Business Cycle


Business Cycle, a term used in economics to designate changes in the economy. Ever since the Industrial Revolution, the level of business activity in industrialized capitalist countries has veered from high to low, taking the economy with it.


The timing of a cycle is not predictable, but its phases seem to be. Many economists cite four phases—prosperity, liquidation, depression, and recovery—using the terms originally developed by the American economist Wesley Mitchell, who devoted his career to studying business cycles.

During a period of prosperity, a rise in production becomes evident. Employment, wages and profits increase correspondingly. Business executives express their optimism through investment to expand production. As the upswing continues, however, obstacles begin to occur that impede further expansion. For example, production costs increase; shortages of raw materials may further hamper production; interest rates rise; prices rise, and consumers react to increased prices by buying less. As consumption starts to lag behind the production, inventories accumulate, causing a price decline. Manufacturers begin to retrench; workers are laid off. Such factors lead to a period of liquidation. Business executives become pessimistic as prices and profits drop. Money is hoarded, not invested. Production cutbacks and factory shutdowns occur. Unemployment becomes widespread. A depression is in progress.

Recovery from a depression may be initiated by several factors, including a resurgence in consumer demand, the exhaustion of inventories, or government action to stimulate the economy. Although generally slow and uneven at the start, recovery soon gathers momentum. Prices rise more rapidly than costs. Employment increases, providing some additional purchasing power. Investment in capital goods industries expands. As optimism pervades the economy, the desire to speculate on new business ventures returns. A new cycle is underway.

In fact, business cycles do not always behave as neatly as the model just given, and no two cycles are alike. Business cycles vary considerably in severity and duration. Major and minor cycles can occur, with varying spans.

The most severe and widespread of all economic depressions occurred in the 1930s. The Great Depression affected the United States first but quickly spread to Western Europe. From 1933 to 1937 the United States began to recover from the depression, but the economy declined again from 1937 to 1938, before regaining its normal level. This decline was called a recession, a term that is now used in preference to liquidation. Real economic recovery was not evident until early 1941.


Apart from the traditional business cycle, specialized cycles sometimes occur in particular industries. The building construction trade, for example, is believed to have cycles ranging from 16 to 20 years in length. Prolonged building slumps made two of the most severe American depressions worse. On the other hand, an upswing in building construction has often helped to stimulate recovery from a depression.


Some economists believe that a long-range cycle, lasting for about half a century, also occurs. Studies of economic trends during the 19th and early part of the 20th centuries were made by the Russian economist Nikolai Kondratieff. He examined the behaviour of wages, raw materials, production and consumption, exports, imports, and other economic quantities in Great Britain and France. The data he collected and analysed seemed to establish the existence of long-range cycles. His “waves” of expansion and contraction fell into three periods averaging 50 years each: 1792-1850, 1850-1896, and 1896-1940. Such studies, however, are not conclusive.


Economists did not try to determine the causes of business cycles until the increasing severity of economic depressions became a major concern in the late 19th and early 20th centuries. Two external factors that have been suggested as possible causes are sunspots and psychological trends. The sunspot theory of the British economist William Jevons was once widely accepted. According to Jevons, sunspots affect meteorological conditions. That is, during periods of sunspots, weather conditions are often more severe. Jevons felt that sunspots affected the quantity and quality of harvested crops; thus, they affected the economy.

A psychological theory of business cycles, formulated by the British economist Arthur Pigou, states that the optimism or pessimism of business leaders may influence an economic trend. Some politicians have clearly subscribed to this theory. During the early years of the Great Depression, for instance, President Herbert Hoover tried to appear publicly optimistic about the inherent vigour of the American economy, thus hoping to stimulate an upsurge.

Several economic theories of the causes of business cycles have been developed. According to the underconsumption theory, identified particularly with the British economist John Hobson, inequality of income causes economic declines. The market becomes glutted with goods because the poor cannot afford to buy, and the rich cannot consume all they can afford. Consequently, the rich accumulate savings that are not reinvested in production, because of insufficient demand for goods. This savings accumulation disrupts economic equilibrium and begins a cycle of production cutbacks.

The Austrian-American economist Joseph Schumpeter, a proponent of the innovation theory, related upswings of the business cycle to new inventions, which stimulate investment in capital goods industries. Because new inventions are developed unevenly, business conditions must alternately be expensive and recessive.

The Austrian-born economists Friedrich von Hayek and Ludwig von Mises subscribed to the overinvestment theory. They suggested that instability is the logical consequence of expanding production to the point where less efficient resources are drawn upon. Production costs then rise, and, if these costs cannot be passed on to the consumer, the producer cuts back production and lays off workers.

A monetary theory of business cycles stresses the importance of the money supply in the economic system. Since many businesses must borrow money to operate or expand production, the availability and cost of money influence their decisions. Sir Ralph George Hawtrey suggested that changes in interest rates determine whether executives decrease or increase their capital investments, thus affecting the cycle.

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Basic to all theories of business-cycle fluctuations and their causes is the relationship between investment and consumption. New investments have what is called a multiplier effect: that is, investment money paid to wage earners and suppliers becomes income to them and then, in turn, becomes income to others as the wage earners or suppliers spend most of their earnings. An expanding ripple effect is thus set into motion.

Similarly, an increasing level of income spent by consumers has an accelerating influence on investment. Higher demand creates greater incentive to increase investment in production, in order to meet that demand. Both of these factors also can work in a negative way, with reduced investment greatly diminishing aggregate income, and reduced consumer demand reducing the amount of investment spending.


Since the Great Depression, devices have been built into most economies to help prevent severe business declines. For instance, unemployment insurance provides most workers with some income when they are laid off. Social security and pensions paid by many organizations furnish some income to the increasing number of retired people. Although not as powerful as they once were, trade unions remain an obstacle against the cumulative wage drops that aggravated previous depressions. Schemes to support crop prices (such as the European Common Agricultural Policy) shield farmers from disastrous loss of income.

The government can also attempt direct intervention to counter a recession. There are three major techniques available: monetary policy, fiscal policy, and incomes policy. Economists differ sharply in their choice of technique.

Monetary policy is preferred by some economists, including the American Milton Friedman and other advocates of monetarism, and is followed by most conservative governments. Monetary policy involves controlling, via the central bank, the money supply, and interest rates. These determine the availability and costs of loans to businesses. Tightening the money supply theoretically helps to counteract inflation; loosening the supply helps recovery from a recession. When inflation and recession occur simultaneously—a phenomenon often called stagflation—it is difficult to know which monetary policy to apply.

Considered more effective by American economist John Kenneth Galbraith are fiscal measures, such as increased taxation of the wealthy, and an incomes policy, which seeks to hold wages and prices down to a level that reflects productivity growth. This latter policy has not had much success in the post-World War II period.