The business cycle
Cycle means repetition of certain phases. GDP does not develop straightforward - there is a pattern of ups and downs.
1. Expansion. Economy begins to recover. During an expansion business and consumer spending begin to increase, business begins to increase production. Unemployment declines as additional workers are hired, and this leads to higher level of consumer spending and still further expansion of employment, output and consumption. Interest rates grow.
2. Peak (boom). At the peak of an expansion, the economy is booming. Business is normally producing at or near capacity and those looking for work can generally find jobs. During peak times, business investments and consumer spending are at the highest levels. But because the economy is at or near full employment and the demand for goods and services is increasing, prices are also increasing and so is inflation. Interest rates are at their highest point, to discourage companies so they wouldn't produce so much.
The risk of overheating happens when the economy is growing too fast, with key indicators getting out of control and a loss of economic stability.
- There is a need for soft landing, the government aims to bring economic activity back to more sustainable levels without the economy going into recession.
A bubble is a period when demand for something grows too fast, leading to the prices also rising too fast.
- Then the bubble burst with the demand falling too fast. Prices crash, with buyers wanting to sell for whatever they can get.
3. Recession. In recession consumers and businesses begin to reduce their spending level. Businesses may lay off workers, reduce their purchases of materials and reduce production, because they have built up excess inventories. Some businesses may decide to continue to use old factories and equipment rather than investing in new machines and buildings. Workers are laid off, consumers have less money, and thus buy less. This leads to still more reductions in production and additional worker layoffs. Interest rates start to fall. A long period of severe recession is a depression or a slump.
4. Depression. The economy will reach the lowest point of a business cycle. Factories will be operating at less than capacity and unemployment will reach high levels, some companies will even go bankrupt. Total output of goods and services continues to decline. Interest rates are at their lowest point to encourage people to produce, so that the economy could recover.
What causes business cycles
A) External factors occur outside the economic system, can't be influenced:
- Inventions and innovations cause boom
- Wars and political events cause recession
B) Internal factors occur within the economy itself, can be influenced:
- Consumption: when production and employment increase, then so does consumer spending.
- Business investment: increase in investment leads to more production and higher employment, leading to higher consumption as people have more purchasing power.
- Government activity: through fiscal policy the government can tax or spend, or through monetary policy – regulating the supply of money and credit in circulation.
Business cycles according to periodicity:
- From 3 to 5 years: happens because of excess production, supply > demand, the inventories of businesses are excessive. The demand declines, prices drop and so businesses reduce production
- From 7 to 11 years: businesses invest unevenly into fixed capital
- From 15 to 25 years: demographic processes such as immigration - if immigrants flow into the country, production rises. If they move out of the country, the opposite happens and the economy declines
- From 45 to 60 years: longer periods of time when multiple inventions are made, it causes a boom on a worldwide scale
Consequences of cyclical development are inflation and unemployment.
Inflation refers to a general rise in the level of prices of goods and services.
Stagflation is used to describe situation when prices and unemployment rise at the same rate, or there is no economic growth.
The main causes of inflation are: more money in circulation, labor union pressure to raise salaries but the productivity stays the same, or too high national debt.
The rate of inflation is measured by calculating the percentage price increase in goods and services usually over a year. Percentage price rises are usually shown by a retail price index.
RPI (current year)–RPI(previous year)
Inflation = ---------------------------------- . 100
RPI = retail price index, it is the average price of all items selected
- Mild inflation: 1-9%, prices are relatively stable, the monetary system works well, people trust money. This measure is acceptable.
- Galloping inflation: 10-100%, this causes troubles in money circulation, money lose their value very quickly, people do not trust money, they invest them into real estates, money is lent on high interest.
- Hyperinflation: 1000%, means disintegration of money circulation, prices grow chaotically, people turn to barter. Occurs usually during wars.
According to the reason we distinguish:
- Demand-pull inflation. When demand increase faster than industry´s ability to satisfy demand, prices rise.
- Cost-push inflation. Rising prices of inputs rise, so there is an increase in the cost of production. Higher costs are passed on to consumers as higher prices. With prices going up, workers often ask for wage increases to keep up with the increased cost of living, but it is not matched by increased productivity and so on in an inflationary spiral. Similarly, efforts by producers to increase profits by increasing prices rather than by reducing costs also trigger an inflationary spiral.
