Causes of Business Cycles

Economic recession refers to the loss of consumer and business confidence. The loss of confidence is directly proportional to demand, implying a decrease in consumer confidence also leads to a decrease in demand. In a business cycle, the decrease in demand due to consumer’s decrease in confidence marks the tipping point. It is at the point where the peak together with irrational exuberance plunges into contraction. the loss of consumer confidence leads to the consumers to limit their expenditures and hence they stop buying leading to a decrease in demand. The issue escalates when most consumers get into panic mode leading to decrease in retail sales slow. Therefore, this paper tasks to identify the causes of business cycle and recessions while also interpreting Fred’s Graph that shows both the business cycle and recession.

To begin with, business cycle refers to the changes observable in Economic growth and the various phases the economy goes through such as boom and bust. There are several factors associated with the economic cycle and they include interest rates, the confidence of the consumers, multiplier effect and the credit cycle (Ruhm, 2015). Other factors contributing towards economic cycle include technological shocks.

The above graph represents the Gross Domestic Product of the US in different years since early 1975-2015. As shown the GDP is neither constant nor does it have an upward trend. Instead, it goes through the various economic cycles which represent the boom and recession period over different years. For instance, in 1975 there was a recession as per the graph and then the subsequent years the production rate of the country increased positively where it reached the peak before 1980, and then started dropping, however, it did not drop to the lows of 1975.

First, the recession is caused by high-interest rates. High-interest rates limit liquidity and hence the amount of money available to invest (Iacoviello, 2015). High-Interest rates other than affecting the economy, does affect the Federal Reserve more. The Federal Reserve is involved with several functions some of them is to ensure sustainable growth within the United States Economy, they are also involved with ensuring that there is high employment rate and that prices are stable. They achieve their goals by managing the amount of money in circulation within the economy. One tool which they apply in managing the amount of money in circulation in the economy is the interest rate. Iacoviello (2015) connotes that higher interests rate results in an expensive money and hence contraction in the amount of money in circulation within the economy. Also, lower interest rates translate to cheaper money and hence more money in circulation within the economy. The 1980 recession was thus caused by the result of the FED raising interest and hence less money in supply and hence recession.

The second cause of the recession is the stock market crash.  Stock market plays a significant role in determining the consumer confidence. Stock refers to the share of ownership in a company and hence their significant role in determining the investors’ confidence based on the future earnings of the company. Since corporate income is dependent on the health of the US economy, and the performance of the shares in the stock market determines the corporate income, it, therefore, implies that stock market is also an indicator for the health of the country’s economy. It thus means that a crash signal in the stock market translates to a massive loss of confidence in the economy which if not rectified leads to recession (Odekon, 2015). However, it is not always that a crash in stock market leads to recession. Sometimes, a crash in the stock market only serves as a warning in the loss of confidence and if the Federal Reserve’s steps in on time, it will rectify the damage and hence restores back the investor’s confidence and hence avoidance of recession. Such is the case of what happened in the first quarter of 2007, where there was a slight stock crash but later in the year, it recovered, and the stock market value increased thus avoiding recession.

The other cause of the recession is the falling housing prices and sales. A fall in sales and house prices leads to a fall in the spending power of the investors and hence translates to a fall in confidence. Also, a fall in house prices leads to a fall in consumers’ source of wealth and hence lowering expenditure and hence, in turn, lowers the economic growth (Mian et al., 2017). For instance, in the boom periods of 1999-2007 when the economy experienced the rising house prices, there was an increased confidence in the consumer’s expenditure and there was also a reduction in saving. The result was an observable growth in the economy due to increased consumer confidence. Increased house prices also lead to an increase in wealth implying there is enough income for re-mortgaging and hence motivated the development in the construction sector.  The result for depreciating house prices is the same as the opposite of the rising house prices. Whereby, a fall in house price will lead to many investors getting trapped in the negative equity and hence they are discouraged from spending and usually opt to save mode.

As shown in the Above graph above, an increase in the house prices boom period of 1990 – 2007, led to an increase in economic growth, and so is the drop-in house prices which lead to a fall in GDP. Besides, an increase in house prices which translates to a growth in the economy would lead to an increase an expenditure and a decrease in savings as shown in the graph below:

Having discussed some of the causes of the business cycle, for instance, the recession, the government can play a role in ensuring the stability of the economy and to avoid the effects associated with the business cycle. The government through the federal reserve can control the flow of money within the economy to help rectify recession and other business cycles (Sheikh, 2015). Adaptation of viable monetary policies, for instance, the monetary inflation during a recession can help rectify it and monetary deflation during the boom periods can help stabilize the economy. For instance, during the economic boom of the period between 2004 and 2005, the government should have adopted a monetary policy which would increase interest rates and hence would have helped in preventing of boom period that followed. The government would also adopt the use of economic stabilizers to help tack recession should it arise.

References

Iacoviello, M. (2015). Financial business cycles. Review of Economic Dynamics, 18(1), 140-163.

Mian, A., Sufi, A., & Verner, E. (2017). Household debt and business cycles worldwide. The Quarterly Journal of Economics, 132(4), 1755-1817.

Odekon, M. (2015). Booms and Busts: An Encyclopedia of Economic History from the First Stock Market Crash of 1792 to the Current Global Economic Crisis. Routledge.

Ruhm, C. J. (2015). Recessions, healthy no more?. Journal of health economics, 42, 17-28.

Sheikh, S. (2015, November 17). How to Control the Business Cycle? | Managerial Economics. Retrieved from http://www.economicsdiscussion.net/business-cycles/how-to-control-the-business-cycle-managerial-economics/13495