TOPIC 2: BUSINESS CYCLES:

Analysis and explanation • Briefly describe the concepts

of business cycles, and • Briefly explain the nature of business cycles
how they are used in
forecasting • Demonstrate/Illustrate a typical business cycle
• Use a diagram and briefly discuss the different phases in a
2.1 The composition and business cycle
features of business cycles • Broadly outline the real business cycle

1.1 COMPOSITION AND CHARACTERISTICS/FEATURES OF BUSINESS CYCLES

BUSINESS CYCLES

Definition:
• Refers to the phenomenon of successive periods of increasing and decreasing economic activity.

OR

• A business cycle is defined as the recurrent but not periodic pattern of expansion and contraction in
the level of economic activity that occurs within a country.

Nature of business cycles:

• Changes in economic activity are recurring but never the same or of the same magnitude.
• Different circumstances and expectations cause consumers and producers to respond differently to
initiating forces.
• The duration and amplitude of every business cycle will be different.
• Business cycles are characterised by the following:
o Two periods, namely contraction and expansion
o Two turning points, namely trough and peak
o Four phases, namely recovery, prosperity, recession and depression.

Typical business cycle:

 • Economic activity clearly shows periods of contractions (recession / depression) and periods of
expansion (recovery / prosperity) in the economy.
• It is shown by the upward and downward movements of the curve.
• A period where there is a general increase in economic activity is known as upswing.
• A period of general decline in the economic activity is called a downswing.
• The business cycle oscillates (swings) between the upper (peak) and lower (trough) turning points.
• The length of the business cycle is measured from peak to peak or from trough to trough.
• The entire period from the peak to the trough is known as the downswing.
• The entire period from the trough to the peak is known as the upswing.
• The period immediately before and through the upper turning point of the cycle is called the boom.
• The period immediately before and through the lower turning point is known as the slump.

Phases of business cycles:

Recovery phase:
• Recovery phase starts once a trough (lower turning point) in the business cycle is reached and the
level of economic activity starts to gradually increase.
• There is a greater demand for goods and services.
• This leads to an increase in production.
• More jobs are created.
• Business confidence rises and there is increased spending by firms and households.
• There is increased economic activity and the country enters into a period of prosperity.

Prosperity phase:
• There is a great degree of optimism in the economy.
• Bank credit is extended so entrepreneurs borrow more money to buy machines and equipment
(investment increases).
• Employment levels rise, and this give rise to a rise in salaries and wages and spending increases as
household’s disposable income increases.
• Imports increase
• A peak is reached.
• There is a larger amount of money in circulation and this leads to an inflationary situation as prices
rise in the economy and eventually lead to a recession.

Recession phase:
• Once the peak is reached, the contraction phase starts.
• A recession phase is when there is negative economic growth rate for two consecutive quarters.
• It is introduced by a decrease in profits of businesses that is the result of inflation and over
production.
• Firms cut back on their employment since fewer goods and services are produced, increasing
unemployment.
• As unemployment increases and this gives rise to a feeling of pessimism.
• Income of households decrease and spending declines.
• There is a decrease in economic activity, and the economy slows down, this results in a decrease in
GDP.
• As the contraction phase worsens, households and firms obtain less credit and loans from banks.
This could turn into a depression.

Depression phase:
• During a depression money is in short supply, leading to a further decline in spending.
• There is a negative impact on investment spending.
• Economic activity is at its lowest, and a trough is reached.
• There is competition for employment opportunities which lead to serious levels of unemployment.
• Cost of production decreases.
• This encourages foreign trade and leads to a recovery.
 2.2 Explanations / Causes • Discuss the exogenous (monetarist) explanation
• Discuss the endogenous (Keynesian) explanation
• Compare both explanations
• Give a broad outline of the types of business cycles
(Kitchin, Jugler, Kuznets and Kondratieff)

1.2 EXPLANATIONS / CAUSES:

Exogenous explanation (monetarist explanation / reasons):

• It is also called the sunspot theory / exogenous approach.

