CHAPTER 3:

ECONOMIC PERFORMANCE AND BUSINESS CYCLE

3.1 Definition and Concepts of Business Cycle

 Periodic fluctuations in economic activities which occur as the economy

moves away from its trend path are known as Business Cycle.
 Business Cycle is the fluctuation in economic activity that an economy
experiences over a period of time.
 One of the major concerns of macroeconomics is the upswing and
downswings in the level of real output called business cycle.
 The total national output of a country changes from time to time depending
on different negative and positive factors.
 Negative factors are factors that adversely affect total national output.

 Positive factors increase the total national output. 1

 The upswing and downswing in the level of real output are cyclical in
nature and move around its trend path.
 The trend path is given by straight-line that shows the movement of
the economy if it is in full employment.
 Phases of the Business Cycle
 These phases are stages through which an economy passes to complete
the business cycle (to complete one cycle).
 The business cycle has two phases and two turning points.

a) The two phases are Recession (Contraction) and Recovery

(Expansion) while

b) The two turning points are Peak (Boom) and Trough (Bottom).

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 Expansion: This phase of the business cycle denotes growth in the economy. In
this phase, businesses, employment, and price level is growing.
 Contraction: This is the downside of the expansion phase. In this phase,
unemployment begins to grow while businesses are downsizing and making cuts.
Two consecutive quarters of this phase denotes a recession.
 Peak: The peak is the height of the expansion phase. This phase is usually not
known until after it is over. Unemployment reaches its lowest point in the cycle
and businesses reach their expansion limits.
 Trough: The trough is the “bottoming out” of the contraction phase. Again, this
phase is usually not known until after it has passed. Unemployment and firm
contraction reach their lowest points in the cycle in this phase.
 (A) Peak (Boom) → (B) Contraction (Recession) → (C) Trough (Bottom) →
(D) Expansion (Recovery) → (A) Peak (Boom) →….. 3
 Trend Line is indicated by the straight dotted line and business cycle which
passes through points of actual economic activity measured by GDP is
shown by bold line.

Figure 3.1: Business Cycle 4

3.2 Sources of Economic Fluctuations
Each phase of the business cycle has its own sources or factors leading the
economy to take that phase.
Economic Recessions (or contractions) and economic troughs are the result of the
following major factors:
Natural factors such as drought caused by shortage of rainfall;
War which diverts resources from production;
Inappropriate economic policies;
Underemployment of the existing economic resources or factors of production; and
so on.
These phases are again characterized by the following cyclical recession or
cyclical trough:
Low output or GDP;
High unemployment (or low employment);
Low aggregate demand for both products and factors of production;
Low per capita income (PCI); and so on. 5
 Economic expansion (or recovery) and peak are the result of the following
major factors which are opposite to the factors that lead to cyclical recession
and cyclical trough.
Political stability;
Use of appropriate economic or macroeconomic policies;
Discovery and use of new economic resources or factors of production such
as minerals like petroleum or oil and deposits of precious metals like gold.
Utilization of idle resources or factors of production such as labour;
Use of improved quality workers through training and so on.
 These phases of expansion or recovery and peak are characterized by:
 Higher aggregate output or GDP;
 Low unemployment (high employment) of factors of production such as
labour and capital;
 High aggregate demand for products and factors of production;
 Larger Per capita Income (PCI); and so on.   
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3.3 Theories of Business Cycle
3.3.1 aggregate demand and supply theories
 There are three types of aggregate demand theories. Those are
1. Keynesian theory
 Keynesian theory holds that changes in aggregate spending are the cause of
variations in real GDP.
 Let’s take a simple example by dividing economy into households (c), business
(i), government (g) and foreign buyers (x-m).
 The aggregate spending includes the sum of all these four sectors.
 Mathematically, we can represent this by the national income identity or
equation discussed earlier under expenditure approach to national income
accounting process.
GDP = C + I +G+ (X-M)
 If the total spending increases, business firms find it profitable to invest and
increase output.
 When total spending falls, however, businesses or producers will find them
profitable by producing a lower volume of goods and services and avoid
inventory. This leads to recession.
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2. Monetarist Theory of Business Cycle
 In this theory, a fluctuation in the money stock is the main source of
economic fluctuations.
 The impulse in the monetarist theory of business cycle is the growth or the
quantity of money.
 An increase in the money supply brings expansion and a decrease in money
supply brings recession.
 When the money growth rate increases, the quantity of real money in the
economy also increases.
 At the same time, interest rates fall and real money balance increases. The
foreign exchange rate also falls.
 Assuming upward slopping supply curve, a rightward shift in aggregate
demand brings not only an increase in GDP, but also the price level.
 Similarly, one can analyze for a decrease in the money supply and show that
the result of it is recession or contraction or trough of the business cycle.

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Figure 3.3 Money Supply and Aggregate Output

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 3. Rational Expectation Theory

 A rational expectation theory is a forecast that is based on the available

and relevant information.

 When aggregate demand decreases, if money wage doesn’t change, then

real GDP and price level decreases.

 The fall in price level in turn leads to an increase in the real wage rate
and unemployment rate. These changes in the economy lead to
recession.

 This is because when prices fall producers become less profitable and
they thus cut their production and reduce employment or their workers.
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 3.3.2. Real Business Cycle Theory (RBC)
 Real Business Cycle Theory asserts that fluctuations in the output and
employment are due to a variety of real shocks that hit the economy.

 This theory explains business cycle through shocks or disturbances and

propagation of shocks throughout the economy. 

 Disturbances are due to the shocks to productivity, supply shocks and shocks to
government.

 This thereby asserts that productivity shocks are due to change in weather and

new method of production.

 The shocks due to the disturbances are spread through the economy. This

principle is known as propagation mechanism.

 This propagation mechanism basically tries to explain why people work more

sometimes than during other times.

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 3.3.3. Political Business Cycle Theory
 Another explanation is where government deliberately causes business
cycle. This situation is known as political business cycle.
 It refers to a business cycle, which is caused by policy makers to improve
re-election chances.
 Governments adopt tight monetary and fiscal policy soon after an election,
but then adopt more expansionary policies as the election approaches to
encourage a ‘feel-good’ factor.
 This theory views politics to be a short-run game where the self-interest of
the politicians is to maximize votes. Voters are also short sighted and want
good news now rather than being promised.
 The difference of this theory of creating recession from other theories is
that political business cycle is deliberate and created by politicians while
other theories are not deliberately created.
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 3.3.4 Forecasting Business Cycle: Indicator Forecasting
Economic variables are inter-related and they show cyclical movements.
Some of these variables or indicators are known as lead indicators.
These indicators turning points occur before those of total economic activity.
Variables like industrial production and business expenditures roughly
coincide with the overall cycle while some other variables like job vacancies
and unit labour costs lag behind the business cycle called lag variables.
Based on the historical experiences of business cycles across the world the
economy can decide about which the lead is and which is the lag variable.
The lead and the lag variables differ depending on the development level of
an economy, institutional set-up of the economy and structure of the economy.
The indicators for a county whose economy is dominated by agricultural
sector is not the same as the indicators (or lead variables) of an industrially
advanced economy.
In the former, the lead variables may be natural factors such as good weather
condition, whereas in the later the lead variables may be market factors such
as demand and income. 13
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THANK YOU

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