Business Cycle

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 Stages of the Business Cycle

There are four stages that describe the business cycle. At any point in time you are in one of these stages:

1. Contraction - When the economy starts slowing down.
2. Trough - When the economy hits bottom, usually in a recession.
3. Expansion - When the economy starts growing again.
4. Peak - When the economy is in a state of "irrational exuberance."

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.

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 1.8% in the first quarter 2008, grew just 1.3% in the second quarter, before falling another 3.9% in the third quarter, and then plummeting a whopping 8.9% in the fourth quarter. The economy received another wallop in the first quarter of 2009, when the economy contracted a brutal 6.9%.

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 .7%.

In the Expansion phase, GDP growth turns positive again. In the 2008 recession, this wasn't until the third quarter 2009, when the GDP grew 1.6%. This was thanks to the stimulus spending from the American Recovery and Reinvestment Act.

In the Expansion phase of the business cycle, the GDP growth rate will be in the healthy 2-3% growth range. If the economy is managed well, it can stay in the Expansion phase for years.The expansion phase started in the third quarter 2009, and is still continuing -- although it is too slow to create enough jobs to lower the 9% unemployment rate. 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 rate was 1.9%.

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 knowing there will be income in the future from better jobs, higher homes 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. This created the housing asset bubble in 2005. It's still the Expansion phase, but if demand isn't cooled down with higher taxes (fiscal policy) or higher interest rates (monetary policy), then the Peak is not far off.

In the Contraction phase, confidence is replaced by fear or even panic. Consumers sell their homes, and stop buying. Businesses lay off workers, and hoard cash. Confidence must be restored to before the Trough can be hit, and the economy re-enters 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.

A trough usually is accompanied by a recession and a bear market, while an expansion is usually signaled by a bull market and inflation.(Updated October 28, 2011)