Determinants of business cycles fluctuations
If businesses were operating in a perfect environment, there would be no reason to worry about recessions and failures. A perfect business environment is where all the necessary requirements are met, and there is an equilibrium between supply and consumption. In such an environment, there is not monogamy, and no firm has the incentive to alter the prices set by the markets. Everything works in perfect harmony with supply equal to demand. Consumption is high because there is perfect information, and consumers know everything about the products – manufacturers also share information freely. In such an environment, every participant is satisfied.
But this is far from the modern business environment. The condition described above is only theoretical. In other words, it is only used as a point of reference for what businesses should look like. The true condition of the state is the imperfection competition. Some firms within markets are biggest than others, and they drive the price of commodities. Since they are seen as producers of standard quality products, their products are valued higher and target the higher market whereas the other the class if left with cheaper products for the lower market. This just the nature of the business, and there is nothing anyone can do about it.
One thing common for both conditions is the business cycle. Economies are never stable. At one point, markets would be experiencing the best inputs and outputs, with pricing heading towards stability, and another point consumption would be dropping, forcing a different direction of prices. Business cycles are important determinants of economic conditions in the world. When things are working well within markets, the same condition is extended to the general economy. And when markets are overwhelming by internal and external factors to the point of failure, the same is spread to the economy. This is where you will find different governments coming up with fiscal and monetary policies to help such businesses stay on the cause. Initiatives to revive such a market can involve the government buying or selling shares to and from the involved parties.
Business cycle fluctuations are related to the volatility of economic growth and the different stages of an economy. Consider the Great Recession of the 2008/2009 financial markets failure that spread across many other economies, for instance. It all started with a burble, with markets seemingly stable and doing well. Financiers became comfortable and loosened their lending terms greatly. Most assets used to cover loans from borrowers come from the housing industry, which boomed at the moment. And because the economy seemed to be at its best, the lenders did not take much consideration into vetting the ability of the borrowers to repay the loans. It was not until the value of the collateral properties dropped significantly that this mistake becomes apparent. Now they only relied on the truthfulness of the lenders to repay. Those who could not recover their investment went into a state of depression, with may failing completely.
Different factors are responsible for business cycles. In some instances, it could be the cause of only one factor, whereas, in other situations, it could be a combination of different reasons. Such factors include interest rate, confidence, credit cycles, and multiplier effect. Some economies focus on the supply-side explanation of business cycles mentioning factors such as technological shocks. Business cycles are a long process that happens over a certain period of time. One business cycle is measured and counted from the end of the previous cycle. For example, economists can look at the quarterly economic growth in the UK between, say 1978 and 1995. In this case, they will pick the two recessions of 1980 and the one in 1990/1992, and compare them to the periods of the recovery and boom that preceded or followed.
The average rate of economic growth in the UK is about 2.5%. This, therefore, means that the long-run trend rate of this economic growth around this percentage. But this is not the actual growth rate. The truth is, the actual growth can vary widely from the average because it goes through different stages of the business cycle. Consider the case of the 1980s period, for instance. There was a rapid growth of the economy by more than 4%. Many became comfortable with the condition and rushed to make their investments without considering many risk factors. And when it was discovered such growth was not sustainable, it led to inflation, and later to the recession of the early 1990s.
Phases of a business cycle
There are four major phases of business cycles;
The economic growth
This is where the boom is witness. There is a real increase in the output causing and increase in supply as demand surges as well. Everything happens right within the economic environment. The markets are enjoying more liquidity, with consumers taking advantage of stabilizing prices. Producers are all in the right condition as prices of goods keep increasing with demand. There are a low inflation rate and unemployment, making more people more comfortable to spend than save. Lenders at this period lessen the lending terms, and borrowers show promise of repaying with ease.
In the period preceding the 2008/2009 recessions, there was an economic bubble, an economic boom, characterized by faster growth of an economy, which tends to be inflationary and unsustainable. It is a rapid growth of an economy that leads markets into believing businesses are all doing well, and the rate of consumption is increased. Everything is on an upward trend, including price within a market. Such a condition attracts more competition, which later ends up with adverse effects. It may seem like competition is good, but when it leads to poor market conditions in the long-run, such as a risk most markets will not hear of.
And economic boom can be compared to an elastic rubber band. When you apply pressure to it by pulling, it stretches as far as possible until it hits its elastic point, and it cannot stretch any further. This point is like the peak of an economic boom. From here, the economy can only head down. The economic downturn is described as the condition where economic rate falls, and the economic growth becomes negative, extending towards recession. It is at this point that markets start putting into action precautionary measures to protect themselves from impending failure.
