What Is the Business Cycle?

The 4 Critical Stages

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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. Here's What Causes the Business Cycle? 

Expansion is between the trough and the peak. That's when economy is growing. Gross domestic product, which measures economic output, is positive. Ideally it is in the healthy 2-3 percent range.

Unemployment reaches its natural rate of around 4 percent. Inflation is near its 2 percent 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 expansion phase is nearing its end when the economy overheats. That's when the GDP growth rate is greater than 3 percent. Inflation is greater than 2 percent, and may reach the double digits. Investors are in a state of "irrational exuberance." 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 contraction.  It starts at the peak and ends at the trough. Economic growth weakens. GDP growth falls below 2 percent. When it turns negative, it becomes a recession. Mass layoffs make headline news. The unemployment rate slowly rises. That happens towards 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. (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 determines business cycle stages using quarterly GDP growth rates. It also uses monthly economic indicators, such as employmentreal personal incomeindustrial production and retail sales. Find out  What Phase of the Business Cycle Are We Currently In?

Who Manages the Business Cycle?

The government manages 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.

Many factors cause an economy to either spin out of control or settle into depression. The most critical factor is consumer confidence.  The confidence of investors and businesses is also important. The economy grows when there is faith in the future and in policymakers. It does the opposite when confidence drops. See Business Cycles Since 1929.

Example

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

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

The expansion phase started in the third quarter 2009 when GDP rose 1.3 percent. That was thanks to the stimulus spending from the American Recovery and Reinvestment Act.  The unemployment rate continued to worsen, reaching 10.0 percent in October. Four years into the expansion phase, the unemployment rate was still above 7 percent. 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 percent. For other examples, see History of Recessions

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