The Business/ Trade Cycle

An economy will not always go through an economic growth; there is usually a cycle, as shown below.

Capture 1Growth– when GDP is rising, unemployment is falling and there are higher living standards in the country. Businesses will look to expand and produce more and will earn high profits.

Boom– when GDP is at its highest and there is too much spending, causing inflation to rapidly rise. Business costs will rise and firms will become worried about how they are going to stay profitable in the near future.

Recession– when GDP starts to fall due of high prices, as demand and spending falls. Firms will cut back production to stay profitable and unemployment may rise as a result.

Slump– when GDP is so low that prices start to fall (deflation) and unemployment will reach very high levels. Many businesses will close down as they cannot survive the very low demand level. The economy will suffer.

(When the government takes measures to increase demand and spending in the economy to take it from a slump to growth, it is called as the ‘recovery’ period). The cycle repeats.

Economic Objectives

Here, we’ll look at the different economic objectives a government might have and how their absence/negligence will affect the economy as well as businesses.

  • Maintain economic growth: economic growth occurs when a country’s Gross Domestic Product (GDP) increase i.e. more goods and services are produced than in the previous year. This will increase the country’s incomes and achieve greater living standards.
    Effects of reducing GDP (recession):

    • As output falls, fewer workers will be needed by firms, so unemployment will rise
    • As goods and services that can be consumed by the people falls, the standard of living in the economy will also fall
  • Achieve price stability: inflation is the increase in average prices of goods and services over time. (Note that, inflation, in the real world, always exists. It is natural for prices to increase as the years go by. In the case there is a fall in the price level, it is called a deflation) Maintaining a low inflation will help the economy to develop and grow better.
    Effects of high inflation:

    • As cost of living will have risen and peoples’ real incomes (the value of income) will have fallen (when prices increase and incomes haven’t, the income will buy lesser goods and services- the purchasing power will fall).
    • Prices of domestic goods will rise as opposed to foreign goods in the market. The country’s exports will become less competitive in the international market. Domestic workers may lose their jobs if their products and firms don’t do well.
    • When prices rise, demand will fall and all costs will rise (as wages, material costs, overheads will all rise)- causing profits to fall. Thus, they will be unwilling to expand and produce more in the future.
    • The living standards (quality of life) in the country may fall when costs of living rise.
  • Reduce unemployment: unemployment exists when people who are willing and able to work cannot find a job. A low unemployment means high output, incomes, living standards etc.
    Effects of high unemployment:

    • Unemployed people do not produce anything and so, the total output/GDP in the country will fall. This will in turn, lead to a fall in economic growth.
    • Unemployed people receive no incomes, thus income inequality can rise in the economy and living standards will fall. It also means that businesses will face low demand due to low incomes.
    • The government pays out unemployment benefits to the unemployed and this will rise during high unemployment and government will not enough money left over to spend on other services like education and health.
  • Maintain balance of payments stability: this records the difference between a country’s exports (goods and services sold from the country to another) and imports (goods and services bought in by the country from another country). The exports and imports needs to equal each other, thus balanced.
    Effect of a disequilibrium in the balance of payments:

    • If the imports of a country exceed its exports, it will cause depreciation in the exchange rate– the value of the country’s currency will fall against other foreign currencies (this will be explained in detail here).
    • If the exports exceed the imports it indicates that the country is selling more goods than it is consuming- the country itself doesn’t benefit from any high output consumption.
  • Reduce income equality/achieve effective income redistribution: the difference/gap between the incomes of rich and poor people should narrow down for income equality to improve. Improved income equality will ensure better living standards and help the economy to grow faster and become more developed.
    Effects of poor income equality:

    • Inequal distribution of goods and services- the poor cannot buy as many goods as the rich- poor living standards will arise.
Government Economic Policies

Government can influence the economic conditions in a country by taking a variety of policies.

Fiscal policy is a government policy which adjusts government spending and taxation to influence the economy. It is the budgetary policy, because it manages the government expenditure and revenue. Government aims for a balance budget and tries to achieve it using fiscal policy.
Increasing government spending and reducing taxes will encourage more production and increase employment, driving up GDP growth. This is because government spending creates employment and increases economic activity in the economy and lower taxes means people have more money to consume and firms have to pay lesser tax on their profits. On the other hand, reducing government spending and increasing taxes will discourage production and consumption, and unemployment and GDP will fall.

Monetary policy is a government policy that adjusts the interest rate and foreign exchange rates to influence the demand and supply of money in the economy, and thus demand and supply. It is usually conducted by the country’s central bank and usually used to maintain price stability, low unemployment and economic growth.
Increasing interest rates will discourage investments and consumption, causing employment and GDP to fall
(as the cost of borrowing-interest on loans – has increased, and people prefer to earn more interest by saving rather than spend). Similarly, reducing interest rates will boost investment, consumption, employment, and thus GDP.

Supply-side policies: both the fiscal and monetary policies directly affect demand, but the policies that influence supply are very different. It can include:

  • Privatisation: selling government organizations to private individuals- this will increase efficiency and productivity that increase supply as well encourage competitors to enter and further increase supply.
  • Improve training and education: governments can spend more on schools, colleges and training centres so that people in the economy can become better skilled and knowledgeable, helping increasing productivity.
  • Increased competition: by acting against monopolies (firms that restrict competitors to enter that industry/having full dominance in the market- refer xxx for more details) and reducing government rules and regulations (often termed ‘deregulation’), the competitive environment can be improved and thus become more productive.

For more details on government policies, check out our Economics notes.

*EXAM TIP: Remember that economic conditions and policies are all interconnected; one change will lead to an effect which will lead to another effect and so on, like a chain reaction in many different ways. In your exams, you should take care to explain those effects that are relevant and appropriate to the business or economy in the question*
How might businesses react to policy changes? It will depend varying on how much impact the policy change will have on the particular business/industry/economy. Here are a few examples:

Capture 2

Notes submitted by Lintha

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