Economic Growth and Business Cycles

One of the best measures of an economy is its growth rate. An economy growing 2% annually will quadruple in about 70 years, which is a little less than life expectancy, while an economy growing at 3% annually will almost octuple during that same lifetime, ending up twice the size of the 2% economy due solely to a 1% difference in annual growth rate.

In the last 50 years, the United States economy has grown about 2.8%; 1.1% of that growth came from population growth and the remaining 1.7% came from productivity improvements, especially technology improvements.

Economic growth is either an increase in real GDP or an increase in real GDP per capita occurring over a specific time period. High GDP indicates high output by the economy, but a high GDP per capita indicates a high standard of living. For instance, China's GDP is much greater than Denmark's, but Denmark's GDP per capita is much higher; hence, Denmark enjoys a higher standard of living than most Chinese.

There are 2 main sources of growth: increases in the factors of production, and increases in the productivity of converting those factors of production into finished products and services.

Adam Smith cited 4 principal causes of economic growth in his book The Wealth of Nations as being increases in:

  1. the labor force,
  2. the degree of labor specialization,
  3. the amount of capital stock, and
  4. the level of technology.

Labor and capital stock are inputs used to produce economic output, while the specialization of labor and technology makes more productive use of the inputs, thus expanding economic output even more. Increases in entrepreneurship also increases productivity as entrepreneurs discover more efficient ways of providing products and services, or even producing new products and services. Generally, the rate of economic growth is commensurate with the rate of growth of these factors of production. Although land is a major factor of production, it cannot be increased, so it is not a source of growth. Although the population of the world is still increasing, leisure is also increasing, so the growth of the labor force is starting to flatten.

The main sources of growth today occur from the advancement of technology, especially in computers, automation, and networking. With better technology, the quantity of production can be increased while also lowering costs. Thus, technology expands the production possibility frontier. For instance, electronic publications, such as documents posted on the Internet, e-books, and other sources of electronic information, have reduced the need for paper, the need to deliver the publications to various destinations, and the need to store such publications in warehouses. Moreover, electronic publications can be produced much faster and the information is much more usable, since it can be easily searched and viewed on portable devices.

The rate of economic growth also depends on the size of the economy. Smaller economies tend to grow faster than larger economies because they are growing from a smaller base. Just as for businesses, the larger the economy, the lower the growth rate tends to be. Moreover, smaller economies are usually less well developed, so they benefit from assistance from more developed nations. Less-developed nations often copy the newest technologies, buy it outright, or their domestic companies partner with companies of developed economies with leading-edge technology. China, for instance, is leveraging many partnerships with leading-edge companies from around the world so that it can acquire the latest technologies and learn the newest methods of doing business.

Increases in productivity also allow an economy to invest more in research and development and take more risks in new enterprises. With economic growth, products and services increase in quality, and people generally enjoy greater amounts of leisure.

Real economic growth is measured by subtracting the real GDP of the previous year from the real GDP of the measured year, then dividing that difference by the real GDP of the previous year.

( Real GDP for Year
– Real GDP for Previous Year )
Real Economic Growth = ÷
Real GDP for Previous Year

For instance, the real domestic product for 2010 was $13.088 trillion in 2005 dollars, while real GDP in 2009 was $12.703 trillion. Therefore, real economic growth from 2009 - 2010 equaled 13.088-12.703=0.385, 0.385/12.703 = 0.0303 = 3.03%

Business Cycles

Economic growth does not increase continually, but rather in spurts, by cycling through peaks and recessions. Often, peaks are associated with higher prosperity, but also with higher inflation, while recessions are associated with higher unemployment. However, business cycles are not uniform – some are short, lasting for several months, while some last for several years. After the economy peaks, then there is a downturn, lessening the amount of inflation, raising unemployment, and lowering economic productivity. Economic output reaches a maximum at the peak of the business cycle, while it reaches a minimum at the trough. The trend of economic growth, however, is generally upward.

