Module 3:

Economic Cycle: What It Means and 4 Phases of

Business Cycles
The economic cycle, also known as a business cycle, refers to fluctuations 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.
Understanding the economic cycle can help investors and businesses determine
when to make investments and when to pull their money out, as it has a direct impact
on stocks and bonds as well as profits and corporate earnings.

When businesses are increasing production, they need more employees. As a result,
more people are hired, there is more money to spend, and businesses make more
profits and can focus on growth. The rate at which production and consumption
change positively is called "economic expansion." It continues until circumstances
occur that cause production to slow.

If business production slows, not as many employees are needed. As a result,

consumers have less spending money, and businesses reduce spending on growth.
The rate at which production and consumption as a whole change negatively is called
"economic contraction."
 • An economic cycle is the overall state of the economy as it goes through four
stages in a cyclical pattern: expansion, peak, contraction, and trough.
• Factors such as GDP, interest rates, total employment, and consumer spending
can help determine the current stage of the economic cycle.
• Insight into economic cycles can be useful for businesses and investors.
• The exact causes of a cycle are highly debated among the different schools of
economics.

Stages of the Economic Cycle

An economic cycle is the circular movement of an economy as it moves from

expansion to contraction and back again. Economic expansion is characterized by
growth. On the other hand, a contraction means a recession, which involves a decline
in economic activity that spreads out over at least a few months. The economic cycle
or business cycle is characterized by four stages. The following breakdown describes
what is happening in the economy during the different phases of the cycle.

Expansion

During expansion, the economy experiences relatively rapid growth, interest rates
tend to be low, and production increases. The economic indicators associated with
growth—such as employment and wages, corporate profits and output, aggregate
demand, and the supply of goods and services—tend to show sustained uptrends
through the expansionary stage. Debtors are generally paying their debts on time,
the velocity of the money supply is high, and investment is high. This process
continues if economic conditions are favorable for expansion. The flow of money
through the economy remains healthy, cost of money is cheap because interest rates
are low. However, the increase in the money supply may cause inflation to pick up
during the economic growth phase.

Peak

The economy reaches the peak of a cycle when growth hits its maximum rate. At
this economic high-water mark, prices and economic indicators may stabilize for a
short period before reversing to the downside. Peak growth typically creates some
imbalances in the economy that need to be corrected. As a result businesses may
start to reevaluate their budgets and spending when they believe that the economic
cycle has reached its peak. The maximum limit of growth is attained. The economic
indicators do not grow further and are at their highest. Prices are at their peak. This
stage marks the reversal point in the trend of economic growth. Consumers tend to
restructure their budgets at this point.

Contraction

A correction occurs through a period of contraction when growth slows, employment

falls, and prices stagnate. As demand begins to fall, businesses may not immediately
adjust production levels, leading to oversaturated markets with surplus supply and
exacerbating the downward movement in prices. During this stage, the economic
indicators that were on an upward trajectory during the expansion phase begin to
deteriorate. The demand for goods and services starts declining rapidly and steadily
in this phase. Producers do not notice the decrease in demand instantly and go on
producing, which creates a situation of excess supply in the market. Prices tend to
fall. All positive economic indicators such as income, output, wages, etc.,
consequently start to fall. There is a commensurate rise in unemployment. If the
contraction continues, the recessionary environment may spiral into a depression.
 Photo by Investopedia
Trough

The trough of the cycle is reached when the economy hits a low point, with supply
and demand scraping the bottom before growth eventually begins to recover. The
low point in the cycle represents a painful moment for the economy, with a
widespread negative impact from stagnating spending and income. However, like
the peak, the low point of the cycle provides an opportunity for individuals and
businesses to reconfigure their finances in anticipation of a recovery. Some analysts
refer to the recovery as a fifth stage in the cycle.

In the depression stage, the economy’s growth rate becomes negative. There is
further decline until the prices of factors, as well as the demand and supply of goods
and services, contract to reach their lowest point. The economy eventually reaches
the trough. It is the negative saturation point for an economy. There is extensive
depletion of national income and expenditure.

After the trough, the economy moves to the stage of recovery. In this phase, there is
a turnaround in the economy, and it begins to recover from the negative growth rate.
Demand starts to pick up due to low prices and, consequently, supply begins to
increase.
The population develops a positive attitude towards investment and employment and
production starts increasing. Employment begins to rise and, due to accumulated
cash balances with the bankers, lending also shows positive signals. In this phase,
depreciated capital is replaced, leading to new investments in the production process.
Recovery continues until the economy returns to steady growth levels.

This completes one full business cycle of boom and contraction. The extreme points
are the peak and the trough.

Measuring Economic Cycles

It's important for investors and corporations to understand how these cycles work
and the risks they carry because they can have a big impact on investment
performance. Investors may find it beneficial to reduce their exposure to certain
sectors and industries when the economy starts to contract and vice versa. Business
leaders may also take cues from the cycle to determine when and how they'll invest
and whether they'll increase or reduce employment levels.

You can use a number of key metrics to determine where the economy is and where
it's headed. For instance, an economy is often in the expansion phase when
unemployment begins to drop and more people are fully employed. Similarly, people
tend to prioritize and curb their spending when the economy contracts. That's
because money and credit are harder to come by as lenders often tighten up their
lending requirements and interest rates are rising.

