business (trade) cycle: phases of the cycle

Business (Trade) Cycle – Phases of the Cycle

1. Why the Business Cycle Matters

• Shows short‑run fluctuations in real GDP, employment, inflation and other macro‑economic variables.
• Guides economists and policymakers in choosing the appropriate mix of fiscal, monetary and supply‑side tools.
• Directly links to Cambridge International AS & A Level Economics (9708) – Units 9, 10 and 11.

2. Core Concepts (Unit 9)

2.1 Circular Flow of Income & Multiplier

• Circular flow (closed economy): Households ↔ Firms (factor & product markets).
• Open economy extension: adds Government and Foreign sector (taxes, transfers, imports‑exports).

Multiplier derivation (including leakages)

Variable	Symbol	Typical value (example)
Marginal propensity to consume	MPC	0.75
Marginal propensity to save	MPS	1‑MPC = 0.25
Marginal tax rate	MRT	0.20
Marginal propensity to import	MPM	0.10

Effective multiplier:

\[ k = \frac{1}{MPS + MRT + MPM} \]

Using the example values: \(k = \frac{1}{0.25 + 0.20 + 0.10}= \frac{1}{0.55}=1.82\).

2.2 Economic Growth & Sustainability (Unit 9.2)

• Actual growth: change in real GDP in a given period.
• Potential (full‑capacity) growth: growth the economy can sustain when all resources are fully employed.
• Output gap: \((Y_{\text{actual}}-Y_{\text{potential}})/Y_{\text{potential}}\). A negative gap indicates under‑utilisation; a positive gap signals overheating.
• Sustainable growth: growth that can be maintained without depleting natural resources, harming the environment or compromising future welfare.

Case‑study box (green R&D subsidy)

• Government introduces a 20 % tax credit for firms investing in renewable‑energy R&D.
• Short‑run effect: boosts autonomous investment → multiplier‑induced rise in AD.
• Long‑run effect: raises potential output by improving productivity while keeping carbon emissions low.

2.3 Employment & Unemployment (Unit 9.3)

Type of unemployment	Definition	Typical phase of the cycle	Policy focus
Frictional	Short‑term job search between jobs	All phases	Labour‑market information services
Structural	Mismatch of skills/locations with job vacancies	Often rises in contraction	Training, re‑skilling, relocation subsidies
Cyclical	Result of insufficient aggregate demand	High in contraction, low in expansion	Demand‑stimulating fiscal/monetary policy
Seasonal	Predictable fluctuations (e.g., tourism)	All phases (regular pattern)	Usually not a policy target

Natural rate of unemployment (NRU) = frictional + structural. When actual unemployment > NRU, the economy is in a contractionary gap.

Link to the Phillips Curve (Unit 10): In the short run, lower unemployment (moving left along the curve) tends to raise inflation; higher unemployment tends to reduce inflation. This trade‑off underpins many policy decisions.

2.4 Money & Banking (Unit 9.4)

• Functions of money: medium of exchange, unit of account, store of value.
• Money‑creation process (simplified flow‑chart):
  1. Central bank sets policy rate & reserve ratio.
  2. Commercial banks receive deposits, keep required reserves, lend the rest.
  3. Each round of lending creates new deposits → money multiplier.

Quantity Theory of Money (MV = PT):

• M = money supply, V = velocity of circulation (assumed stable in the short run), P = price level, T = real transactions (≈ real GDP).
• Implication: If V is stable, changes in M have a direct effect on nominal GDP (P·T).

Interest‑rate determination theories

• Liquidity‑preference theory (Keynes): interest rate adjusts to equate money supply with money demand.
• Loanable‑funds theory (classical): interest rate balances savings (supply of funds) with investment (demand for funds).

3. Phases of the Business Cycle

The cycle is conventionally divided into four phases. Each phase has characteristic macro‑variables, typical policy tools, and sustainability considerations.

