What Is the Business Cycle?

How Does the Business Cycle Work?

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.

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 transitioning to another phase. The National Bureau of Economic Research (NBER) determines which cycle the economy is in using quarterly gross domestic product (GDP) growth rates. It also uses monthly economic indicators, such as employment, real personal income, industrial production, and retail sales.

Three factors can contribute to each phase of the business cycle: the forces of supply and demand, the availability of capital, and consumer and investor confidence. Confidence in the future plays a key role. When consumers and investors have faith in the future and policymakers, the economy tends to expand. It does the opposite when confidence levels drop.

The Four Phases of the Business Cycle

A business cycle typically goes through four phases before it's complete: expansion, peak, contraction, and trough.

Expansion

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. In some cases, 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 often used to gauge economic output. During the expansion phase, GDP increases. Economists consider a GDP growth rate range of around 2% to be healthy.

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.

Peak

The peak is the second phase of the cycle. It occurs when all of the expansionary indicators begin to level off before heading into a contraction. 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.

Contraction

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.

Trough

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.

Example of a Business Cycle

The peak that preceded the 2008 recession occurred in the third quarter of 2007 when GDP growth was 2.4%. The 2008 recession was a rough one because the economy immediately contracted by 1.6% in the first quarter of 2008. It rebounded 2.3% in the second quarter, an optimistic sign. However, it contracted 2.1% in the third quarter and then 8.5% in the fourth quarter. In the first quarter of 2009, it contracted by 4.6%.

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 NBER. GDP only contracted by 0.7%. Unemployment, however, rose to 10.2% by October 2009 because it is a lagging indicator.

The expansion phase started in the third quarter of 2009 when GDP rose 1.5%. 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.

What Influences the Business Cycle?

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's contracting, the government can lower taxes and increase spending. This is called fiscal policy.

The Federal Reserve, the nation's central bank, influences the business cycle by influencing 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.

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