A business cycle, also known as a “trade cycle” or “economic cycle,” is the term used to describe the various stages that the economy goes through as it grows and shrinks. It is generally gauged by the rise and fall of a nation’s gross domestic product (GDP), which is constantly repeated.
All countries with capitalist economies experience business cycles. Although not all at the same time, all of these economies will go through these normal cycles of expansion and collapse. Business cycles across nations do, however, synchronize more frequently than they did in the past due to greater globalization.
Individuals, investors, and governments can all make better financial decisions, lifestyle decisions, and policy decisions by understanding the various business cycle phases.
Business cycle phases
Consider economic cycles to be like the tides, which naturally and endlessly flow from high tide to low tide and back again. Additionally, there may be interim, contradictory bumps — either up or down — in the middle of a specific phase, just as the waves can seem to surge or seem low abruptly, depending on whether the tide is coming in or out.
An extended period of economic expansion is followed by an extended period of economic contraction, which serve as the bookends for all business cycles. An economic cycle includes four distinct stages that can be identified: expansion, peak, contraction, and trough.
Expansion: An up time, regarded to be the “normal” or at the very least the most favored state of the economy. In an expansion, businesses and corporations continuously increase their output and earnings, unemployment is kept to a minimum, and the stock market does well. As a result of consumer spending and investment, prices start to rise for both products and services.
The GDP growth rate is between 2% and 3%, the inflation rate is at the 2% objective, the unemployment rate is between 3.5% and 4.5%, and the stock market is experiencing a bull market, among other factors, decide if the economy is in a healthy period of expansion.
Peak: Once these figures begin to rise above their normal ranges and begin to spiral out of control, the economy is in trouble. The economy can become unbalanced for any number of reasons. There may be reckless company growth. An asset bubble could be created if overconfident investors purchase up a lot of assets at considerably higher prices than their actual value, which is not supported by the market. Costs start to rise too quickly.
The expansion’s end, which is marked by the peak, signals the culmination of all this frantic activity and the limit of both production and pricing. This is the tipping point: There is only downward movement now that there is no more room for growth. There will soon be a contraction.
Contraction: Time between the peak and the trough is referred to as a contraction. Economic activity is declining at this time. The unemployment rate normally rises during a downturn, equities experience a bear market, and GDP growth is below 2%, indicating that businesses have scaled back their operations.
The economy is frequently thought to be in a recession when the GDP has fallen for two straight quarters. Even when a recession is declared to be finished, this does not mean that the economy has fully recovered.
Trough: If the cycle’s high point is its peak, then its low point is its trough. When the recession, or contraction phase, reaches its lowest point and begins to recover into an expansion phase, the business cycle resets and begins all over again. The road to a complete economic recovery is not always easy to follow, nor is it necessarily swift. April 2020 marked the most recent low point.
Market cycles versus business cycles
Despite being frequently used synonymously, a business cycle and a market cycle are actually distinct from one another. While the business cycle represents the state of the economy as a whole, a market cycle specifically refers to the many growth and decline stages of the stock market.
But there is no doubt that the two go together. The stages of a business cycle have a significant impact on and typically parallel the stock market. A bear market occurs when investors sell their holdings during a cycle’s contractionary phase, which lowers stock prices. In contrast, investors embark on a buying binge during the expansionary phase, which results in a bull market and higher stock prices.
What is the average length of a business cycle?
There are no set durations for business cycles. Depending on its length, a business cycle may be brief (a few months) or extensive (a few years).
The lengths can vary, but generally speaking, periods of expansion last longer than times of contraction. According to the Congressional Research Service, since the end of World War II, the US has experienced an average expansion of 65 months and an average contraction of around 11 months.
The US experienced its most recent peak in February 2020, and before that, it had been in the longest expansionary phase ever documented, lasting around 128 months.
One such shock in recent memory was the subprime mortgage crisis of 2007, and another in 2020 with the start of the COVID-19 pandemic caused a two-month recession.
What variables affect a business cycle?
The phases of an economic cycle can be changed by a variety of factors, such as technical advancements and wars. But, according to the Congressional Research Service, the main factor comes down to the overall supply and demand of an economy, which is economistspeak for the total amount of money spent by people and businesses. A contraction takes place when that demand falls. Similar to how supply expands in response to rising demand.
What drives the business cycle: supply and demand
In the beginning: Consumers’ confidence in the economy causes the expansion. They consider that income and employment are both reliable. As a result, customers spend more, which increases demand, prompting businesses to expand hiring and capital expenditures to match that need. Stock prices rise as a result of investors allocating more capital to assets.
Getting too hot: The expansionary phase peaks when demand exceeds supply, and firms take on more risk to meet the growing demand and maintain competitiveness.
Reducing: An economy has a contraction when interest rates rise quickly, inflation rises too quickly, or there is a financial crisis. The confidence that sparked demand swiftly fades, and is quickly replaced by waning customer confidence. Individuals choose to save their money rather than spend it, which lowers demand, while firms reduce output and lay off workers when their sales decline. Stock prices fall further as investors sell their holdings to prevent their portfolio values from declining.
Hitting the bottom: At their lowest point, demand and production are at the trough phase. However, necessities do eventually come back into force. As production and commercial activity begin to revive, frequently as a result of government policies and actions, consumers gradually start to regain confidence. They start spending and making investments, and the economy returns to expansion.
The impact of governments on business cycles
Business cycles can still be altered despite the fact that they follow a natural cycle. Using monetary and fiscal policy, nations can and do strive to control the different stages, slowing or speeding them up. The government controls fiscal policy, while a country’s central bank controls monetary policy.
For instance, when an economy is contracting, especially during a recession, governments implement expansionary fiscal policy, which entails raising spending on public projects or lowering taxes. These actions improve consumer spending power by increasing their disposable income, which in turn spurs economic expansion.
Similar to this, a central bank, such as the Federal Reserve in the US, will utilize an expansionary monetary policy to end a contractionary period by lowering interest rates, which makes borrowing money cheaper, therefore increasing expenditure and ultimately the economy.
Governments will adopt a contractionary monetary strategy, which entails reducing expenditure and raising taxes, if an economy is expanding too quickly. This slows down progress by lowering the available disposable income. A central bank will raise interest rates to implement a contractionary monetary policy, making borrowing more expensive and deterring consumers from spending as a result.
The final word
Business cycles have many real-world effects on people, despite appearing to just have an impact on “the economy.” People’s lifestyle choices can be influenced by being aware of the current cycle.
For investors, it’s essential to comprehend the business cycle. Investors can reduce risks and potentially increase their portfolio’s value during a contractionary phase by knowing which assets, particularly stocks, perform well during the various stages of an economic cycle.
For instance, despite the present economy cycle, certain industries like healthcare and energy continue to be important. On the other hand, it could be advisable to steer clear of speculative investments and risky stocks. A company’s balance sheet, which lists the company’s assets and liabilities, is an excellent place to start when making these investment selections. Even when it appears as though the market is about to enter a contraction phase, a solid balance sheet has more assets than liabilities.