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Four Phases of Business Cycle

Business Cycle (or Trade Cycle) is divided into the following four phases :1. Prosperity Phase : Expansion or Boom or Upswing of economy. 2. Recession Phase : from prosperity to recession (upper turning point). 3. Depression Phase : Contraction or Downswing of economy. 4. Recovery Phase : from depression to prosperity (lower turning Point).

Diagram of Four Phases of Business Cycle

The four phases of business cycles are shown in the following diagram :-

The business cycle starts from a trough (lower point) and passes through a recovery phase followed by a period of expansion (upper turning point) and prosperity. After the peak point is reached there is a

declining phase of recession followed by a depression. Again the business cycle continues similarly with ups and downs.

Explanation of Four Phases of Business Cycle

The four phases of a business cycle are briefly explained as follows :-

1. Prosperity Phase

When there is an expansion of output, income, employment, prices and profits, there is also a rise in the standard of living. This period is termed as Prosperity phase. The features of prosperity are :1. High level of output and trade. 2. High level of effective demand. 3. High level of income and employment. 4. Rising interest rates. 5. Inflation. 6. Large expansion of bank credit. 7. Overall business optimism. 8. A high level of MEC (Marginal efficiency of capital) and investment. Due to full employment of resources, the level of production is Maximum and there is a rise in GNP (Gross National Product). Due to a high level ofeconomic activity, it causes a rise in prices and profits. There is an upswing in the economic activity and economy reaches its Peak. This is also called as a Boom Period.

2. Recession Phase

The turning point from prosperity to depression is termed as Recession Phase. During a recession period, the economic activities slow down. When demand starts falling, the overproduction and future investment plans are also given up. There is a steady decline in the output, income, employment, prices and profits. The businessmen lose confidence and become pessimistic (Negative). It reduces investment. The banks and the people try to get greater liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are cancelled and people start losing their jobs. The increase in unemployment causes a sharp decline in income and aggregate demand. Generally, recession lasts for a short period.

3. Depression Phase

When there is a continuous decrease of output, income, employment, prices and profits, there is a fall in the standard of living and depression sets in. The features of depression are :1. Fall in volume of output and trade. 2. Fall in income and rise in unemployment. 3. Decline in consumption and demand. 4. Fall in interest rate. 5. Deflation. 6. Contraction of bank credit. 7. Overall business pessimism. 8. Fall in MEC (Marginal efficiency of capital) and investment.

In depression, there is under-utilization of resources and fall in GNP (Gross National Product). The aggregate economic activity is at the lowest, causing a decline in prices and profits until the economy reaches its Trough (low point).

4. Recovery Phase

The turning point from depression to expansion is termed as Recovery orRevival Phase. During the period of revival or recovery, there are expansions and rise in economic activities. When demand starts rising, production increases and this causes an increase in investment. There is a steady rise in output, income, employment, prices and profits. The businessmen gain confidence and become optimistic (Positive). This increases investments. The stimulation of investment brings about the revival or recovery of the economy. The banks expand credit, business expansion takes place and stock markets are activated. There is an increase in employment, production, income and aggregate demand, prices and profits start rising, and business expands. Revival slowly emerges into prosperity, and the business cycle is repeated. Thus we see that, during the expansionary or prosperity phase, there is inflation and during the contraction or depression phase, there is a deflation.

Readers Question: What are the causes of business cycles? How do business cycles impact the economy? The business or trade cycle relates to the volatility of economic growth, and the different periods the economy goes through (e.g. boom and bust)

In the UK, the average rate of economic growth is about 2.5%. However, the actual growth rate can vary. For example, as the diagram above shows, the UK has experienced many economic booms and also recessions.

Graph showing the UK economy cycle. Includes three recessions in 1981, 1991 and 2009. For example, in the late 1980s, we experienced rapid economic growth of over 5% a year. However, this growth proved unsustainable leading to inflation and then a recession in the early 1990s.

Phases of the Business Cycle

1. Economic growth when real output increases.

2. Economic boom fast economic growth which tends to be inflationary and unsustainable. 3. Economic downturn when the growth rate falls and the economy heads towards recession 4. Recession when there is a period of negative economic growth and real output falls.

Causes of Business Cycle

1. Interest rates. Changes in the interest rate affect consumer spending and economic growth For example, if the interest rate is cut, this reduces borrowing costs and therefore increases disposable income for consumers. This leads to higher spending and economic growth. However, if the Central Bank increase interest rates to reduce inflation, this will tend to reduce consumer spending and investment, leading to an economic downturn and recession. See: Interest rate cycle 2. Changes in house prices

A rise in house prices creates a wealth effect and leads to higher consumer spending. A fall in house prices causes lower consumer spending and bank losses. (house prices and consumer spending) In the late 1980s, the boom in house prices caused an economic boom. The drop in house prices in early 1990s caused the recession of 1991-92. 3. Consumer and business confidence. People are easily influenced by external events. If there is a succession of bad economic news, this tends to discourage people from spending and investing making a small downturn into a bigger recession. But, when the economy recovers this can cause a positive bandwagon effect. Economic growth, encourages consumers to borrow and banks to lend. This causes higher economic growth. Confidence is an important factor in causing the business cycle. 4. Multiplier effect. The multiplier effect states that a fall in injections may cause a bigger final fall in real GDP. For example, if the government cut public investment, there would be fall in aggregate demand and a rise in unemployment. However, those who lost their jobs would

also spend less, leading to even lower demand in the economy. Alternatively, an injection could have a positive multiplier effect. 5. Accelerator effect. This states that investment depends on the rate of change of economic growth. If the growth rate falls, firms reduce investment because they dont expect output to rise as quickly.