• Believe markets are inherently stable.
• Deviations from the equilibrium state are caused by exogenous factors (factors outside of the
market system).
• When disequilibrium exist in the economy, market forces (supply and demand) kick in and bring the
economy back to its natural state or equilibrium route.
• Government interference is not part of the normal forces operating in the market.
• Governments should not interfere in the markets.
• The straight bold line indicates the natural growth of the economy.

Causes of economic fluctuations:

2. Inappropriate government policies
3. Undesirable increases and decreases in money supply
4. Weather conditions, e.g. droughts and floods
5. Shocks, e.g. sudden/severe increases in the price of fuel or a war
6. Structural changes in the economy (e.g. electronic development)
 1. Endogenous explanation (Keynesian explanation):

• Also known as the Keynesian approach or Interventionism.

• Hold the view that markets are inherently unstable.
• Level of economic activity constantly tend to be continually above or below its potential.
• Price mechanism fails to co-ordinate demand and supply in markets.
• Prices are not flexible enough e.g. wages.
• Business cycle is an inherent feature of market economy.
• The potential growth path is indicated by the thin black line.
• The cyclical bold line around the thin black line indicates the real path of the economy.
• Governments must intervene in the economy processes to smoothen the peaks and the troughs as
far as possible.
• They use Monetary and Fiscal Policies to do this.

Types of business cycles:

Types of business cycle Description

Business cycles In South Africa ±60 months.
There are clear expansions and contraction periods.
During these periods the major sectors of the economy move
up and down more or less together.
Their duration is not fixed.
Kitchin cycles They last between 3 to 5 years.
This happen because businesses adapt their inventory levels.
Jugler cycles They last 7 to 11 years
Are caused by changes in net investments by business and
the government.
Kuznets Cycles They last 15 to 20 years.
They are caused by changes in the building and construction
industries.
They are also called building cycles.
Kontratieff Cycles They last 50 years and longer.
They are caused by technological innovation, wars, and
discoveries of new deposits, e.g. gold.

2.3 Government policy Explain the composition of the following policies:

- Fiscal policy
o Taxes and government expenditure
o Briefly relate to the budget
- Monetary policy
o Interest rates (repo rate)
o Open market transactions
o Cash reserve requirement
o Moral suasion
6.1 GOVERNMENT POLICIES USED TO SMOOTH OUT BUSINESS CYCLES:
• Government must intervene in the economy with policies to smooth out peaks and troughs.
• Higher peaks lead to Inflation.
• Lower troughs lead to unemployment.
• The new economic paradigm, results in the state using monetary policy and fiscal policy to smooth
out the business cycle.

Fiscal policy:
• It has been successfully used to stimulate a depressed economy.

Stimulate private sector demand / private sector demand can become too low (at E)
• An increase in unemployment is the indicator.
• The government has THREE choices that can lead to an increase in total spending and therefore
an increase in demand.

1. Decrease Taxation (↓T)

• Households and producers have more disposable income which they can spent on goods
and services.
• There is an increase in consumption spending (C) which lead to an increase in demand.
• The economy is stimulated, and it leads to employment.

2. Increase government spending (↑G)

• Achieved with borrowed money.
• Reason: as a result of the deficit on the budget.
• Total spending increase and demand increase.
• The economy is stimulated and employment increase.

3. Increased government spending and decreasing taxes simultaneously

• This will have a double strength effect.
• Government spending increases.
• Consumers and producers have more disposable income to spend on goods and services.
• Demand increases.
• Employment increases.

Reduce private sector demand / Private sector demand can become too high at (E)
• Inflation is the indicator.
• The government has THREE choices that can lead to a decrease in total spending and therefore a
decrease in demand.

1. Reduce government spending (↓G)

• Unspent money is preserved (Frozen)
• Total spending decreases.
• Demand decreases.
• Inflation will decrease.

2. Increase taxation (↑T)

• Tax income is preserved (frozen).
• Consumers and producers have less disposable income to spend on goods and services.
 • Demand decreases.
• Inflation decreases.