The National Bureau of Economic Research (NBER) is the definitive source of

setting official dates for U.S. economic cycles. Relying primarily on changes in
GDP, NBER measures the length of economic cycles from trough to trough or peak
to peak.

This wide variation in cycle length dispels the myth that economic cycles can die of
old age or that they are a regular natural rhythm of activity akin to physical waves
or swings of a pendulum. But there is debate as to what factors contribute to the
length of an economic cycle and what causes them to exist in the first place.

Managing Economic Cycles

Governments, financial institutions, and investors manage the course and effects of
economic cycles differently. Governments often use fiscal policy. To end a
recession, the government may use expansionary fiscal policy, which involves rapid
deficit spending. It can also try contractionary fiscal policy by taxing and running a
budget surplus to reduce aggregate spending to stop the economy from overheating
during expansions.

Central banks may use monetary policy. When the cycle hits the downturn, a central
bank can lower interest rates or implement expansionary monetary policy to boost
spending and investment. During 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.

During times of expansion, investors often find opportunities in the technology,

capital goods, and basic energy sectors. When the economy contracts, investors may
purchase companies that thrive during recessions such as utilities, consumer staples,
and healthcare.

Businesses that track the relationship between their performance and business cycles
can plan strategically to protect themselves from approaching downturns and
position themselves to take maximum advantage of economic expansions. For
example, if your business follows the rest of the economy, warning signs of an
impending recession may suggest you should not expand. You may be better off
building up your cash reserves.

What Causes an Economic Cycle?

The causes of an economic cycle are widely debated among different economic
schools of thought. Monetarists, for example, link the economic cycle to the credit
cycle. Here, interest rates, which intimately affect the price of debt, influence
consumer spending and economic activity.

The Bottom Line

The economic cycle, or business cycle, refers to the cyclical pattern experienced by
the economy. The economy remains in an expansion phase until it reaches its peak,
reversing to the downside and entering a contraction, before it reaches a trough and
begins to expand once again. Indicators such as GDP, interest rates, employment
levels, and consumer spending can help shed light on where the economic cycle
currently stands. Although there are different economic theories to explain what
drives the economic cycle, the conditions associated with each stage can have a
significant impact on business and investment decisions.
How Is the Business Cycle Influenced?

Photo by Investopedia

The government monitors the business cycle, and legislators attempt to influence it
by implementing tax and spending changes. When the economy is expanding, taxes
can be increased, and spending can be decreased. If it is contracting, the government
can lower taxes and increase spending. This is called "fiscal policy."

The Fed, the nation's central bank, influences the business cycle by targeting
inflation and unemployment with targeted rates. It uses tools designed to change
interest rates, lending, and borrowing by businesses, banks and consumers. This is
called "monetary policy."

The Fed lowers its target interest rates to encourage borrowing in attempts to end a
contraction or trough. This is called expansionary monetary policy because they are
attempting to push the business cycle back into the expansionary phase.

To keep the economy from growing too quickly, the central bank raises its target
interest rates to discourage borrowing and spending. This is called "contractionary
monetary policy," because the bank is trying to contract economic output to keep
expansion under control.

The goal of fiscal and monetary policy is to keep the economy growing at a
sustainable rate while creating enough jobs for everyone who wants one and being
slow enough not to increase inflation.

How long does a business cycle last?

Business cycles have no defined time frames. A business cycle can be short, lasting
a few months, or long, lasting several years.
Generally, periods of expansion are more prolonged than periods of contraction, but
the actual lengths can vary. Since the end of World War II, the average period of
expansion in the US lasted 65 months, and the average contraction lasted about 11
months, according to the Congressional Research Service.
Most recently, the US hit a peak in February 2020, and before that was in a period
of expansion that had lasted roughly 128 months, making it the longest in recorded
history.
Business cycles vs. Market cycles

Though often used interchangeably, a business cycle is technically different from a

market cycle. A market cycle specifically refers to the different growth and decline
stages of the stock market, while the business cycle reflects the economy as a whole.
But the two are definitely related.

The stock market is greatly influenced by the phases of a business cycle and
generally mirrors its stages. During the contractionary phase of a cycle, investors
sell their holdings, depressing stock prices — a bear market. In the expansionary
phase, the opposite occurs: Investors go on a buying spree, causing stock prices to
rise — a bull market.
How supply and demand drives the business cycle

• In the beginning: The expansion happens because consumers are confident in

the economy. They believe that employment is steady and income is
guaranteed. As a result, they spend more, which leads to increased demand,
which leads to businesses hiring more employees, and increasing capital
expenditures to meet that demand. Investors allocate more capital to assets,
increasing stock prices.

• Getting overheated: The expansionary phase hits a peak when the demand is
greater than the supply, and businesses take on additional risks to meet
increased demand and remain competitive.

• Scaling back: When interest rates rise quickly, inflation increases too fast, or
a financial crisis occurs, an economy enters a contraction. The confidence that
stimulated demand quickly evaporates, replaced with dwindling consumer
confidence. Individuals save money rather than spend, reducing demand, and
businesses cut production and lay off employees as their sales dry up.
Investors sell stocks to avoid a drop in the value of their portfolios, which
further drops stock prices.

• Hitting bottom: During the trough phase, demand and production are at their
lowest point. But eventually, needs reassert themselves. Consumers slowly
start to gain confidence as production and business activity start to improve,
often spurred on by government policies and action. They begin to buy and
invest, and the economy reenters the expansion phase.
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