1 Describe all four phases of a business cycle 2 Identify an

1. Describe all four phases of a business cycle. 2. Identify and describe three most severe recessions of the 20th century in the United States. 3. What will happen to unemployment and inflation during a recession? Explain

Solution

Q1. The alternating periods of expansion and contraction in economic activity is referred to as business cycles.

The duration of business cycle is not of same length. It varies from a minimum of two years to a maximum of ten to twelve years. However, business cycles are repetitive and regular.

In some business cycles there are large swings away from the normal but in some swing is of only moderate nature. It is the business cycles with large swings that create damage to the economy.

Business Cycles are generally consists of four phases –

1. Expansion – It is also known as period of boom or prosperity

2. Peak – It is the upper turning point of the business cycle.

3. Contraction – It is also known as period of recession or downswing.

4. Trough – It is the lower turning point of the business cycle.

Expansion – In this phase, economy experiences an increase in both output and employment. Net investment in positive manner occurs in the economy with demand for durable goods gather momentum. Price level also rise during this phase generally on back of higher aggregate demand as people are experiencing an increase in standard of living on back of high level of economic activity.

Peak – This is the top point of the business cycle and where expansion phase comes to an end. At this point, economy is producing its highest possible output given the resources. In other words, economy is at its full employment level. Gap between potential real GDP and actual real GDP becomes zero in this phase. Only natural rate of unemployment exists in this phase.

Contraction – This is the phase when economy starts experiencing a fall in output and employment. There are many causes to this trend like reduction in credit availability, rise in price of important natural resource or adverse impact on profit expectations or households and businesses becoming pessimistic about economy. This phase is characterized by the rise in unemployment. Net investment becomes negative and demand for durable goods declines rapidly leading to creation of excess capacity in industries. Purchasing power of people falls on back of lower economic activity.

Trough – This is the lowest point of business cycle. At this point production in economy is at its lowest and unemployment is at its highest. Resources are left unutilized. Economy is producing at under-employment level. Gap between potential real GDP and actual real GDP becomes highest in this phase.