Phase	Key Indicators (what we observe)	Typical Policy Tools (what we do)	Policy Objectives (price stability, employment, growth, balance of payments)	Sustainability Focus
Expansion (Recovery)	Real GDP ↑ (ΔY > 0) Unemployment ↓ (cyclical component falls) Capacity utilisation ↑, spare‑capacity falls Moderate inflation (≈ 2‑3 %)	Monetary: neutral or modest tightening (small rate rise) if inflationary pressure builds. Fiscal: maintain current spending; consider consolidation if deficits widen. Supply‑side: incentives for R&D, training, green‑technology adoption.	Price stability – avoid overheating. Low unemployment – sustain job creation. Growth – keep output expanding. External balance – monitor import demand.	Invest in renewable‑energy R&D and energy‑efficient capital. Introduce “green taxes” (e.g., carbon tax) while the economy can absorb them.
Peak	Output at or above potential (Y ≈ Y*). Full‑employment level of labour (cyclical unemployment ≈ 0). High inflation (π > 3 %).	Monetary: contractionary – raise policy rate, possibly sell government bonds. Fiscal: reduce aggregate demand (higher taxes, cut non‑essential spending). Supply‑side: shift incentives toward low‑carbon industries; phase‑out fossil‑fuel subsidies.	Price stability – curb inflation. External balance – reduce import‑led pressure.	Lock‑in structural changes that lower long‑run carbon intensity. Prevent “boom‑bust” cycles that waste resources and increase debt.
Contraction (Recession)	Real GDP ↓ (ΔY < 0) – negative output gap. Cyclical unemployment ↑. Investment and consumer confidence fall. Inflation slows; risk of deflation.	Monetary: expansionary – cut policy rate, quantitative easing, lower reserve requirements. Fiscal: stimulus (increase G, cut taxes) to raise aggregate demand. Supply‑side: targeted training programmes, green‑skill development, infrastructure projects.	Reduce unemployment. Support growth – lift output toward potential. Maintain price stability – avoid deflationary spiral.	Design stimulus to avoid “green‑washing”; ensure funds go to genuinely sustainable projects. Opportunity to build low‑carbon infrastructure (public transport, smart grids).
Trough	Lowest level of output and employment in the current cycle. High cyclical unemployment; price levels stabilise.	Continue expansionary monetary policy until clear recovery signals appear. Maintain fiscal stimulus or adopt a “green recovery” package. Supply‑side: structural reforms (labour‑market flexibility, green‑technology adoption).	Kick‑start growth and employment. Ensure external balance does not deteriorate further.	Plan for a resilient, low‑carbon growth path – e.g., renewable‑energy‑focused public works. Strengthen climate‑adaptation capacity to reduce future shock vulnerability.

4. Policy Conflicts, Trade‑offs & Government Failure (Unit 10)

• Phillips‑curve trade‑off: Reducing unemployment via expansionary policy can increase inflation; tightening to curb inflation may raise unemployment.
• Policy lags: Recognition, decision and implementation lags can cause overshooting or undershooting of targets.
• Government failure:
  • Timing errors (e.g., stimulus arriving after recovery has begun).
  • Crowding‑out of private investment when government borrowing pushes up interest rates.
  • Political pressures leading to inappropriate policy mix.

5. International Economic Issues (Unit 11)

5.1 Balance of Payments (BoP)

The BoP consists of three main accounts:

• Current account: trade in goods & services, primary income, secondary income.
• Capital account: transfers of non‑produced, non‑financial assets (e.g., debt forgiveness).
• Financial account: direct investment, portfolio investment, other investment, reserve assets.

5.2 Exchange‑Rate Regimes

Regime	Key Features	Policy Implications
Fixed (or pegged)	Central bank commits to a set rate; intervenes in forex market.	Monetary policy constrained; requires sufficient foreign‑exchange reserves.
Managed float (dirty float)	Rate determined by market but with occasional official intervention.	More flexibility than fixed; still some policy influence.
Free float	Rate determined entirely by supply and demand.	Monetary policy independent; exchange‑rate volatility possible.