This condition is the opposite of economic growth. It is initiated by an economic downturn that leads everything towards the negative. A recession happens when there is a period of negative growth, and there is a big drop in real output. Whereas economic growth ends at the peak, economic recessions end the trough – the lowest point at economic growth can drop to. This is where many markets fail, and governments are forced to come up with different fiscal and monetary policies to restore the economy.
What determines the business cycle?
There are a number of factors that cause business cycles. The most common ones include the following:
Interest rate and exchange rates
Businesses depend on borrowing funds for their expansion. In this case, the rate of lending becomes critical, both in terms of making a profit and comfortably repaying the loans. When interest rates change, therefore, they affect consumer spending and economic growth at large. For instance, if these rates are cut, they reduce borrowing costs while increasing disposable income for consumers. In this case, the end result becomes higher spending and economic growth. But if the Central Bank decides to increase the lending rate, it discourages consumers from borrowing, which reduces spending and investment, such a condition will lead to an economic downturn and recession. In 1991-92 the recession that happened was attributed to high-interest rates. Note, however, that sometimes the interest is increased or reduced to control the economic cycle.
Trade between countries is one of the major contributors to economic growth. This is where exchange rates come in. Countries always struggle to ensure their currencies are higher in value than others so that they can be favored in exchange rates. High economic rates can scare potential investors away while very low rates can devalue the goods from the involved country. This means, for a stable economy, a country must ensure stability in the exchange rates. This affects most firms that operate across international borders.
Changes in house prices
During the period leading to the 2008/2009 Great Recession, the price of houses was surging. It was, for this reason, the lenders become too comfortable and started offering loans without properly investigating the ability of the borrower to repay. This rise created a positive wealth effect and led to higher consumer lending. And then house prices dropped abruptly, leading to less consumer spending at the banks. This led to one of the worst economic recession the world has ever seen. Many businesses dropped in output and went out of the market completely.
Consumer and business confidence
Business market and advertise a lot because they want to make a good reputation for the consumer. People are rational decision-makers who are easily influenced by external activities. This means anything happening within an economy affects how they make decisions. If, for instance, there is a succession of bad news, this tends to discourage consumers from spending and investing, this condition can create a big recession out of a small downturn. When the economy recovers, this situation can create a positive bandwagon effect. The good economic growth is where consumers are ready to easily borrow and banks to lend, which leads to higher economic growth. Confidence is a critical factor in the business cycle.
In the multiplier effect, the fall in projections can cause a big final fall in the real GDP. For instance, if a government reduced public investment, there would be low aggregated demand and a rise in the unemployment rate. This means those who lose their jobs will spend less too, which leads to an even lower demand within and economy. The most rational step would be to inject investing in the markets, which gives rise to a positive multiplier effect.
This effect states that the rate of investment depends on the rate of change in the growth of an economy. If there is a fall in the growth, it leads to reduced investment, which means firms reduce their investment because they do not expect a quick rise in the investment. According to this thought, investment is more volatile, and small changes in the growth rate can greatly affect investment levels.
Lending and finance cycle
During the 2008 recession, there was less emphasis on the condition of the financial system. But the credit crunch of this period become a major contributor to the recession that followed. There was a boom in credit and lending, especially in sub-prime lending across the US, which promoted economic growth during the 2000s. However, banks were stretched beyond their elastic point and needed to call for a loan. The credit crunch has since created more attention to theories of financial stability.
Some economists believe that there is a natural inventory cycle. For instance, there are certain goods referred to as ‘luxury goods’ that consumers but every three years or so. In a downturn, consumers delay buying these goods, which leads to a bigger downturn.
Recession and its cause
A business cycle can go into recession as influenced by a set of different factors. Some of the major factors include falling house prices, which cause a negative wealth effect and lower spending from consumers. This effect is similar to a credit crunch that causes and increase in the cost of borrowing and a shortage of funds. Apart from these, volatile stock, higher interest rates, tight fiscal policy, and appreciation of exchange rates are all part of the wider cause of business cycle fluctuations.
The business cycle has a huge impact on the general economy. Some experts look at it as an essential aspect of economic development and growth. This means even downturns play an important role as it tends to ‘shake and sieve out’ the economy, getting rid of ‘unwanted weed.’ Only the strong survive. Nevertheless, this view remains highly controversial.
Author: James Hamilton