Definition: The business cycle describes the phases of growth and decline in an economy. The goal of economic policy is to keep the economy in a healthy growth rate -- fast enough to create jobs for everyone who wants one, but slow enough to avoid inflation. Unfortunately, life is not so simple. 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 confidence in the future and in policymakers, and does the opposite when confidence drops.
The 4 Stages of the Business CycleThere are four phases that describe the business cycle. At any point in time you are in one of these stages:
- Contraction - When the economy starts slowing down. It's usually accompanied by a bear market.
- Trough - When the economy hits bottom, usually in a recession.
- Expansion - When the economy starts growing again. It's usually signaled by a bull market.
- Peak - When the economy is in a state of "irrational exuberance." This is when inflation rears its ugly head.
Who Determines the Business Cycle Stages?The National Bureau of Economic Research (NBER) analyzes economic indicators to determine the phases of the business cycle. The Business Cycle Dating Committee uses quarterly GDP growth rates as the primary indicator of economic activity. The Bureau also uses monthly figures, such as employment, real personal income, industrial production and retail sales. For this reason, the NBER has the final say on economic expansions and contractions, or business cycles.
What GDP Can You Expect in Each Business Cycle Phase?
In the Contraction phase, GDP growth rates usually slow to the 1%-2% level before actually turning negative. The 2008 recession was so nasty because the economy immediately shrank 2.7% in the first quarter 2008, rebounded 2% in the second quarter, leading everyone to think the downturn was over. It fell another 2% in the third quarter, before plummeting a whopping 8.3% in the fourth quarter. The economy received another wallop in the first quarter of 2009, when the economy contracted a brutal 5.4%. (For more, see 2008 GDP Statistics)
In the Trough phase, GDP growth may still be negative, but it's not as bad. It's clear that the economy has turned a corner. According to the NBER, this occurred in the second quarter 2009, when GDP contracted a mere .4%.
In the Expansion phase, GDP growth turns positive again, and should be in the healthy 2-3% range. If the economy is managed well, it can stay in the Expansion phase for years. The current expansion phase started in the third quarter 2009, when GDP rose 1.3%. This was thanks to the stimulus spending from the American Recovery and Reinvestment Act. However, four years into the expansion phase, the unemployment rate was still above 7%. That's because the Contraction phase was so harsh.
The Peak phase is when the economy's expansion slows. It's usually the last healthy growth quarter before the recession starts. You usually don't know you are in a peak until it is too late. However, if the GDP growth rate is 4% or higher for two or more quarters in a row, you can bet the peak is not far off. In the 2008 recession, the peak occurred in the fourth quarter 2007, when the GDP growth was 1.5%.
What Causes the Business Cycle?
The business cycle is affected by all the forces of supply and demand. When consumers are confident, they buy now because they know there will be future income from better jobs, higher home values and increasing stock prices. Even a little healthy inflation can trigger demand by spurring shoppers to buy now before prices go up. As demand increases, businesses hire new workers, which further stimulates more demand. This is the Expansion phase.
If demand outstrips supply, then the economy can overheat. In addition, investors and businesses compete to outperform the market, taking on more risk to gain some extra return. This combination of excess demand, and the creation of risky deriviatives, created the housing asset bubble in 2005.
If demand isn't cooled down with higher taxes (fiscal policy) or higher interest rates (monetary policy), then the Peak is not far off. You can always recognize a peak by two things: First, the media is saying that the expansion will never end. Second, it seems everyone and his brother is making tons of money from whatever the asset bubble is.
In the Contraction phase, confidence is replaced by fear or even panic. Investors sell stocks, and buy bonds, gold and the U.S. dollar. Consumers lose their jobs, sell their homes, and stop buying anything but necessities. Businesses lay off workers, and hoard cash. Confidence must be restored for the economy to enter a new Expansion phase.
In addition to demand, the business cycle is also heavily dependent on the availability of capital. This is known as liquidity, and is itself dependent upon interest rates. Too much capital will turn a healthy expansion into a peak, at which point greed will bid up the price of assets, often causing inflation. At this point, a stock market correction may indicate that assets are overvalued, creating fear and a contraction. The Federal Reserve lowers interest rates to spur the economy into expansion during a trough. It raises rates during an expansion to avoid too much of a peak. Article updated August 31, 2013)