Volatile investment

This theory suggests investment is quite volatile and small changes in the rate of growth have a big effect on investment levels. 6. Inventory cycle. Some argue that there is a natural inventory cycle. For example, there are some luxury goods we buy every five years or so. When the economy is doing well, people buy these luxury items causing faster economic growth. But, in a downturn, people delay buying luxury goods and so we get a bigger economic downturn.

Causes of Recessions
The business cycle can go into recession for a variety of reasons, such as:

Falling house prices causing negative wealth effect and lower consumer spending Credit crunch causing an increase in cost of borrowing and shortage of funds Volatile stock markets and money markets undermining business and investment confidence. Higher interest rates causing lower spending and investment. Tight fiscal policy higher taxes and lower spending.

Appreciation in the exchange rate. See: causes of recessions

Examples of Business Cycles

In the post war economy, there appeared to be a simple trade off between unemployment and inflation, shown by the Phillips curve. There were several economic booms, followed by an economic downturn. In the late 1980s, there was a classic boom and bust, with economic growth exceeding the long-term trend rate and causing inflation. Eventually, the government tried to reduce inflation and the boom turned into a recession. See: Lawson Boom and Bust The end of the business cycle? During the great moderation, some economists hoped we had seen the end of the business cycle because we experienced a long period of economic expansion without inflation. However, in 2008, the global credit crunch pushed the world economy into recession, showing the business cycle hadnt ended. For further reading see: Financial instability hypothesis - why economic stability can cause financial instability.

Impact of Business Cycle on Economy

A volatile business cycle is considered bad for the economy. A period of economic boom (rapid growth in economy) invariably leads to inflation with various economic costs. This inflationary growth tends to be unsustainable and leads to a bust (recession). The biggest problem of the business cycle is that recession represent a large wastage of resources. A prolonged period of unemployment can also lead to a loss of labour productivity as workers get discouraged and leave the labour market. Monetary authorities tend to try and minimise fluctuations in the business cycle. They seek to avoid inflation and avoid a recession. In the UK, the main tool to smooth the business cycle is the use of interest rates. The government may also use fiscal policy. In a recession, the government could try increasing government spending and cutting tax. Some economists argue that the business cycle is an essential part of an economy. Even downturns have their role to play as it tends to shakeup the economy and weed out inefficient firms and creating greater incentives to cut costs and be efficient. However, this view is controversial and other economists argue that in a recession, even good efficient firms can go out of business leading to a permanent loss of productive capacity.

The crucial error was to allow financial institutions to trade on their own behalf. Today, many large trading banks are betting against their own customers. In the real estate market, banks aggressively promoted mortgages to people who could not afford them. These were assembled in packages. They were carried on the books as tangible assets when they were worthless. The institutions assembling them hedged their loans by betting against them. When the mortgages failed, profits were made despite and because of their failure. This process has been targeted by financial reform measures that many in both parties oppose because well, lobbyists have persuaded them. There is no moral justification for how Wall Street functions today. A Chicago group named Magnetar was particularly successful in creating such poisoned instruments for the sole purpose of hedging against them. Most of the big Wall Street players knew exactly what the Magnetar Trade was and welcomed it. The more mortgages failed, the more money they made. They actually continued to sell the bad mortgages to their clients as good investments. What is a CDS?
Credit default swaps are derivative contracts. They were invented in the late 1990s and are a form of insurance on bonds issued by companies or countries that investors buy and sell. By 2007 the market was huge about $50tn (33tn) unregulated and opaque. If it looks like an issuer might have trouble paying, its CDS price rises because the bond is more risky and it will cost more to insure. CDS contracts can be used by bond investors as a hedge against potential defaults or traded separately when they are called naked CDSs. What is 'Subprime


A type of mortgage that is normally made out to borrowers with lower credit ratings. As a result of the borrower's lowered credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk. There are several different kinds of subprime mortgage structures available. The most common is the adjustable rate mortgage (ARM), which initially charges a fixed interest rate, and then convert to a floating rate based on an index such as LIBOR, plus a margin. The better known types of ARMs include 3/27 and 2/28 ARMs. ARMs are somewhat misleading to subprime borrowers in that the borrowers initially pay a lower interest rate. When their mortgages reset to the higher, variable rate, mortgage payments increase significantly. This is one of the factors that lead to the sharp increase in the number of subprime mortgage foreclosures in August of 2006, and the subprime mortgage meltdown that ensued

Many lenders were more liberal in granting these loans from 2004 to 2006 as a result of lower interest rates and high capital liquidity. Lenders sought additional profits through these higher risk loans, and they charged interest rates above prime in order to compensate for the additional risk they assumed. Consequently, once the rate of subprime mortgage foreclosures skyrocketed, many lenders experienced extreme financial difficulties, and even bankruptcy.