- Imported inflation. As the value of euro falls against other foreign currencies, the price paid for imported products will rise even if the prices of those goods in dollars or other foreign currencies have not changed.
Those most likely to suffer from inflation are:
- People living on relatively fixed incomes - pensioners, women on maternity leave
- Savers who put their money into saving accounts or bonds that guarantee a fixed rate of return (interest). Unless the rate of interests is at least as high as the inflation rate, the money returned to a saver will purchase less than the sum he set aside.
- Lenders. If inflation increases during the term of a loan, the money paid when the loan comes due will be worth less than the original loan.
- Business. Inflation causes uncertainty and makes it hard for managers to predict future costs. It also raises production costs.
Those who are not affected (or benefit):
- Those who can increase their incomes. Certain professions, industries and labour groups find it easier to increase prices and wages during periods of inflation than at other times. Those people will be better off than before (jewelery trade, land owners)
- Borrowers will be returning money that is worth less at the end of the loan peiod than it was at the beginning. If the inerest charged on the loan is less than the inflation rate, those who borrowed will benefit from the difference.
- Government. During inflation, people tend to earn higher incomes, putting more taxpayers into higher tax brackets (if progressive taxing is applied).
Unemployment is a situation, when not everyone in their productive age is employed. Unemployed people are those who are in productive age from 16 to 62, they are capable of, available for and actively seeking work but unable to find jobs.
The Labour Department gathers this information and gives it to Bureau of Labour Statistics that then calculates the unemployment rate. People claiming unemployment benefits must enter a Jobseekers Agreement, setting out the action they will take to find work and improve their prospects of finding employment.
Unemployment rate = –––––––––––––––––––––– x 100
People working in part-time jobs or young people on government training schemes, or graduates are not counted in unemployment figures because they are not in the Jobseekers Agreement. Groups of people like these are said to be the hidden unemployment.
We distinguish different types of unemployment:
Frictional unemployment occurs as people voluntarily change their job and spend some time looking for a new one. It is a short-term and often voluntary unemployment
Seasonal unemployment occurs because consumer demand for some goods and services is seasonal. Jobs in tourism, the building industry, agriculture
Cyclical unemployment occurs when there is too little demand for goods and services in the economy during an economic recession.
Structural unemployment. If the fall of demand for some goods or services is permanent because of change in peoples tastes maybe because of cheaper sources of supply from overseas firms, the change in demand is called structural. Structural unemployment arises from long-term changes in the structure of the economy as entire industries close down because of a lack of demand for the goods or services they produce. Workers whose skills are no longer wanted have to be re-trained in new skills which may help them become more mobile and find a new job. (coal mining, elevator operator)
Full employment does not mean the total elimination of unemployment. Frictional and structural unemployment are expected, and economists combine these two rates in what is described as the natural rate of unemployment. When the actual rate of unemployment equals the natural rate = about 5% of unemployment, the economy is at full employment
Imperfections in the labor market:
- Powerful trade unions demand wages for their members that are too high and not matched by improvements in productivity. As wages rise, employers may not be able to afford as many workers so they reduce their demand for labor.
- Benefits paid to the unemployed reduce the incentive to work. Some people would only be willing to work at much higher wages. This is called voluntary unemployment.
- Employers' national insurance contributions. For every worker a firm employs it must pay the government a tax in the form of employer's insurance. Cutting employers' contribution may give them the incentive to employ more workers.
- The immobility of labour prevents workers from finding new jobs. If workers are unable to move to a different job because it requires different skills and people are not qualified, this is called occupational immobility. If a worker is unable or unwilling to move to a different area, this is called geographical immobility.
- It organizes re-training courses via educational institutes
- It organizes training schemes for graduates (max. 6 months, 20 hours work per week)
- It provides some contributions (grants) to those who are willing to move to different area to find a new job (the person has to persist at least 2 years in a new place of work)
- It provides some contributions to those who want to start their own business (the volume of contribution differs from region to region and one of conditions to be granted the money is running the business for at least 3 years).
- It organizes some activation work for long-term unemployed and less educated who have difficulties to find a job (4 hours a day, at least 10 hours a week).
- It provides unemployment benefits for 6 month of unemployment