5.3 Exchange‑Rate Effects on the Cycle

• Depreciation → cheaper exports, more competitive abroad → boost to net exports → helpful in a contraction.
• Appreciation → imports become cheaper, export demand falls → can dampen demand during an expansion.

5.4 Development & Sustainability Indicators

• Human Development Index (HDI) – combines life expectancy, education and per‑capita income.
• Gini coefficient – measures income inequality (0 = perfect equality, 1 = perfect inequality).
• Kuznets curve – hypothesises an inverted‑U relationship between income per‑capita and inequality.
• Ecological footprint – measures resource consumption relative to planetary boundaries.

5.5 Globalisation Themes

• Trade liberalisation can accelerate growth but may increase exposure to external shocks.
• Foreign direct investment (FDI) brings technology transfer but can raise concerns about profit repatriation.
• International climate agreements (e.g., Paris Agreement) influence domestic policy choices, especially during peaks and troughs.

6. Worked Example – Multiplier & Okun’s Law (Units 9 & 10)

Scenario: The government increases autonomous government spending (ΔG) by £5 billion during a recession. MPC = 0.75, MRT = 0.20, MPM = 0.10.

1. Calculate the effective multiplier: \[ k = \frac{1}{MPS + MRT + MPM}= \frac{1}{(1-0.75)+0.20+0.10}= \frac{1}{0.55}=1.82 \]
2. Total change in aggregate demand: \[ \Delta AD = k \times \Delta G = 1.82 \times £5\text{ bn}= £9.1\text{ bn} \]
3. Output gap: Potential output \(Y^{*}=£500\text{ bn}\); actual output \(Y=£480\text{ bn}\). \[ \text{Output gap}= \frac{Y-Y^{*}}{Y^{*}}= \frac{480-500}{500}= -0.04\;(‑4\%) \]
4. Okun’s Law (Δu = –β × output‑gap, β≈2.5): \[ \Delta u = -2.5 \times (-0.04)=+0.10\;(10\% \text{ reduction in cyclical unemployment}) \]
5. Interpretation: The stimulus raises AD by about £9 bn, narrowing the output gap and potentially cutting cyclical unemployment by 10 percentage points, provided the multiplier estimate holds.

7. Teacher’s Checklist – Alignment with Cambridge 9708 Syllabus (2026‑2028)

Syllabus Area	Covered?	Action Required
9.1 – Circular flow & multiplier	✓	Include the circular‑flow diagram and the full‑leakage multiplier example (already added).
9.2 – Economic growth & sustainability	✓	Emphasise actual vs potential growth, output gap, and the green‑R&D case study.
9.3 – Employment & unemployment	✓	Table of unemployment types, link to output gap & Phillips curve.
9.4 – Money & banking	✓	Money‑creation flowchart, quantity theory, liquidity‑preference & loanable‑funds notes.
10 – Government macro‑economic intervention	✓	Added policy‑conflict box and government‑failure points.
11 – International economic issues	✓	Full BoP accounts, exchange‑rate regime table, development indicators, globalisation notes.

8. Illustrative Diagram (Suggested for Lecture Slides)

Figure 1 – Sinusoidal Business‑Cycle Curve

• X‑axis: Time (years)
• Y‑axis: Real GDP as % of potential output
• Four phases labelled (Expansion, Peak, Contraction, Trough).
• Arrows at each phase indicating the dominant policy tool (e.g., “Lower rates” at Contraction).
• Side notes on sustainability actions (green stimulus at Trough, carbon tax at Peak).

9. Summary

• The business cycle records short‑run fluctuations in output, employment, inflation and external balances.
• Understanding each phase enables targeted use of fiscal, monetary and supply‑side policies while recognising trade‑offs (e.g., Phillips‑curve) and possible government failures.
• Integrating sustainability into every phase ensures that short‑run stabilisation does not compromise long‑run environmental objectives.
• Linkages to the international arena (exchange rates, BoP, development indicators) are essential for a complete A‑Level answer.