What Is the Business Cycle?

The 4 Critical Stages

Investing personal finance for safe retirement and pension
Drazen Lovric/E+/Getty Images

Definition: The business cycle is the natural rise and fall of economic growth that occurs over time. Each business cycle has four phases. They are expansion, peak, contraction, and trough. 

Expansion is between the trough and the peak. The economy is growing. Gross Domestic Product, which measures economic output, is positive. Ideally, it is in the healthy 2-3% range. Unemployment reaches its natural rate of around 4%.

 Inflation is near its 2% target. The stock market is in a bull market.A well-managed economy can remain in the expansion phase for years. That's called a Goldilocks economy.The economy reaches the end of the expansion when it overheats. GDP growth is greater than three percent. Inflation is greater than 2%, and may reach the double digits. Investors are in a state of "irrational exuberance." They create asset bubbles.  

The second phase is the peak. It is the month when the expansion transitions into the contraction phase.

The third phase is contraction.  It starts at the peak and ends at the trough. Economic growth weakens. The GDP growth rate falls below 2%. When it turns negative, it becomes a recession.Mass layoffs make headline news. The unemployment rate slowly rises. That happens towards then 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 fourth phase is the trough. That's the month when the economy transitions from the contraction phase to the expansion phase. when the economy hits bottom. (Source: "The National Business Cycle Dating Procedure: Frequently Asked Questions," National Bureau of Economic Research.)

The business cycle's four phases can be so severe that it's also called the boom and bust cycle.

Who Measures the Business Cycle?

The National Bureau of Economic Research (NBER) uses quarterly GDP growth rates to determine business cycle stages. It also uses monthly economic indicators, such as employmentreal personal incomeindustrial production, and retail sales. The NBER defines the Current Phase of the Business Cycle.

Who Manages the Business Cycle?

The government tries to manage the business cycle. Congress uses fiscal policy. It uses expansionary fiscal policy to end a recession. The nation's central bank uses monetary policy. It lowers interest rates to end a contraction or trough. That's called expansionary monetary policy.  It raises them to manage an expansion so it doesn't peak. That's contractionary monetary policy.

The goal of economic policy is to keep the economy in a healthy growth rate. That's  fast enough to create jobs for everyone who wants one but slow enough to avoid inflation.

Unfortunately, many factors can cause an economy to spin out of control, or settle into depression. The most important, over-riding factor is confidence of investors, consumers, businesses, and politicians. The economy grows when there is faith in the future and in policymakers. It does the opposite when confidence drops. 

Example

The 2008 recession was so nasty because the economy immediately contracted 2.7% in the first quarter 2008, but rebounded 2% in the second quarter. Everyone thought the downturn was over. The economy contracted another 1.9% in the third quarter, before plummeting a whopping 8.2% in the fourth quarter. The economy received another wallop in the first quarter of 2009 when it contracted a brutal 5.4%. The unemployment rate rose from 5.0% in January to 7.3% by December. See 2008 GDP Statistics.

The trough occurred in the second quarter 2009, according to the NBER.  GDP contracted 0.5%. Unemployment rose to 9.5%.

The current expansion phase started in the third quarter 2009 when GDP rose 1.3%. That was thanks to the stimulus spending from the American Recovery and Reinvestment Act.  The unemployment rate continued to worsen, reaching 10.0% in October. Four years into the expansion phase, the unemployment rate was still above 7%. That's because the contraction phase was so harsh. 

The peak that preceded the 2008 recessions occurred in the third quarter 2007.  GDP growth was 2.7%. 

More on the Business Cycle

Continue Reading...