Demand and the Business Cycle

The Phases of the business cycle

RECESSION

* Businesses complaining of falling demand

* Cuts in output

* Rising unemployment

* Few job opportunities

* Gloomy Expectations

* Falling levels of Investment

* Many businesses make losses

* Some Businesses closing down

A recession starts with falling sales. At first, the firm tries to keep things going, making extra marketing effort. It will be intensely conscious of competition, since customers may seem very price sensitive. If the situation continues, cuts in output and unemployment follow. Though most businesses keep their 'key' workers - people with skills which are hard to replace even when times improve. Few businesses implement the expansion plans they may have had.

RECOVERY

When it comes, recovery is usually rather halting. Firms are unsure that the improvement in demand will be sustained. Their expectations remain depressed and unenthusiastic about taking the risk of investment. In particular, they will not want to take on more labour until they are sure that the recovery is real. Therefore unemployment is likely to stay high.

Recovery phases can last a long time. Initially businesses use their under-utilised capital equipment to increase output. When they are running at full capacity, they put expansion plans in motion, investing in new buildings, plant and machinery.

THE BOOM

* As investment increases, suppliers have difficulty supplying to all firms

* Most businesses are working flat out

* Many businesses experience shortages of skilled labour

* Firms bid against each other for employees, so wages increase faster than inflation

* Prices are increased

* Higher demand means that higher prices have little effect on the growth of sales

* Inflation increase

DOWNTURN

The rising costs associated with a boom, will in time discourage continuing growth. They have a tendency to reduce profitability and the attractiveness of further investment. But usually government anticipates the need to damp down the economy. Rising interest rates put people off spending. Consumers who have to pay more for their mortgages spend less on consumer goods. Businesses which borrow to finance investment find their calculations less favourable when they have to pay higher interest charges.

The result is that demand for all sorts of products will fall. This has a cumulative effect on the economy. It has a big impact on construction. Higher mortgage rates mean lower demand for housing. Builders find that the houses they are working on are less profitable than they hoped. So they cut back on employees, which may find it hard to get another job, therefore they spend less on luxury goods, and theme parks and restaurants face a drop in demand, and inevitably, income.

The role of investment

Experience shows that investment fluctuates far more than consumption. This can have a major effect on the business cycle. Supposing the economy has been weak, leading to a fall in interest rates. Some people in business become a little more optimistic and make some positive investment decisions. The increased spending generates a further increase in incomes. Aggregate demands begin to rise and business expectations improve further.

STOCKS AND THE BUSINESS CYCLE

Investment in stocks of inputs or finished goals can also be an important factor in the cycle. When demand is rising, businesses will meet it partly by selling stocks. This is a signal to them to increase output. Similarly, early signs of recession may include rising stock levels as buyers spend less.

A decision to hold lower levels of stock can mean that output will sharply fall for a while, known as destocking. The resulting fall in incomes is likely to affect aggregate demand, and if widely spread, the whole economy. The converse if also true; if firms increase their stock levels there will be a rise in output, incomes and employment, which will stimulate the economy.

CONSUMER DURABLES

Changes in spending on consumer durables affect the economy in the same way that investment spending does. This is because purchases can be postponed or brought forward. Like the changes in stocks, changes in demand for durables can explain the nature of business fluctuations.

How businesses are affected

Often it is during recessions that businesses address their weaknesses. If they survive the recession they may emerge stronger and better able to compete. They may use improved human resource management strategies, new technologies, or more efficient approaches to organisation generally. They may try to predict the start of a recession to be ready for when it comes.

One way to survive a recession is to diversify the product range so that the business is not too dependant for its profits on items which are likely to experience wide variations in demand over the course of the cycle. This can be a good strategy for suppliers of consumer goods, but maybe of little help to a supplier of, e.g. specialist steels. Such firms would need to make sufficient profits during economic upturns to survive the difficult times. Shareholders should come to expect a wide variation in profits over time.