The economic cycle (or the business cycle) is a term economists use to describe the cyclical flow of economic growth and decline.
Due to the freedom of economic choice found within a free market economy, businesses and consumers often react to the economic
environment in ways that would most benefit them, but with little consideration to the economy at large. Thus, we observe the
aggregate affect of hundreds of thousands of people all pursuing similar goals, for similar reasons, at similar times. The final affect
of this behavior is an economic cycle that tends to swing up and down as people act, and react, to the economic environment in
unison. The economic cycle will thus move repeatedly through periods of economic recovery,
expansion, decline, and recession.
Let's begin our analysis of the economic cycle in a period of economic recovery. This is when the cycle is just starting to expand out of
a period of recession. First, we will consider how consumer spending influences this economic environment. If a consumer purchases
a certain product, they inject money into the economy and add to the demand for that particular product. As a result, the seller of the
product has gained income. This increase in income might influence the seller to increase the hours of a part-time worker. Now that
part-time worker also has more money to spend. These increased wages may then be spent on other goods or services. The seller
of those goods or services will then experience increased profits, and thus hire more employees. Those employees are now earning more
money - which they quickly spend on goods and services. The compounded effect of all this hiring and spending will then lead to a
period of tremendous economic activity, which we call economic expansion.
As you can imagine, thousands of different people, all acting independently to pursue their own self-interest, tend to produce a
compounding effect within the economy. Consumer spending increases, causing business profits to increase, which causes
employment to increase, which causes consumer spending to increase further! We are now experiencing economic expansion
(or boom). Economic expansion is described as a time of high economic growth, which is characterized by high spending,
high production, and high employment. This all seems quite wonderful, but unfortunately the cycle cannot continue to expand
indefinitely. The same group behavior which caused economic expansion will soon start to inspire
economic decline.
Decline happens as a result of the secondary effects which accompany economic growth. You see, when demand for products
and services increases, businesses will soon become inspired to increase prices. In
addition, increased spending, business expansion, and consumer confidence during ecomic expansion causes the demand
for borrowed money to increase - which causes interest rates to rise. After a while, increased prices (inflation) and high interest
rates, start to reduce consumer spending (see law of demand). As spending slows down, more and more businesses are motivated to retain profits
by cutting expenses. Thus, businesses will lay off employees as they become less necessary. As these employees are laid off,
they experience a sharp decline in income, and thus their spending is greatly reduced. As this spending is
reduced, it causes more and more employees to suffer the same fate. Before you know it, the situation has compounded into a
recession.
Recession is the most painful period within the economic cycle. Employment is low, incomes are low, and business production
is low. During mild recessions decreased incomes may cause consumers and businesses to merely cut back on expenditures.
However, during severe recessions, individuals and families may be forced to sell their homes as they become unable to make
mortgage payments. Some businesses may fail completely - causing the chances for a quick recovery to decrease, and causing
wealthier individuals and businesses to permanently lose wealth in failed stock investments.
Fortunately, the cycle does not stop here. After a while, the lack of consumer demand for goods and services, as well as the lack of demand for borrowed money, will cause both prices and interest rates to drop. Soon, lower prices will inspire some people to finally buy items they may not have purchased before. Still other people will take advantage of low interest rates to borrow money. (Naturally, this borrowed money is quickly spent within the economy.) Before you know it, the cycle has returned to a period of recovery.