Business Cycle - Explained
What is the Business Cycle?
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Table of ContentsWhat is the Business Cycle?Phases of the Business Cycle?What is the Modigliani Miller theorem?Academic Research on Business Cycle
What is the Business Cycle?
From a conceptual observation, the business cycle is defined as the economy-wide fluctuations in trade and the general economic activity. The cycle is upward as well as the downward movement of various levels from gross domestic products.
More simply, the business cycle signifies variations in the production of goods and services in a nation. These business cycles are usually determined as per the increase and decrease in real gross domestic product or adjustments made in GDP for inflation. Business cycle and market cycle are different in nature. The business cycle is determined using indices of the stock market. Debt cycle, which is a term different from the business cycle, is the increase and decrease in privately and publicly held debt. The business cycle is also referred to as the economic cycle, or trade cycle.
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Phases of the Business Cycle?
It also refers to the period of expansion coupled with contractions in different economic activities and businesses around a long-term trend of growth. Besides, business cycles are characterized by a great boom in one sector and a period of collapse in the next in different economic activities. These fluctuations are known as phases. They are of four types:
Expansion: Theexpansion stage is also referred to as prosperity. It includes a steady growth and development throughout the business cycle. In the phase of expansion, there will be some increase noticed that will be coupled with different economic factors including production, output, wages, demand as well as the supply of products.
Peak: The peak phase entails the gradual slow down of the economic cycle which is also accompanied by the increase in growth rate of the business cycle until it reaches a limit. In this phase, some of the economic elements such as profit, sales, employment as well as production are relatively higher, but they don't increase further than that specified level.
Recession: The peak phase entails a slow stage of a gradual decrease in demand because of the increase in prices of various inputs. When the decline in need of multiple products becomes rapid, the recession phase takes place. In the recession phase, the economic factors including product prices and saving as well as investment begins to decrease. Producers aren't aware of the decrease in demand for products. This phase is also characterized by the trough stage in which the economic activities of a country decline instantly thereby hitting below average. The interest rates will decrease. So will there be a rapid decline in the general national income.
Recovery Phase: In the trough phase, the economy of a country reaches its lowest level of shrinking. This is the limit to which the economy of a country shrinks. Once it touches the lowest level, it becomes the end of negativism and then the beginning of positivism. The reversal of the business cycle then occurs.
What is the Modigliani Miller theorem?
Born in Rome, Italy, Franco Modigliani, was the son of Enrico Modigliani and Olga Flaschel. His father was a revered pediatrician in their city while his mother served as a volunteer in social work. His early school performance was outstanding. In 1932, he lost his father in an operation table. The event took aback as his life was grievously affected. He then moved to the best school in Rome and managed to challenge himself into registering excellent performance. When he turned 17, he joined the University of Rome. Franco Modigliani became an economist as well as an educator. His works were so outstanding to the point of receiving the Nobel Prize for Economics based on his works on household savings as well as the dynamics. He was also awarded for spearheading research in different fields such as economics and creating the theory of the life cycle in marketing which proposes that people develop a store of wealth in their youthful years while working not to pass their savings to their heirs but to indulge in consumption at old age. As such, he came up with the Modigliani Miller theorem which reiterates the basis of modern thinking based on capital structure. The fundamental theorem also states that in the absence of various state taxes, agency costs, or asymmetric information, or efficient market, the value of a corporation is unaffected by how the company is financed. The theorem was created in a universe that had no taxes. But, if people were to move to a world with taxes, when the interest debt is tax-deductible, the value of the company would increase instead.
