Skillsfirst Level 5 Diploma in Financial Trading (RQF) - Module 1 - Trading Introduction
Skillsfirst Level 5 Diploma in Financial Trading (RQF) - Module 2 - Financial Products
Skillsfirst Level 5 Diploma in Financial Trading (RQF) - Module 3 - Economic Principles
1 of 2

THE BUSINESS CYCLE

Over time, the level of economic performance oscillates in a way that gives rise to the Business Cycle, which measures the rise and fall in economic activity via the Real Gross Domestic Product. The reason for these fluctuations is due to differences between the levels of overall demand and supply in the overall economy. A business cycle is therefore defined as the time between two separate but successive periods of economic expansion, as shown in the image below.

Historically, these periods occur at regular intervals. As economic activity expands, the divergence between demand and supply increases in favour of demand, leading to a restriction in the supply of credit needed to generate further economic growth. As the cost of borrowing increases, resource prices begin to rise, adding further pressure of aggregate supply. This leads to business margins becoming thinner and thinner until overall production and output is curtailed – leading to a downturn in economic activity.

These downturns are known as Recessions, and may also be triggered by economic sentiment becoming increasingly pessimistic among both consumers and producers. For example, this pessimism may lead to a decline in both consumption, resulting in an increase in inventory among firms unable to sell output. Businesses will then usually respond to higher amounts of unsold stock by cutting back production, and laying off workers – creating a so-called ‘self-fulfilling prophecy’ as this leads to economic downturn initially feared. Officially however, a recession is defined as two or more consecutive quarters of economic decline.

The cyclical nature of economic activity can be more accurately represented with respect to longer term trend, most notably the trend in the growth of Potential Economic Output, represented by Y*. This represents the maximum level of production the economy can possibly operate at, within the constraints of the resources currently available within the economy. However, Potential Output may be increased by increased access to raw materials, labour supplies, and capital, as well as improvements in the level of technology across the economy.

But, demand- and supply-side shocks (such as changing economic expectations, policies and conditions) will ensure Real GDP will fluctuate around Potential GDP. This difference is known as the Output Gap, which is expressed by the following equation:

Output Gap = Yr. – Y*

Therefore, when Real GDP exceeds Potential GDP (or when the Output Gap is positive), a condition is created known as an Inflationary Gap. With overall demand for goods and services outstripping the economy’s capacity to produce them, general price levels rise. Conversely, when Real GDP is below Potential GDP (or when the Output Gap is negative), a condition is created known as the Deflationary Gap. With the overall supply and goods and services outstripping the economy’s demand for them, general prices levels fall.

The History: Since World War II, most business cycles would last 3-5 years peak-to-peak. The average duration of an expansion was 44.8 months and the average duration of a recession has been 11 months. As a comparison, the Great Depression which saw a decline in economic activity between 1929 and 1933, lasted 43 months peak-to-trough.

Scroll to Top