time, the deflation process has been completed, bank reserves
are high, and interest rates are low.
The combination of easy credit and lower prices begins to stimulate
demand, first through revival of consumer spending and eventually through
business expansion. Unemployment
begins to decline. 6. Prosperity.
As the demand for goods increases,
industrial activity picks up and more labor and capital are employed,
resulting in increased purchasing power.
This, in turn, stimulates demand.
Because inventories are comparatively low, production and deliveries
lag orders, and idle labor and productive capacity are pressed into service.
This condition leads to increased production costs and rising wages,
prices, and profits. With
the revival of credit demand, interest rates begin an upward trend. 7. Overextension
and speculation. Eventually,
businesses find existing plant and equipment inadequate to supply the
demand. This leads to an expansion
of capital spending but at higher cost and at higher interest rates on
borrowed money. Although product
prices and profits are rising, production costs tend to rise faster as
less productive inputs are brought into use.
To maintain profit levels, producers raise product prices until
they meet buyer resistance, which sets the state for another crisis. Many
hypotheses have been advanced as to the cause of the business cycle.
Haberler (Prosperity and Depression, 3rd ed.,
1952) has identified the following classification of theories:
(1) purely monetary; (2) overinvestment; (3) changes in costs,
horizontal maladjustments, and over indebtedness; (4) underconsumption;
(5) psychological factors, and (6) the harvest theories (relating agriculture
and the business cycle, including the sun spot theories). The
analytical tools found in Keynes General Theory of Employment, Interest
and Money (1936) - liquidity preference, marginal efficiency of capital,
and the consumption function - are compatible with any of the above theories,
but Keynes himself seemed to stress the psychological factors, emphasizing
the role of expectations in the behaviour of both consumers and investors.
Followers of Keynes, however, cite underconsumption or oversaving
- both consequences of changed expectations - as casual factors. A
monetarist school, led by Milton Friedman and often called the Chicago
school because of his position on the faculty of the University of Chicago
has emphasized the importance of changes in the money supply as being
more important than interest rates in determining the national economic
health. In its simplest form,
the approach argues that the central government should ensure modest but
regular increase in the real money stock to allow for orderly long-run
growth. This approach found
much favor in the early 1980s but proved more difficult to implement than
expected. In
recent times, the great debate regarding business cycles is whether government
countercyclical measures now preclude the possibility of a serious depression.
Since the Great Depression of the 1930s many measures have evolved
that are intended to take the "edge" off of the traditional business cycle.
FISCAL POLICY and MONETARY POLICY, acting within a more effective
institutional environment, can derail economic developments that once
led inexorably to crisis. AUTOMATIC
STABILIZERS help prop up or slow down consumer spending that might otherwise
exacerbate cyclical lows and highs.
Greater regulation of financial institutions and practices helps
prevent panic and abuse. Better
economic information helps prevent the unanticipated accumulation of inventories. A
counterargument is that private investment is the keystone of cyclical
phenomena. Investment responds
to changes in sales expectations - that is, it anticipates demand but
not in time to stimulate investment based on expectations of demand.
Automatic stabilizers might slow down but could not prevent a prolonged
downtrend in business activity. Fiscal
policy mechanisms are slow and cumbersome and monetary policy alone cannot
actively stimulate business investment if the business community does
not anticipate sustained or increased demand for products and services.
(It can, however, discourage business investment by raising the
cost of credit.) Therefore,
competitive markets, rather than government directives, are as a rule
the most efficient instruments for organizing production and consumption.
The government creates an atmosphere favorable to economic activity
when it encourages private initiative, curbs monopolistic tendencies,
avoids encroachment on the private sector, and "privatizes" as much as
of its own work as is practicable. In
the mid-1970s, partly as a result of the large increases in the price
of oil, the economy was confronted with "stagflation", characterized by
the coexistence of inflation and stagnant or falling demand.
This combination tested many economic theories and in 1974-75 produced
the most severe recession since the 1930s.
In late 1979, the Federal Reserve Board tightened credit severely
to bring inflation under control.
This policy dampened the economy during the early 1980s but also
set the stage for the long period of prosperity that was still in progress
in 1988. The
National Bureau of Economic Research has measured the duration of Major
business cycles expansions and contractions from 1919 to 1987 are presented
in the appended table. BIBLIOGRAPHY AUERBACH,
A.J. "The Index of Leading
Indicators: 'Measurement Without
Theory, 'Thirty-Five Years Later."
The Review of Economics and Statistics, November, 1982. |