What Is a Business Cycle?
The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles are generally measured using the rise and fall in real gross domestic product (GDP) or GDP adjusted for inflation.
The business cycle should not be confused with market cycles, which are measured using broad stock market indices. The business cycle is also different from the debt cycle, which refers to the rise and fall in household and government debt.
The business cycle is also known as the economic cycle or trade cycle.
Understanding Business Cycles
Business cycles are fluctuations in economic activity that an economy experiences over a period of time. Actual fluctuations in real GDP, however, are far from consistent. These fluctuations include output from all sectors including households, nonprofits, governments, as well as business output. "Output cycle" is thus a better description of what is measured.
The business cycle is characterized by expansion and contraction. During expansion, the economy experiences growth, while a contraction is a period of economic decline. Contractions are also called recessions.
After World War II, expansions were mostly associated with population growth, urban sprawl, and the advent of consumerism. By the 1970s, growth came more from debt injections through consumer credit cards, mortgages, commercial, and industrial loans—as opposed to equity funding—followed by the dotcom speculation and then more mortgage debt.
Fiscal and regulatory policy, technology, demographics, and external events like oil price spikes have affected the business cycle.
Stages of the Business Cycle
All business cycles are characterized by several different stages, as seen below.
1. Expansion. This is the first stage. When expansion occurs, there is an increase in employment, incomes, production, and sales. People generally pay their debts on time. The economy has a steady flow in the money supply and investment is booming.
2. Peak. The second stage is a peak when the economy hits a snag, having reached the maximum level of growth. Prices hit their highest level, and economic indicators stop growing. Many people start to restructure as the economy's growth starts to reverse.
3. Recession: These are periods of contraction. During a recession, unemployment rises, production slows down, sales start to drop because of a decline in demand, and incomes become stagnant or decline.
4. Depression: Economic growth continues to drop while unemployment rises and production plummets. Consumers and businesses find it hard to secure credit, trade is reduced, and bankruptcies start to increase. Consumer confidence and investment levels also drop.
5. Trough: This period marks the end of the depression, leading an economy into the next step: recovery.
6. Recovery: In this stage, the economy starts to turn around. Low prices spur an increase in demand, employment and production start to rise, and lenders start to open up their credit coffers. This stage marks the end of one business cycle.
Measuring the Business Cycle
An expansion is measured from the trough (or bottom) of the previous business cycle to the peak of the current cycle, while a recession is measured from the peak to the trough.
The National Bureau of Economic Research (NBER) determines the dates for business cycles in the United States. Committee members look at real GDP and other indicators including real income, employment, industrial production, and wholesale-retail sales. Combining these measures with debt and market measures helps understand the causes of expansions.
According to the NBER, the average expansion lasted 58 months while the average contraction lasted 11 months since 1945. After the 1990s, the NBER estimates the average expansion lasted 95 months, while the average contraction remained the same.
Choosing June 2009 as the trough for the most recent recession was difficult for NBER committee members. When they looked at the data, ten measures hit lows in the period from June to December 2009. The recession began in December 2007 and lasted 18 months, making it the longest downturn recession since World War II. The longest postwar recessions were those of 1973 to 1975 and 1981 to 1982, both of which lasted 16 months.
Economists and the Business Cycle
Some economists believe that the business cycle is a natural part of the economy. But there are others who believe that central banks indirectly control the cycle by intervening with monetary policy. When the economy is expanding too quickly, central bankers will step in and tighten the money supply and raise interest rates.
Conversely, if the economy is slowing down too quickly, they will lower rates and increase the money supply. Critics believe that if central bankers stop intervening, it would all but rid the economy of these cycles.
Investors and the Business Cycle
investors may be able to use the business cycle to profit from the market by choosing the right stocks at the right time.
For example, an investor may choose to invest in commodities and technology stocks at the end of the business cycle because they may be cheap, and then sell them during the early part of an expansion.
When the economy is overheating and has reached its peak, the investor may decide to put his or her money into utilities, consumer staples, and healthcare. These sectors tend to outperform the market during recessions because demand doesn't decrease even during times of instability, and because of their cash flows and dividend yields.
- Business cycles are the rise and fall in production output of goods and services in an economy.
- The stages in the business cycle include expansion, peak, recession or contraction, depression, trough, and recovery.
- Business cycles are measured by the National Bureau of Economic Research in the United States.
- After the 1990s, the average expansion lasted 95 months, while the average contraction lasted 11 months.
The Business Cycle and Markets
Recessions can extract a tremendous toll on stock markets. Most major equity indexes around the world endured declines of over 50% in the 18-month period of the Great Recession, which was the worst global contraction since the 1930s Depression. Global equities also underwent a significant correction in the 2001 recession, with the Nasdaq Composite among the worst-hit. The index plunged by almost 80% from its 2001 peak to its 2002 low.
Importantly, recessions due to credit bubbles bursting are far worse on income and consumption than from stock market speculative bubbles bursting.