Academic Research on Business Cycle
- The political business cycle, Nordhaus, W. D. (1975). The political business cycle.The review of economic studies,42(2), 169-190.The financial accelerator in a quantitativebusiness cycleframework, Bernanke, B. S., Gertler, M., & Gilchrist, S. (1999). The financial accelerator in a quantitative business cycle framework.Handbook of macroeconomics,1, 1341-1393. This chapter develops a dynamic general equilibrium model that is intended to help clarify the role of credit market frictions in business fluctuations, from both a qualitative and a quantitative standpoint. The model is a synthesis of the leading approaches in the literature. In particular, the framework exhibits a financial accelerator, in that endogenous developments in credit markets work to amplify and propagate shocks to the macroeconomy. In addition, we add several features to the model that are designed to enhance the empirical relevance. First, we incorporate money and price stickiness, which allows us to study how credit market frictions may influence the transmission of monetary policy. In addition, we allow for lags in investment which enables the model to generate both hump-shaped output dynamics and a lead-lag relation between asset prices and investment, as is consistent with the data. Finally, we allow for heterogeneity among firms to capture the fact that borrowers have differential access to capital markets. Under reasonable parametrizations of the model, the financial accelerator has a significant influence on business cycle dynamics.
- A perspective on modernbusiness cycletheory,Kiyotaki, N. (2011). A perspective on modern business cycle theory.FRB Richmond Economic Quarterly,97(3), 195-208. In this article I provide a perspective on the current state of modern business cycle theory. This theory has developed from an application of the Arrow-Debreu general equilibrium framework to the neoclassical growth model. On the positive side, this approach is able to accommodate various sources of heterogeneity in preferences and production within its complete markets framework. On the negative side, this approach has to rely on persistent exogenous shocks to account for business cycles since its internal propagation mechanism is weak. I discuss the implications of three important extensions of the basic framework. The first two extensions, noncompetitive pricing and frictional labor markets, do not overcome the basic weakness of limited propagation. The third extension, limited insurance and exogenous credit constraints, shows promise to account for the amplification and propagation of exogenous shocks.
- Monetary cycles, financialcyclesand thebusiness cycle, Adrian, T., Estrella, A., & Shin, H. S. (2010). Monetary cycles, financial cycles and the business cycle.FRB of New York Staff Report, (421). One of the most robust stylized facts in macroeconomics is the forecasting power of the term spread for future real activity. The economic rationale for this forecasting power usually appeals to expectations of future interest rates, which affect the slope of the term structure. In this paper, we propose a possible causal mechanism for the forecasting power of the term spread, deriving from the balance sheet management of financial intermediaries. When monetary tightening is associated with a flattening of the term spread, it reduces net interest margin, which in turn makes lending less profitable, leading to a contraction in the supply of credit. We provide empirical support for this hypothesis, thereby linking monetary cycles, financial cycles, and the business cycle.
- Indivisible labor and the business cycle, Hansen, G. D. (1985). Indivisible labor and the business cycle.Journal of monetary Economics,16(3), 309-327. A growth model with shocks to technology is studied. Labor is indivisible, so all variability in hours worked is due to fluctuations in the number employed. We find that, unlike previous equilibrium models of the business cycle, this economy displays large fluctuations in hours worked and relatively small fluctuations in productivity. This finding is independent of individuals' willingness to substitute leisure across time. This and other findings are the result of studying and comparing summary statistics describing this economy, an economy with divisible labor, and post-war U.S. time series.
- Detrending, stylized facts and the business cycle, Harvey, A. C., & Jaeger, A. (1993). Detrending, stylized facts and the business cycle.Journal of applied econometrics,8(3), 231-247. The stylized facts of macroeconomic time series can be presented by fitting structural time series models. Within this framework, we analyse the consequences of the widely used detrending technique popularised by Hodrick and Prescott (1980). It is shown that mechanical detrending based on the HodrickPrescott filter can lead investigators to report spurious cyclical behaviour, and this point is illustrated with empirical examples. Structural timeseries models also allow investigators to deal explicitly with seasonal and irregular movements that may distort estimated cyclical components. Finally, the structural framework provides a basis for exposing the limitations of ARIMA methodology and models based on a deterministic trend with a single break.