3. Reduce government spending and simultaneously increasing taxation

• This will have a double strength effect.
• Government spending decreases.
• Consumers and producers have less money to spend on goods and services.
• Demand decreases.
• Inflation decreases.

Monetary policy:

Monetary policy
• Monetary policy uses interest rates and money supply to expand or contract aggregate demand.
• Large increases in money supply lead to inflation.
• Monetary policy can be utilised more effectively to dampen an overheated economy with severe
inflationary pressures.

Monetary policy instruments:

1. Interest Rates:
• Overheated economy / Boom
o Increase interest rates.
o Decrease money supply.
o This will make credit more expensive and reduce and discourage consumer credit.
o Demand will decrease.

• Recession / Slump
o Decrease interest rates.
o Increase money supply.
o This will make credit cheaper and it will increase and promote consumer credit.
o Consumer demand will increase.
o It will stimulate the economy.

2. Cash reserve requirements:

• Banks are required by law to keep cash reserves at the SARB.
• SARB can increase or decrease these cash reserve requirements.

Overheated economy / Boom

• An increase in the cash reserve requirements - decrease the supply of capital to commercial
banks, so that banks have less money to lend to consumers.
• Demand will decrease.

Recession / Slump
• A decrease in the cash reserve requirements – Increase in the supply of capital to
commercial banks, so that banks have more money to lend to consumers.
• Demand will increase.

3. Open market transactions:

• The SARB can directly increase or decrease the amount of money in the economy.

Overheated Economy / Boom

• If they want to reduce the supply of money in the economy, they can sell government bonds
/ securities on the open market.

Recession / Slump
• If they want to increase the supply of money in the economy, they buy government bonds /
securities on the open market.
 4. Moral persuasion / moral suasion:
• The SARB can enter into discussion with banks, to morally persuade them to limit credit and
increase the cooperation to fight inflation.

2.4 The new economic • Discuss in detail 'The new economic paradigm'/Explain the
paradigm (smoothing of 'smoothing of cycles'
cycles) - Explain demand-side policies.
o Explain clearly how monetary and fiscal
policies (expansionary and contractionary)
can be used in smoothing out business
cycles
o Relate to inflation (peak) and unemployment
(trough) by using the Phillips curve
- Explain supply-side policies and how aggregate supply can
be stimulated through:
o Reduction in costs
o Improving efficiency in inputs
o Improving efficiency in markets
• Explain the effect of demand-side and supply-side
policies using a graph (aggregate demand and
aggregate supply).

6.2 THE NEW ECONOMIC PARADIGM:

• In real life circumstances, governments must strive towards economic growth.
• They must do it irrespective if markets are inherent stable or inherent unstable.
• Governments learned to be pragmatic.
• They apply policies that are not extreme, but it must be transparent.
• Economists are convinced that it is possible for production output to rise at a high rate for an
extended period of time, without being tripped by supply constraints and without the pressure of
inflation.
• This paradigm lies in demand-side and supply-side policies.

Demand-side policy:
• Monetary policy and fiscal policy focus on aggregate demand.
• Demand-side policy is relying on aggregate demand only.
• Demand-side policy does not render ideal results on its own.
• Growth is often cut short because of all sorts of bottle necks that develop in the economy.
• Bottle necks such as, inflation, balance of payments deficits, and shortages of skilled labour, etc.
• Aggregate supply also needs to be managed.
• If the cost of increasing production is flexible; a greater real production output can be supplied at
any given price level.

Inflation:
Interpretation of the graph.

