Economic Cycle

Economic cycle: meaning

There are some economies right now that are experiencing growth over the long term, whose growth domestic product (GDP) has been trending upwards for several years. On the other hand, some economies have been experiencing negative growth, and their GDP has been trending downwards for many years.

Regardless of which case you consider, there will be fluctuations in their positive or negative growth trend. That is to say: there are periods in which these economies will have experienced either upward or downward movements. Although an economy might have been growing, it has undergone some downward movements at some point and has picked up again.

There are many reasons why an economy experiences fluctuations regardless of whether it’s an upward or downward trend.

Firstly, it could be due to what we know as seasonal fluctuations. These fluctuations are highly correlated with the season that the economy is in. For instance, during winter, the economy of a coastal country dependent on tourism might experience a fall in output as there are not many tourists coming, and jobs and production have fallen as a result of that. These seasonal fluctuations are temporary and usually last a very short time.

What are economic cycles?

Economic cycles are upswings or downswings in an economy that last for a long period, usually 4–10 years. However, there are economies that experience fluctuations for longer periods of time where the total output of a country keeps falling for years.

Many factors cause these economic cycles. It could be that a shock hit the aggregate demand of an economy, resulting in higher output for a period of time. Or it could also be the Covid-19 pandemic, which has shut down supply operations in many countries causing the output to fall in many countries.

One important thing to remember is that economic cycles are inevitable and all economies worldwide will experience them.

Four stages of economic cycle

There are four main stages of an economic cycle:

• expansion
• peak
• contraction
• trough.

To better understand them, you'll have to use figure 1. Initially, the economy is an equilibrium at point 1, which is illustrated by the pink dot on the graph. This is the economy's trend and the path the economy would have followed if it wasn't for the economic cycles that cause the economy to deviate from the trend.

However, to measure and observe these deviations from trend output, you use the actual output.

Don’t get confused: the actual production is the one that is impacted by economic cycles, and it is the output in the real world.

Fig. 1 - Phases of economic cycle

Assume that we are considering an economy that is initially in an expansionary period. This phase of the economic cycle involves having the actual output grow above the trend output.

Several reasons could cause the economy to expand. For instance, the government could have lowered the credit rate, which caused the aggregate demand to increase and with it the actual output.

The expansionary period lasts for some years, and the economy keeps experiencing growth in its actual output. However, this growth stops as another shock hits the economy at some point. This phase of the economic cycle is known as the peak. The peak refers to when the total output has reached the highest point and begins to drop.

After reaching the peak, the contractionary phase of the economic cycle begins. This phase is associated with a decline in the real output below the trend output. Throughout this phase, there are fewer jobs in the economy, less production, etc. The contractionary period continues for some time until it reaches a point where there is a reverse in the trend, meaning that the actual output increases.

The point at which the economy has reached its minimum and begins to recover is known as the trough. After the economy reaches the trough, the expansionary period begins, and the economic cycle repeats.

Economists use several economic indicators to identify and analyse economic cycles. Some of these economic indicators include real GDP, level of investment, and unemployment rate. The most common measure used to identify economic cycles is the real GDP, as it measures the actual growth of a country in terms of its production of goods and services.

The causes of economic cycles

Economic cycles are a result of various domestic as well as external shocks.

The main important factors that cause economic cycles are:

Aggregate demand fluctuations

Fluctuations in aggregate demand can cause an economic cycle that could be persistent. A shift to the right of the aggregate demand curve causes an expansion, whereas a shift to the left of the aggregate demand curve causes a contraction. Some common reasons why aggregate demand shifts include consumer and business confidence.

Supply-side factors

Factors related to the supply-side can also cause economic cycles to shift. New technologies that could make the production process more efficient could result in an expansionary economic cycle where output increases and prices decrease. This is usually associated with a shift of the supply curve to the right.

Speculative bubbles

This is one of the most common causes of the recession. Speculative bubbles often occur when assets and houses in the economy are overpriced. It comes to a point when those assets have to make up for their price, and then investors realize that the assets aren't as worthy as they were thought to be.

This causes investors to quickly sell all these assets and houses, resulting in turmoil in the market. This then leads the economy into a recession.

Political business cycles

The elections occur every 4 to 5 years in a democratic country. Most of the countries experience an expansionary period prior to the elections and a somewhat recession after. The reason for that is that the ruling party tries to boost the economy before the election by increasing government spending and cutting taxes to guarantee the chair again.

However, after the elections, someone has to pay for that expense, and that's why countries usually experience an economic fall after elections.

External shocks

These shocks come from outside the economy and usually hit either the aggregate demand or the aggregate supply.

An example of this would be oil shortages resulting from Russia invading Ukraine. As Russia is a significant oil exporter, a political conflict could send waves across other countries economies. This would then hit the aggregate supply as the cost of input increases, causing a new economic cycle.

Fig. 2 - Output gaps

Please look at figure 2 to better understand output gaps. Output gaps are gaps between the actual output that an economy experiences and its output trend. There are periods in which the actual output produced could be above the output trend and vice versa.

You should be aware of two main types of output gaps: positive output gaps and negative output gaps.

Positive output gaps occur when the actual output is above the output trend. This is a period where the economy is outperforming the expected output.

Negative output gaps occur when the actual output is below the output trend. This is a period where the economy is underperforming compared to the expected output.

Real GDP is used as a measurement of output gaps. The UK government defines output gaps from the moment a gap occurs until it finishes, regardless of whether the economy enters a recession or not.

In the above graph, you can see a positive output gap from point 1 to point 2 and a negative output gap from point 2 to point 3.

To learn more about this topic check our explanation on Recessions.

Economic cycles: example

The most significant economic cycle experienced recently was that of the 2008–09 financial crisis that started in the US and quickly spread over the world. It began when the US economy peaked at $69 trillion of household and non-profit net worth in 2007 and continued up to 2009 when it reached a trough.¹

This was the most significant fall in the real GDP of the US economy since the Great Depression in 1929, according to Federal Reserves History. The leading cause of the financial crisis was the overvalue of the real estate market in the US and complex financial products called Collateralized Debt Obligations (CDOs).

These financial products were basically made of pools of loans made to individuals and households who could not afford to pay the loans back. Large banks constructed CDOs and sold them to large financial institutions.

When many people could not pay their debt on time, the financial crisis happened. Other economies also experienced the recession that resulted from the financial crisis as they were exposed to the financial institutions in the US that led to the crisis.

Sources

1. Robert Rich, The Great Recession, Federal Reserve History, 2013.

The economic cycle and output gaps