Causes of Business Cycles

Many hypotheses attempt to explain the causes of the business cycle. Some say that major innovations are the cause of business cycles, such as the development of the railroad, motor vehicle, and computer technology. Indeed, when fundamental innovations are made, many business people discover how to capitalize on the new technology. For instance, the framework of the Internet as it exists today coupled with programming languages, especially open source programming languages, allows innovators to develop a wide variety of services based on these fundamental technologies.

Others argue that variations in the supply of money cause business cycles. Indeed, an increase in the money supply will have a stimulatory effect, at least at first, but eventually it ends because people start anticipating inflation that results when the money supply is continually increasing. However, the contraction of the money supply will certainly cause a contraction of the economy, because businesses cannot make a profit without being able to sell their wares. When money supply declines, deflation sets in, which causes many people to hold onto their money since it becomes more valuable in time.

However, the main cause of business cycles is a fluctuation in consumer spending. As the economy recovers from recession, people's confidence increases, so their spending increases, which gives rise to a multiplier effect, raising the income of both individuals and businesses, which in turn, stimulates more spending. However, at some point, the business cycle peaks because people have no more money to spend, and indeed, many people have borrowed money, so their debt load forces them to stop spending at some point, since they have to repay their debt, with the result that consumer spending declines.

A cycle diagram of the debt cycle, showing how lowering interest rates leads to more borrowing and spending, creating an economic boom. Then interest rates are raised to cool the economy and borrowers must repay the loans, so they cut spending and many default on their loans, leading to less economic activity, higher unemployment, and an economic bust. Then the central bank decreases interest rates to stimulate the economy, causing the cycle to recur.

Another major cause of business cycles is the debt cycle. When the economy falters, central banks lower interest rates to stimulate the economy. This leads to more borrowing and more spending. The economy heats up. The multiplier effect increases business and employment, leading ultimately to an economic boom. Then central banks raise interest rates to cool the economy and borrowers must repay their loans, leading to less spending and lower economic activity. More people become unemployed, which depresses economic activity even more, causing many borrowers to default and businesses to lay off even more people, ultimately leading to an economic bust. Then the cycle repeats itself.

Another part of the debt cycle is shadow banking, companies lending money outside of the banking system, free of the rules controlling risk in bank. When interest rates are low, yield-hungry investors seek higher returns by investing in companies that make loans to other companies, such as business development companies. Some of these loans are also made to family investment companies seeking to increase their leverage in a rising market. However, when the economy declines, many of these borrowers will default, depressing the economy even more. Thus, this money from shadow banking increases the money supply during the good times but causes more damage when the economy tanks. Furthermore, because shadow banks do not have deposit insurance or lender of last resort facilities from central banks and have less regulatory oversight, investors are more likely to yank out their money at the 1st signs of trouble, to prevent losses, thereby precipitating more downturns for the economy, amplified by the multiplier effect.

How Capital Goods and Consumer Durables Are Affected by the Business Cycle

When the economy starts to decline, the first companies that suffer are the ones that produce capital goods and durable consumer items, such as automobiles, computers, and appliances. Businesses generally do not have a need to increase their purchase of capital stock in a declining economy, because the equipment that they have can produce enough output to satisfy declining needs. Likewise, consumers lose confidence in the economy, so they cut back on major purchases, such as cars and trucks, computers, and appliances, since most people replace these items when they want a newer or better version. However, in an uncertain economy, people will hold onto what they have for longer periods of time. Through the multiplier effect, the economy slows even more until it reaches a trough. However, most services and nondurable consumer goods are relatively unaffected by recession, because it is difficult for consumers to put off such purchases, such as for food, clothing, and medical services. Indeed, some firms actually receive increased business during a recession, such as auto repair shops and law firms specializing in bankruptcy, since the need for these services usually increases as a result of the recession.

At some point however, the economy bottoms out because people can only put off purchases for so long. Indeed, because they have put off purchases, there is actually an acceleration of purchases as the economy recovers. For instance, people can keep their cars and trucks for a few more years, but at some point, repairs will get more expensive than buying a new vehicle. Likewise, many people who were contemplating elective medical procedures can delay the procedures until a later time, but at some point, they usually have to get it done. Another factor that helps the economy to recover is that people pay down their debt, since they have reduced their spending, so they have more money when they decide to start buying again.