• Aggregate Demand (AD) is the total spending on goods and services in the economy, i.e. AD =
C+I+G+(X-M).
• Aggregate Supply (AS) is the total quantity of goods and services supplied at every price level.
• It is the total value of goods and services produced in the economy in a given period.
• At point C, Aggregate Demand (AD) and Aggregate Supply (AS) are in equilibrium.
• When Aggregate Demand (AD) increases in the economy, it shifts the Aggregate Demand (AD) to
the right, to AD1.
• If the Aggregate Supply curve responds promptly and increase, the Aggregate Supply (AS) shifts to
the right, to AS1.
• At point E the new equilibrium is formed – The new AD1 and AS1 intersect at point E.
• At this point a larger production output becomes available (Q to Q1), without any increase in price.
• This occurs over the long-term – because aggregate supply adjusts easier over the long-term.
• Supply does not adjust easy over the short term.
• Over the short-term:
• When Aggregate Demand (AD) increase, it shifts to the right (AD1) and when Aggregate Supply
(AS) remains unchanged, the AD1 intersect the AS at point F.
• At point F a new equilibrium is formed.
• At point F real production increase but the prices also increase.
• Inflation increases.
• To solve this problem, a situation must be created where supply is more flexible.

Unemployment:

• Unemployment is illustrated by the Philips curve (PC).

• The Philips curve illustrates the relationship between Unemployment and Inflation.
• As unemployment decreases, inflation increases and vice versa.

Interpretation of the graph.

• PC indicates the original situation. At point A, the PC intersects the x-axis.

Point A indicates the natural employment level.

• At this point unemployment is 14% with no inflation pressures (0% inflation)
• A movement left from point A to point B will cause a decrease in unemployment (increase in
employment) and an increase in inflation.

At Point B
• If economic growth occurs and it causes a decrease in unemployment to 10%, it means more
people will get jobs.
• Wages increase (people have more money to spend) and this will lead to an increase in inflation to
2%.
 At Point C
• If unemployment decreases to 8% - this will lead to an increase in inflation to 6%.
• This increase in inflation is caused by an increase in wages of people because they have more
purchasing power.
• If unemployment decreases, then inflation will increase.
• The government decides the percentage of unemployment they will accept for less inflation.

Supply side measures can be used to shift the PC to PC1.

Supply side measures are:
1. Improved education
2. Effective training
3. Fewer restrictions on migration of skilled labour.

• If the PC shifts to the left (PC1), the natural level of unemployment will decrease from 14% to 9%.
• It means that unemployment is lower at 9% and the inflation rate is 0

Supply side policy:

1. Reduction of cost:
• Infrastructure services: are supplied by the government. It contributes substantially to the cost of
businesses.
• Administrative cost: inspections, reports on the implementation of laws, regulations, all contribute
to increased costs and expenditure of businesses.
• Cash incentives: Subsidies can be given to businesses when they want to establish their business
in neglected areas where unemployment is high.

2. Improving the efficiency of inputs:

• Tax rates: High personal income tax is disincentives to work. Higher company taxes are
disincentives to investment.
• Capital consumption: Replacing of capital goods create opportunities to keep up with technology
and to compete with their competitors.
• Human resources: The quality of labour of people increased the efficiency of businesses. The
quality human resources are created by improving health care, education, training schemes, etc.
• Free advisory services: These are services that promote exports. E.g. research, agricultural
services, statistical information, etc.

3. Improving the efficiency in markets:

• Deregulation: It is the removal of laws and regulations and all other forms of government control to
make the markets freer.
• Competition: It creates the establishment of new businesses. It also attracts foreign investment.
• Leveling of the playing fields: Private sector businesses cannot compete with the public sector.
Public enterprises have legislative protection and they are supported by the government.
Privatisation is therefore important.
Effect of demand-side and supply-side policies using a graph (aggregate demand and aggregate supply):

Inflation
• Aggregate demand and aggregate supply is in equilibrium at point C.
• Aggregate demand is stimulated and move to AD – supply reacts and shifts to AS1.
1
• A bigger real output without price increases.

Supply is often sticky and fixed over the short term

• With an increase in demand to AD , supply remains constant – intersects at point F.
1
• Real production and prices increase (inflation).
• Creates situations where supply is more adaptable using supply-side measures.

