The Economics of Business Cycles: Understanding the Ups and Downs of Economic Activity

Since the Industrial Revolution, our global economy has seen unprecedented growth. By one measure, annual growth in GDP per person has averaged 1.5% since 1750. That 1.5% growth in GDP has allowed the average citizen in an industrialized nation today to live better than Roman emperors. But growth is not constant. Even ignoring the wars, famines, and depressions that mark our history, we know that an economy tends to expand and contract, and expand again and contract again, and so on. We call this cycle of expansions and contractions the business cycle. In this article, we'll answer the following questions. First, how do economists define a business cycle? Second, how long do business cycles last? Third, how did economists think of business cycles in the past? Finally, how do economists think of business cycles today?

All business cycles have four phases: an expansion, a peak, a contraction, and a trough. A new business cycle begins when economic activity peaks. Afterwards, the economy contracts until economic 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. In the United States, the measuring and dating of business cycles is handled by the National Bureau of Economic Research. In the United Kingdom, the National Institute of Economic and Social Research takes on this responsibility. Although an economy's GDP is an important variable to date business cycles, it is not the only one.

Business cycles occur more or less at random intervals. In the United States, the most recent business cycle measuring from peak to peak was the longest cycle on record, from December 2007 to February 2020. Between 1854 and 2020, business cycles in the United States lasted, on average, for about 60 months. However, since 1945, business cycles have lasted 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.

Perfectly competitive markets are an important feature of the classical view of business cycles. Real Business Cycle Theory focuses on real economic variables, such as employment, and the disturbances that affect business cycles are the same disturbances which affect the quantity demanded and the quantity supplied in any given market. Real Business Cycle Theorists focused on technological change and government purchases. However, this theory suffers from many issues, such as the sporadic nature of technology progress and the imperfections of real-world markets.

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. Paul Volcker's tenure as the US Fed chairman in the 1980s is a prime example of how monetary policy can have a significant impact on economic activity.

It would be nice if our economies were always growing. Unfortunately, fluctuations in economic activity are part of any market economy. That won't change anytime soon. Economists are still debating about the relevant factors that explain most of the mood swings we see in our economies. Although it's clear that money plays a significant role in any discussion on business cycles, this isn't to say that technology and government purchases have no effect. As mentioned already, it's likely that these variables and others exhibit small changes that