Why tracking economic cycles matters

There is need for checking trade cycles and how they affect a country’s economy to be able to keep up with the times. 

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Influential economist Alan Blinder said “in the classic old business cycles, there would be a diminution in sales; it would take a little while for this information to reach corporate headquarters. And there would be an inventory pileup. And then – bam- businesses would react, sometimes violently, by cutting production.”

With the current technology and speed of information exchange, this has since changed. After the industrial revolution, our global economy has seen unprecedented growth. As per the Bank of England, “on average, GDP growth per person since 1750 has been 1.5 percent per year.” This means on average an industrialised or industrialising economy doubled roughly every 50 years.

Could it be said that the 1.5 per cent growth in GDP has allowed the average citizen in an industrialised nation today to live reasonably better lives? Growth is not constant. Even ignoring the wars, famines, and depressions marking our history and also evident today, the global economy tends to expand and contract in a cyclical fashion. The cycle of expansions and contractions is called the business cycle.

It is important for economies to track the business cycles as this helps professionals forecast the direction of the economy. All business cycles have four phases, including an expansion, a peak, a contraction, and a trough. A new business cycle occurs when business activity peaks.

Afterwards, the economy contracts until activity bottoms out or reaches a trough. Finally, the economy expands until it peaks again. That is one business cycle. Different institutions measure and date business cycles for their country using similar parameters.

According to the British National Institute of Economic and Social Research, “the average UK business cycle, from peak to peak or from trough to trough, lasts some 62 months, with some room for standard error up to 28 months.”

In the United States, measuring and dating of business cycles are handled by the National Bureau of Economic Research. Although an economy’s GDP is an important variable to date business cycles, it is not the only factor.

For instance, in addition to real GDP, the National Bureau of Economic Research, considers employment, industrial productivity, consumption, wages, wholesale, retail sales, and personal income. When economists refer to economic contraction and expansion they were referring to total economic activity, not just an economy's real GDP figures. Kenya too is undergoing a trough in the business cycle and will experience a gradual recovery.

This is dependent on many factors including attraction of foreign investors into the country and growth in investments leading to greater employment, income generation, and spending as well as savings and dynamic response to changing business environment.

Random intervals

Business cycles occur more or less and random intervals. In America, the most recent business cycle measuring from peak to peak being the longest cycle on record in the past few decades was from December 2007 to February 2020 roughly 146 months. In contrast, there are short cycles too, such as the business cycle in the USA between August 1918 to January 1920 about 17 months.

Between 1854 and 2020 business cycles in the United States lasted on average approximately 60 months. However, since 1945 business cycles have gone for more than 70 months on average. One reason why business cycles are mostly random has to do with many factors which affect business cycles, small changes in any of these factors on their own are unlikely to affect economic activity.

But when the small changes feed on each other and spread throughout the economy, they can cause dramatic changes. This is why most economic research focuses on trying to understand the factors that affect business cycles instead of trying to predict business cycles. Perfectly competitive markets are an important feature of the classical view of business cycles. The market is perfectly competitive when all agents in the market have complete information on all prices and goods.

Today, in the technological era, and with countries opening their borders to trade, there is great competition for trade regionally. Importantly, prices adjust quickly in response to changes in the quantity demanded by consumers and the quantity supplied by firms. From the perspective of perfect competition, the disturbances that affect business cycles are the same that affect the quantity demanded, and the quantity supplied in any given market.

To understand why money does not affect business cycles in this classical view, it is important to remember that we are assuming that prices adjust almost instantly to changes in supply and demand. If for instance wages increased by five per cent individuals would earn more and would afford to buy more goods and services. But the high demand results in higher prices and because markets are perfectly competitive, the price increase is almost instant.

So although wages, increased by five per cent prices will increase by five per cent too almost instantly. Therefore an individual’s real disposable income is left unaffected. The focus on real economic variables gave this classical view of business cycles the name “real business cycle theory”. While there are many possible disturbances that affect demand and supply, real business cycle theorists focus on technological change and government purchases. When technology improves labour and capital become more productive, which increases consumption and real output. An increase in government expenditures would increase taxes thus leaving households with less disposable income to spend on consumption.

Business cycles

Former chair of the Federal Reserve of United States Paul Volcker said “Less emphasis on inventories. I think, may tend to dampen business cycles, because business cycles are typically in the grasp of inventory cycles and heavy industry cycles.” If markets are imperfect then prices don’t adjust quickly to changes in demand and supply.

This means that money is an important factor in explaining business cycles. How do economists explain business cycles today? Most economists today agree that money plays an important role in understanding business cycles. In fact prior to the popularity of real business cycle theory, in the 1980s economists accepted that money affects real economic variables.

Perhaps the best example of money affecting the real economy can be found in the US during the 10-year period of Federal Reserve Chairman Paul Volcker in the 1980s. During the 1970s and 1980s the United States was suffering from persistently high inflation in response Paul Volcker contracted the money supply, which created the greatest deepest post-war recessions in US history at the time. At least Volker got the inflation under control.

Money, technology, and government purchases have a vast role to play in the cycle as they affect economic output. Economist Joseph Schumpeter sums up the solution very succinctly in his quote “it is, after all, only common sense to realise that, but for the fact that economic life is a process of incessant internal change, the business cycle, as we know it, would not exist.”

Ritesh Barot is a business and financial analyst [email protected]