Unemployment
• Demand-side policies are effective in stimulating economic growth.
• Leads to an increase in the demand for labour.
• Reduces unemployment.
• Inflation increases.
 2.5 Features underpinning • Briefly describe the relevant concepts
forecasting business cycles • Discuss in detail the features underpinning forecasting:
- Indicators
o Leading
o Coincidence
o Lagging
o Composite
- Length of a cycle
- Amplitude
- The trend line
- Extrapolation
- Moving averages
• Use a diagram and discuss the cycle length, amplitude and the
trend line as features underpinning forecasting

6.3 FEATURES UNDERPINNING FORECASTING BUSINESS CYCLES:

Definition of forecasting
• Forecasting is the process of making predictions about changing conditions and future events that
may significantly affects the economy.
• Accurate forecasting in the economy is not possible.
• The best that economists can do is to predict what could happen.
• A range of techniques are available to assist economists to predict business cycles.
• Quantitative methods make use of historical time series data / past performance to predict what will
happen in the future.
• Judgemental methods rely on opinion and are more subjective in nature.

Indicators:
Leading economic indicators:
• These are indicators that change before the economy changes.
• They give consumers, business leaders and policy makers a glimpse of where the economy might
be heading.
• When these indicators rise, the level of economic activities will also rise in a few months’ time.
• E.g. job advertising space / inventory / sales ratio / share price / building plans passed.

Lagging economic indicators:

• They do not change direction until after the business cycle has changed its direction.
• They serve to confirm the behaviour of co-incident indicators.
• E.g. the value of wholesalers’ sales of machinery / Investment in capital goods.
• If the business cycle reaches a peak and begins to decline, then we can predict the value of new
machinery sold.

Co-incidental economic indicators:

• They simply move at the same time as the economy.
• It indicates the actual state of the economy.
• E.g. value of retail sales.
• If the business cycle reaches a peak and then begins to decline, then the value of retail sales will
reach a peak and then begin to decline at same time

Composite indicators:
• It is a grouping of various indicators of the same type into a single value. The single figure forms the
number of years it takes for the economy to get from one peak to the next.
• It is useful to know the length of the cycle because the length tends to remain relatively constant
over time.
• If a business cycle has the length of 10 years it can be predicted that 10 years will pass between
successive peaks or troughs in the economy.
• Longer cycles show strength and shorter cycles show weakness.
• Cycles can overshoot.
 The length of a business cycle
• Is the time it takes for a business cycle to move through one complete cycle (peak
to recession to a trough, the back to a trough, a boom and to a peak.
• It is useful to know the length of a business cycle, because the length tends to
remain relatively constant over time, e.g. if a business cycle has a length of 12
years, it can be predicted that 12 years will pass between successive peaks or
troughs or that it will take 6 years for the economy to pass through a recession.
• Longer cycles show strength and shorter cycles weaknesses.
• Cycles may overshoot: when activity in terms of composite indicators increases
beyond its normal level.

Amplitude:
• The amplitude refers to the vertical difference between a trough and the next
peak of a cycle.
• The amplitude measures the distance from the trend line to the peak or trough.
• A large amplitude during an upswing indicates strong underlying forces –
which result in longer cycles.
• The larger the amplitude the more extreme the changes that may occur.
• E.g. during an upswing inflation may increase from 5% to 10 % (i.e. 100 %
increase).

Trend line:
• It represents the average position of a cycle.
• Indicates the general direction in which the economy is moving.
• An upward trend suggests that the economy is growing.
• Trend line usually has a positive slope, because production capacity increases
over time.

Extrapolation:
• It is when forecasters use past data e.g. trends and by assuming that this
trend will continue, and then they make predictions about the future
• E.g. if it becomes clear that the business cycle has passed through a trough
and has entered a boom phase, forecasters might predict that the economy
will grow in the months that follow
• It’s also used to make economic predictions in other settings e.g.
prediction of future share prices

Moving average:
• It is a statistical analytical tool that is used to analyse the changes that occur in a
series of data over a certain period.
• E.g. the moving average could be calculated for the past three months to
smooth out any minor fluctuations
They are calculated to iron out small fluctuations and reveal long-term trends in the business
cycle