What is a Business Cycle?
A business cycle, also called economic cycle, is a period of changing economic activity comprised of expansions and contractions as measured by real GDP. In other words, it’s a period of time where the economy grows, peaks, shrinks, and bottoms out. Then the cycle repeats itself.
A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural growth rate. It explains the expansion and contraction in economic activity that an economy experiences over time.
A business cycle is completed when it goes through a single boom and a single contraction in sequence. The time period to complete this sequence is called the length of the business cycle. A boom is characterized by a period of rapid economic growth whereas a period of relatively stagnated economic growth is a recession. These are measured in terms of the growth of the real GDP, which is inflation-adjusted.
In 1946, economists Arthur F. Burns and Wesley C. Mitchell provided the now standard definition of business cycles in their book Measuring Business Cycles:
Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.
According to A. F. Burns:
Business cycles are not merely fluctuations in aggregate economic activity. The critical feature that distinguishes them from the commercial convulsions of earlier centuries or from the seasonal and other short term variations of our own age is that the fluctuations are widely diffused over the economy – its industry, its commercial dealings, and its tangles of finance. The economy of the western world is a system of closely interrelated parts. He who would understand business cycles must master the workings of an economic system organized largely in a network of free enterprises searching for profit. The problem of how business cycles come about is therefore inseparable from the problem of how a capitalist economy functions.
Stages of the Business Cycle
In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves about the line. Below is a more detailed description of each stage in the business cycle:
The first stage in the business cycle is expansion. In this stage, there is an increase in positive economic indicators such as employment, income, output, wages, profits, demand, and supply of goods and services. Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment is high. This process continues as long as economic conditions are favorable for expansion.
The economy then reaches a saturation point, or peak, which is the second stage of the business cycle. The maximum limit of growth is attained. The economic indicators do not grow further and are at their highest. Prices are at their peak. This stage marks the reversal point in the trend of economic growth. Consumers tend to restructure their budgets at this point.
The recession is the stage that follows the peak phase. The demand for goods and services starts declining rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive economic indicators such as income, output, wages, etc., consequently start to fall.
There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as this falls below the steady growth line, the stage is called a depression.
In the depression stage, the economy’s growth rate becomes negative. There is further decline until the prices of factors, as well as the demand and supply of goods and services, contract to reach their lowest point. The economy eventually reaches the trough. It is the negative saturation point for an economy. There is extensive depletion of national income and expenditure.
After the trough, the economy moves to the stage of recovery. In this phase, there is a turnaround in the economy, and it begins to recover from the negative growth rate. Demand starts to pick up due to low prices and, consequently, supply begins to increase. The population develops a positive attitude towards investment and employment and production starts increasing.
Employment begins to rise and, due to accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced, leading to new investments in the production process. Recovery continues until the economy returns to steady growth levels.
This completes one full business cycle of boom and contraction. The extreme points are the peak and the trough.
How Does the Business Cycle Work?
The duration of a business cycle is the period of time containing a single boom and contraction in sequence. The time it takes to complete this sequence is referred to as the length of the business cycle.
Each business cycle has four phases: expansion, peak, contraction, and trough. They don’t occur at regular intervals, but they do have recognizable indicators.
An expansion is between the trough and the peak. That’s when the economy is growing. The gross domestic product, which measures economic output, is increasing. The GDP growth rate is in the healthy 2% to 3% range. Unemployment reaches its natural rate of 3.5% to 4.5%. Inflation is near its 2% target. And the stock market is in a bull market. A well-managed economy can remain in the expansion phase for years, which is called a Goldilocks economy.
The expansion phase nears its end when the economy overheats and the GDP growth rate is greater than 3%. Inflation is greater than 2% and may reach the double digits. Investors are in a state of “irrational exuberance.” That’s when they create asset bubbles.
The peak is the second phase. It is the month when the expansion transitions into the contraction phase.
The third phase is a contraction. It starts at the peak and ends at the trough. Economic growth weakens. GDP growth falls below 2%. When it turns negative, that is what economists call a recession. Mass layoffs make headline news. The unemployment rate begins to rise. It doesn’t happen until toward the end of the contraction phase because it’s a lagging indicator. Businesses wait to hire new workers until they are sure the recession is over. Stocks enter a bear market as investors sell.
The trough is the fourth phase. That’s the month when the economy transitions from the contraction phase to the expansion phase. It’s when the economy hits bottom.
