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The business cycle encapsulates the cycle of economic activity. The first stage, known as expansion, involves economic expansion – when economic activity increases and more goods and services are produced than before.
Once growth reaches its limit and cannot continue, an economy enters a peak phase. Economic indicators such as employment rates, wages and prices stop increasing while consumers adjust their budgets accordingly.
Expansion
As economic indicators improve during expansion phases, positive economic indicators continue to climb: employment, output, incomes, profits and demand increase. Money circulates freely in the economy while debts are paid on time, investments grow and companies may invest in new facilities, hire more employees and increase production to take advantage of strong economic conditions.
At this stage, government policies can have an immense effect on business cycles. If, for instance, governments increase military spending to fight wars, defense contractors will increase production of weapons and equipment in response. This increases supply while simultaneously decreasing prices across other goods in the economy – leading to an economic surge that may last years or longer.
Understanding a business cycle is vitally important to workers, consumers and investors alike. Knowing when the cycle starts is invaluable in taking advantage of good times while mitigating bad ones – for example if a recession looms nearer you may wish to invest short-term or stash your savings away until things improve again.
There are various theories as to why economies cycle, but some theories hold more weight than others. Some believe the cause lies in fluctuations in debt and credit levels; post-Keynesian economist Hyman Minsky in particular advocated financial fragility as being at the core of it all.
Exogenous factors – weather changes, unexpected discoveries or war – may also impact business cycles by shifting economic growth beyond or below its full employment level of output.
Peak
At the peak of a business cycle, economic indicators increase and individuals spend more money on goods and services. Businesses and individuals also look for ways to cut expenses by cutting budgets in order to save costs; eventually the economy reaches saturation point and its rate of growth begins to diminish; at that point the NBER’s Business Cycle Dating Committee uses various economic indicators as signals that its peak has been reached; such indicators include rising employment rates and prices for goods and services as well as increased investor interest as well as frequent investments by private and public entities.
Dependent upon the indicator, there can be any number of potential peak dates. Unfortunately, due to using various economic indicators to frame business cycles – each one with their own history – peak moments can sometimes be missed by NBER’s Business Cycle Dating Committee.
So the committee may only realize the economy has reached its peak once indicators begin declining further than their previous low points. Even once NBER announces that a peak has occurred, significant time must pass until it resumes growth again.
Peaks and troughs vary in their amplitude, which means some are smaller than others. Furthermore, it should be noted that expansions and recessions occur at different speeds.
Some economists, like John Keynes and Karl Marx, hold that business cycles are an inherent part of capitalism and cannot be managed directly; others such as Carl Sagan believe they may be managed through economic policies such as interest rate changes or supply and demand adjustments; these measures, however, can only do so much; ultimately it’s down to businesses and consumers themselves who will dictate its economy’s health; being prepared will allow a company to navigate these fluctuations more effectively, helping avoid an acute recessionary phase altogether.
Contraction
The contraction phase of a business cycle features a general decrease in economic activity, with output declining and unemployment rising. It typically falls during a recession but may also coincide with other economic downturns like stock market crashes or commodity crises. At such times, economic activity slows significantly; as such, interest rates may also fall as part of efforts by the Federal Reserve to promote borrowing and stimulate growth.
An expansion is marked by rapid increases in employment, output and profits. Inflation poses a threat as its price inflation can quickly make products and services more costly for companies and consumers. Businesses may therefore need to hire fewer workers and spend less money on supplies, rent, advertising etc; as consumers stop spending and businesses reduce production accordingly, the economy could slow down and decline over time.
Economists can often assess whether an economy is expanding or peaking by looking at leading and lagging indicators. Leading indicators, like stock market indices, consumer spending and new home construction show when an economic shift may be imminent while lagging indicators such as industrial production can be used to indicate when contraction has started and thus mark an imminent end to an economic boom.
Although every economy will experience periods of contraction and expansion, economic policy can help slow or prevent recessions altogether. The Federal Reserve serves as the nation’s central bank and acts to manage monetary and fiscal policy in an attempt to protect it from overheating or withering by manipulating interest rates to either spur borrowing and end a contraction or raise them during peak times as needed.
Expansion or peak, and contraction, can vary considerably; however, recession is usually defined by two consecutive quarters of negative real GDP growth. The National Bureau of Economic Research, an independent think tank that tracks the economy, uses several criteria to ascertain when and if recession has begun and ended – such as quarterly real GDP growth rates, employment and manufacturing data and various other indicators.
Trough
During the contraction phase, economic indicators like GDP, employment, real income and wholesale-retail sales plummet, marking a low point of the business cycle and eventually leading to its recovery and revival. Once in recovery mode, growth returns.
Understanding how a business cycle functions is integral to understanding an economy’s functioning. It helps explain why there are booms and busts; when consumer spending surges and businesses gain profits during an upswing, demand rises rapidly resulting in prices increasing as product and services supply becomes scarcer.
As soon as an economy reaches its maximum level of economic expansion, growth slows significantly – an indication of overheating which may lead to inflation. At this time, the Federal Reserve, our nation’s central bank, may use various monetary policy tools in order to minimize inflation and unemployment during this phase of economic activity.
A business cycle’s trough can be seen when unemployment, GDP and wages reach high levels simultaneously; its outcome can often be difficult to anticipate. The National Bureau of Economic Research (NBER) serves as the official tracker of U.S. business cycles by keeping an accurate chronology of its different phases.
This chronology includes data from several sectors, such as industrial production and gross domestic product (GDP). The NBER also developed an algorithm, known as Bry-Boschan Algorithm, which detects peaks and troughs in time series data – this program honors Gerhard Bry and Charlotte Boschan as its creators; thus helping organizations such as Conference Board create business cycle chronologies for economic variables or entire economies.
Analysts, economists and others rely on the National Bureau of Economic Research’s chronology to gain an understanding of the economy and its trends, as well as to pinpoint when recessions begin and end; though its exact endpoint can often remain difficult to pin down due to its effects lingering long after an official announcement from NBER that one has ended.
Although fluctuations in the business cycle cannot be completely avoided, governments can limit their impact by employing various monetary and fiscal policies. For instance, the Federal Reserve Bank can lower interest rates during periods of contraction to promote borrowing for expansion purposes and ultimately boost consumer spending and decrease inflation.
