What Is the Economic Cycle?

The economic cycle is the fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as: gross domestic product (GDP), interest rates, total employment, and consumer spending, can help to determine the current stage of the economic cycle.

Key Takeaways

  • Economic cycle refers to the overall state of the economy going through four stages in a cyclical pattern.
  • Economic cycles are a major focus of economic research and policy, but the exact causes the of cycle are highly debated among the different schools of economics.
  • Insight into economic cycles can be very useful for businesses and investors.

4 Stages Of The Economic Cycle

The Four Stages of the 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 rate. 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 and growth begins to recover.

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 five 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 the current record long expansion that began in 2009.

What Causes the Economic Cycle

This wide variation in cycle length dispels the myth that economic cycles can die of old age, or are a regular natural rhythm of activity akin to physical waves or swings of a pendulum. However, there is some debate as to what determines their length and 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 by households, businesses, and the government more or less expensive. Adding to the complexity of interpreting business cycles, famed economist and proto-monetarist 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.

The Keynesian approach argues that changes in aggregate demand, spurred by inherent instability and volatility in investment demand, is responsible for generating cycles. When, for whatever reason, business sentiment turns gloomy and investment slows, a self-fulfilling loop of economic malaise can result. Less spending means less demand, which induces businesses to lay off workers and cut back even further. Unemployed workers mean less consumer spending and the whole economy sours, with no clear solution other than government intervention and economic stimulus, according to the Keynesians.

Austrian economists argue that the manipulation of credit and interest rates by the central bank creates unsustainable distortions in the structure of relationships between industries and businesses which are corrected during a recession. Whenever the central bank lowers rates below what the market would naturally determine, investment and business gets skewed toward industries and production processes that benefit the most from low rates.

But at the same time, the real saving necessary to finance these investments gets suppressed by the artificially low rates. Ultimately, the unsustainable investments go bust in a rash of business failures and declining asset prices that result in an economic downturn.

Managing the Economic Cycle

Governments and major financial institutions use various means to try to manage the course and effects of economic cycles. One too at the government’s disposal is fiscal policy. To end a recession, the government can employ expansionary fiscal policy, which involves rapid deficit spending. Conversely, it can use contractionary fiscal policy to stop the economy from overheating during expansions, by taxing and running a budget surplus to reduce aggregate spending.

Central banks try to use monetary policy to help manage and control the economic cycle. When the cycle hits the downturn, a central bank can lower interest rates or implement expansionary monetary policy to boost spending and investment. During an expansion, it can employ contractionary monetary policy by raising interest rates and slowing the flow of credit into the economy to reduce inflationary pressures and the need for a market correction.

Businesses and investors also need to manage their strategy over economic cycles, not so much to control them but to survive them and perhaps profit from them. During times of expansion, investors seek to purchase companies in technology, capital goods, and basic energy. During times of contraction, investors look to purchase companies such as utilities, financials, and healthcare.

Businesses that can track the relationship between their performance and business cycles over time can plan strategically to protect themselves from approaching downturns, and position themselves to take maximum advantage of economic expansions.