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What is the 'Economic Cycle'

The economic cycle is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle. During times of expansion, investors seek to purchase companies in technology, capital goods and basic energy, and during times of contraction, investors look to purchase companies such as utilities, financials and healthcare.

BREAKING DOWN 'Economic Cycle'

An economic cycle, also referred to as the business cycle, has four stages: expansion, peak, contraction and trough. During the expansion phase, the economy experiences relatively rapid growth, interest rates tend to be low, production increases and inflationary pressures build. The peak of a cycle is reached when growth hits its maximum output. Peak growth typically creates some imbalances in the economy that need to be corrected. This correction occurs through a period of contraction when growth slows, employment falls and prices stagnate. The trough of the cycle is reached when the economy hits a low point in growth from which a recovery can begin.

Economic Cycle Length

The National Bureau of Economic Research (NBER) is the definitive source of setting official dates for U.S. economic cycles. Measured by changes in gross domestic product (GDP) , NBER measures the length of economic cycles from trough to trough, or peak to peak. From the 1950s to present day, U.S. economic cycles have lasted about 5 and a half years on average. However, there is wide variation in the length of cycles, ranging from just 18 months during the peak to peak cycle in 1981-1982, up to 10 years from 1991 to 2001.

Managing the Economic Cycle

The economic or business cycle is managed by the government. The biggest tool at its disposal to control the cycle is fiscal policy. In order to end a recession, the government will employ expansionary fiscal policy, and conversely, it will use contractionary fiscal policy to stop the economy from overheating. 

Central banks will use monetary policy in order to help manage and control the economic cycle. When the cycle hits the trough, a central bank will lower interest rates or implement expansionary monetary policy. When it raises rates, or uses contractionary monetary policy, it manages an economic expansion to prevent it from peaking. 

What Causes the Economic Cycle?

This wide variation in cycle length dispels the myth that economic cycles can die of old age. However, there is some debate as to what causes cycles to exist in the first place. The monetarist school of economic thought ties the economic cycle to the credit cycle. Changes in interest rates can reduce or induce economic activity by making borrowing to households, businesses and the government more or less expensive. The Keynesian approach argues that changes in aggregate demand, spurred by inherent instability and volatility in investment demand, is responsible for generating cycles. Adding to the complexity of interpreting business cycles, other famed economists, such as Irving Fisher, argued that there no such thing as equilibrium and therefore, cycles exist because the economy naturally shifts across a range of disequilibrium as producers constantly over- or under-invest and over- or under-produce as they try to match ever-changing consumer demands.

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