Business Cycles: Boom and Bust

As we have discussed in other tutorials, the government is constantly working to keep the

economy growing. However, economies often unpredictably shrink. While there are booms,

there are also busts. We call this a business cycle, or a period of macroeconomic expansion

followed by a period of contraction. At times, the business cycle can feel like

a rollercoaster due to how unpredictable it is. In this tutorial, we will look at what

drives business cycles and how economists try to prevent economies from shrinking.

When things are going well in life, we often don’t seem to notice, and this is also the case with

the economy. In fact, we don’t have many terms for when things are going right in an economy.

“Stable,” “growing,” and “secure” are perhaps three adjectives that could describe a “good”

economy. On the other hand, we have many terms for when things go wrong. Although definitions vary,

a recession is an economic contraction that lasts at least six months. In other words,

for six consecutive months, even as the population continues to increase, the economy

is smaller than it was before. A depression, on the other hand, is a really long and really

bad recession. The most famous depression in world history is the Great Depression,

which lasted from 1929 to around 1939, and had devastating effects. International trade went down

by more than 65%. One third of all banks failed. Unemployment in the United States got as high as

25%. And inflation increased substantially. One of the worst things that can happen in a

business cycle is stagflation. Stagflation is a recession combined with inflation. So people are

unable to find work or make higher wages while prices continue to steadily rise. Economists

first recognized stagflation during the 1970s when the Organization of Petroleum Exporting Countries,

or OPEC, issued an embargo against European and North American countries. This caused the global

price of oil to skyrocket, which then led to the increasing costs of other goods, and a rise in

unemployment. Governments greatly struggle with knowing how to properly respond to stagflation.

Economists use many tools in trying to predict business cycles, even though they are very

difficult to predict. The leading indicators are a set of important economic variables that yield

specific data. While we will go over many of these indicators in a future tutorial,

examples include gross domestic product, employment figures, the inflation rate,

and consumer spending. In the meantime, let’s focus on four main variables economists

have identified which drive business cycles: business investment, interest rates and credit,

consumer expectations, and external shocks. If businesses are not investing in their own growth,

economies tend to suffer. If they are, economies tend to thrive. If banks make it more difficult to

borrow money, economies tend to suffer. If they make it easier to borrow money, economies tend

to thrive. Consumer expectations can be the most difficult variable to interpret for economists.

While some things are more certain, like knowing that consumers are more likely to buy goods around

the holidays, other consumer expectations seem to come out of nowhere. Similarly,

an external shock is an unexpected event that dramatically changes an economy. A recent example

of an external shock is the COVID-19 pandemic. During the Great Depression, two prominent

economists arose who had sharply different views regarding how to interpret and respond

to business cycles. Those were Friedrich Hayek and John Maynard Keynes. While both feared the