What factors shape a business cycle?
From technological innovations to wars, a variety of things can trigger a business cycle’s phases. But, according to the Congressional Research Service, the key influence boils down to the aggregate supply and demand within an economy — economist-speak for the total spending that individuals and companies do. When that demand decreases, a contraction occurs. Likewise, when demand increases, an expansion occurs.
How supply and demand drives the business cycle
- In the beginning: The expansion happens because consumers are confident in the economy. They believe that employment is steady and income is guaranteed. As a result, they spend more, which leads to increased demand, which leads to businesses hiring more employees and increasing capital expenditures to meet that demand. Investors allocate more capital to assets, increasing stock prices.
- Getting overheated: The expansionary phase hits a peak when the demand is greater than the supply, and businesses take on additional risks to meet increased demand and remain competitive.
- Scaling back: When interest rates rise quickly, inflation increases too fast, or a financial crisis occurs, an economy enters a contraction. The confidence that stimulated it quickly evaporates, replaced with dwindling consumer confidence. Individuals save money rather than spend, reducing demand, and businesses cut production and layoff employees as their sales dry up. Investors sell stocks to avoid a drop in the value of their portfolios.
- Hitting bottom: During the trough phase, demand and production are at their lowest point. But eventually, needs reassert themselves. Consumers slowly start to gain confidence as production and business activity starts to improve, often spurred on by government policies and action. They begin to buy and invest, and the economy enters a new expansion phase.
Business Cycle Fluctuations
Business cycle fluctuations occur around a long-term growth trend and are usually measured in terms of the growth rate of real gross domestic product.
In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle. An expansion is the period from a trough to a peak, and a recession as the period from a peak to a trough. The NBER identifies a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production”. This is significantly different from the commonly cited definition of a recession being signaled by two consecutive quarters of decline in real GDP. If the economy does not begin to expand again then the economy may be considered to be in a state of depression.
Business Cycles vs. Market Cycles
Though often used interchangeably, technically a business cycle is different from a market cycle. A market cycle specifically refers to the different growth and decline stages of the stock market, while the business cycle reflects the economy as a whole.
But the two are definitely related. The stock market is greatly influenced by the phases of a business cycle and generally mirrors its stages. During the contractionary phase of a cycle, investors sell their holdings, depressing stock prices — a bear market. In the expansionary phase, the opposite occurs: Investors go on a buying spree, causing stock prices to rise — a bull market.
How Governments Influence Business Cycles
The fact that business cycles move in natural phases doesn’t mean they can’t be influenced. Countries can and do try to manage the various stages — slowing them down or speeding them up — using monetary policy and fiscal policy. Fiscal policy is carried out by the government; monetary policy is carried out by a nation’s central bank.
For example, when an economy is in a contraction, particularly a recession, governments use expansionary fiscal policy, which consists of increasing expenditures on projects or cutting taxes. These moves provide increased levels of disposable income that consumers can spend, which in turn stimulates economic growth.
Similarly, a central bank — like the Federal Reserve in the US — will use an expansionary monetary policy to end a contractionary period by reducing interest rates, which makes borrowing money cheaper, thus stimulating spending, and eventually the economy.
If an economy is growing too fast, governments will employ a contractionary monetary policy, which involves cutting spending and increasing taxes. This reduces the amount of disposable income to spend, slowing things down. To employ a contractionary monetary policy, a central bank will increase interest rates, making borrowing more expensive and therefore spending money less attractive.
How Long does a Business Cycle Last?
Business cycles have no defined time frames. A business cycle can be short, lasting a few months, or long, lasting several years.
Generally, periods of expansion are more prolonged than periods of contraction, but the actual lengths can vary. Since the end of World War II, the average period of expansion in the US lasted 65 months, and the average contraction lasted about 11 months, according to the Congressional Research Service.
Most recently, the US hit a peak in February 2020, and before that was in a period of expansion that had lasted roughly 128 months, making it the longest in recorded history.
The many variables in an economy fluctuate differently over time, causing shifts in the economy, and non-economic factors, such as natural disasters and disease, play a part in shaping the economy as well. “Essentially, market economies want to expand, but if they’re hit by an adverse shock, they may contract,” says Vincent Reinhart, chief economist and macro strategist at Mellon Investments.
In recent history, the subprime mortgage crisis of 2007 was one such shock, and the onset of the COVID-19 pandemic in 2020 was another.