The business cycle is the natural rise and fall of economic growth that occurs over time. The cycle is a useful tool for analyzing the economy and business performance.
Learn more about the business cycle, how it works, and the four phases it goes through.
Definition and Example of the Business Cycle
The business cycle is a term used by economists to describe the increase and decrease in economic activity over time. The economy is all activities that produce, trade, and consume goods and services within the U.S.—such as businesses, employees, and consumers. Thus, the measured amount of productivity is what the business cycle refers to.
- Alternate definition: The business cycle is the downward and upward fluctuations of the productivity level of the economy, along with its natural growth rate over a long period.
- Alternate names: Economic cycle, trade cycle
When businesses are increasing production, they need more employees. As a result, more people are hired, there is more money to spend, and businesses make more profits and can focus on growth. The rate at which production and consumption change positively is called "economic expansion." It continues until circumstances occur that cause production to slow.
If business production slows, not as many employees are needed. As a result, consumers have less spending money, and businesses reduce spending on growth. The rate at which production and consumption as a whole change negatively is called "economic contraction."
How Does the Business Cycle Work?
The duration of a business cycle is the period containing one expansion and contraction in sequence. One complete business cycle has four phases: expansion, peak, contraction, and trough. They don’t occur at regular intervals or lengths of time, but they do have recognizable indicators.
It's important to understand that there are mini-fluctuations within an economic phase that can make it appear as if the economy is transistioning to another phase. The National Bureau of Economic Research determines which cycle the economy is in using quarterly GDP growth rates. It also uses monthly economic indicators, such as employment, real personal income, industrial production, and retail sales.
While you'll hear speculation in the media about the state of the economy, there is no official notice of what cycle the economy is in until it's already in progress—or complete—and the NBER has had a chance to analyze the data and declare it.
Three factors cause each phase of the business cycle: the forces of supply and demand, the availability of capital, and consumer and investor confidence. The most critical is confidence in the future—when consumers and investors have faith in the future and policymakers, the economy tends to expand. It does the opposite when confidence levels drop.
An economic expansion is a period of growth throughout an economy. Because productivity is increasing, it is generally represented on a curve as an upward movement. The expansion phase is also known as the economic recovery phase because it occurs after the economy has contracted for a long period.
Gross domestic product is the measurement that is most used to indicate economic output. During the expansion phase, it increases. Economists consider a GDP growth rate range of between 2% to 3% to be healthy.
During expansion, unemployment reaches a natural rate of 3.5% to 4.5%. Inflation, the measurement of the change in prices, hovers around 2%—also considered healthy by economists and officials.
In an expansion, the stock market experiences rising prices, and investors are confident. Businesses receive more funding and make more, and consumers have more money to spend. An economy can remain in the expansion phase for years.
The expansion phase nears its end when the economy begins to grow too fast. This is called "overheating"—the unemployment rate is well below the natural rate, and inflation is increasing. Stock market investors are in a state of "irrational exuberance" where they become overly enthusiastic about prices and believe they will continue to rise—this causes stock prices to rise to a point where they are very overvalued.
The peak is the second phase of the cycle. It occurs when all of the expansionary indicators begin to level off. The economy might take weeks or a year to transition into the contraction phase. The GPD growth rate falls below 2% and continues to decline. The peak is displayed on a graph as the highest portion of the curve before moving downward.
The third phase is the contraction stage. It begins after the economy peaks and ends when GDP and other indicators cease to decrease. In this stage, the economy does not experience growth; instead, it shrinks. When the GDP rate turns negative, the economy enters a recession. Businesses lay off employees, the unemployment rate rises above normal levels, and prices begin to decline.
A contraction is generally portrayed on a graph as the part of the curve that is consistently decreasing.
The trough is the fourth phase of the business cycle. The declining GDP begins to decrease its rate of negative change, eventually turning positive again. The economy begins a transition from the contraction phase to the expansion phase. A trough is displayed on a graph as the lowest point of the curve. The business cycle begins again when GDP begins to increase, and the curve moves upward consistently.
The business cycle's four phases can be so severe that they have been called the "boom and bust cycle."
How Is the Business Cycle Influenced?
The government monitors the business cycle, and legislators attempt to influence it by implementing tax and spending changes. When the economy is expanding, taxes can be increased, and spending can be decreased. If it is contracting, the government can lower taxes and increase spending. This is called "fiscal policy."
The Federal Reserve (the Fed), the nation's central bank, influences the business cycle by targeting inflation and unemployment with targeted rates. It uses tools designed to change interest rates, lending, and borrowing by businesses, banks and consumers. This is called "monetary policy."
The Fed lowers its target interest rates to encourage borrowing in attempts to end a contraction or trough. This is called expansionary monetary policy because they are attempting to push the business cycle back into the expansionary phase.
To keep the economy from growing too quickly, the central bank raises its target interest rates to discourage borrowing and spending. This is called "contractionary monetary policy," because the bank is trying to contract economic output to keep expansion under control.
The goal of fiscal and monetary policy is to keep the economy growing at a sustainable rate while creating enough jobs for everyone who wants one and being slow enough not to increase inflation.
The peak that preceded the 2008 recession occurred in the third quarter of 2007, when GDP growth was 2.2%. The 2008 recession was a rough one, because the economy immediately contracted by 2.3% in the first quarter of 2008. It rebounded by 2.1% in the second quarter, causing many people to believe that it wouldn't drop any further. However, it contracted by another 2.1% in the third quarter and then by 8.4% in the fourth quarter. In the first quarter of 2009, it contracted by 4.4% more.
During 2008, the unemployment rate rose from 4.9% in January to 7.2% by December.
The trough occurred at the end of the second quarter of 2009, according to the National Bureau of Economic Research. GDP only contracted by 0.6%. Unemployment, however, rose to 9.5%, because it is a lagging indicator.
The expansion phase started in the third quarter of 2009 when GDP rose by 1.5%. The government passed the American Recovery and Reinvestment Act to help stimulate the economy. The unemployment rate continued to worsen, reaching 10.2% in October. Four years into the expansion phase, the unemployment rate was still above 7%, because the contraction phase moved the economy so low that it took much longer to recover.
- The business cycle goes through four major phases: expansion, peak, contraction, and trough.
- All economies go through this cycle, though the length and intensity of each phase varies.
- The Federal Reserve helps to manage the cycle with monetary policy, while heads of state and governing bodies use fiscal policy.
- Consumer and investor confidence play roles in influencing economic performance and the phases in the cycle.