:max_bytes(150000):strip_icc()/Term-Definitions_Economic-cycle-caf22d58aef949fcb919389e16db647a.jpg "Understanding the Economic Cycle and Its Four Stages")
:max_bytes(150000):strip_icc():format(jpeg)/Term-Definitions_Economic-cycle-caf22d58aef949fcb919389e16db647a-2afc44d70b724ae5af20bc3757a06d15.jpg)
Key Takeaways
- An economic cycle includes expansion, peak, contraction, and trough stages.
- The average U.S. economic cycle lasts about five and a half years.
- Key factors include GDP, consumer spending, interest rates, and inflation.
- The NBER determines the length of economic cycles.
- Causes of economic cycles are debated among economic schools of thought.
What Is the Economic Cycle?
The economic cycle is the fluctuation of economic activity between periods of expansion and contraction.
The stages of the cycle are predictable, but their timing is not. Factors such as gross domestic product (GDP), interest rates, total employment, and consumer spending are analyzed to help determine what stage the economy is currently in and when the next stage might begin.
Understanding the economic cycle helps investors and businesses determine when to make investments and when to pull their money out, as each cycle impacts stock and bond prices as well as corporate earnings and profits.
Fast Fact
The economic cycle is a repeating pattern of economic activity. It moves from expansion toward contraction and back again.
The Stages of the Economic Cycle
An economic cycle is the movement of an economy as it moves from expansion to contraction and back again. Economic expansion is characterized by growth and contraction, including recession, a decline in economic activity that can last several months. Four stages characterize the economic cycle: expansion, peak, contraction, and trough.
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. The flow of money through the economy remains healthy, and the cost of money is cheap. However, the increase in the money supply may spur inflation during the economic growth phase.
Peak
The peak of a cycle is when growth hits its maximum rate. 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.
Contraction
A correction occurs when growth slows, employment falls, and prices stagnate. As demand decreases, businesses may not immediately adjust production levels, leading to oversaturated markets with surplus supply and a downward movement in prices. If the contraction continues, then the recessionary environment may spiral into a depression.
Trough
The trough of the cycle is reached when the economy hits a low point, with supply and demand hitting bottom before a recovery. The low point in the cycle represents a painful moment for the economy, with a widespread negative impact from stagnating spending and income. The low point provides an opportunity for individuals and businesses to reconfigure their finances in anticipation of a recovery.
How to Measure Economic Cycles
Key metrics determine where the economy is and where it’s headed. The National Bureau of Economic Research (NBER) is the definitive source for marking the official dates for U.S. economic cycles. Relying primarily on changes in GDP, the NBER measures the length of economic cycles from trough to trough or peak to peak.
Since the 1950s, a U.S. economic cycle, on average, lasted about five and a half years. However, there is wide variation in the length of cycles, ranging from just 18 months during the peak-to-peak cycle in 1981 to 1982 up to the expansion that began in 2009. According to the NBER, two peaks occurred between 2019 and 2020. The first was in the fourth quarter of 2019, a peak in quarterly economic activity. The monthly peak happened in a different quarter, which was noted as taking place in February 2020.
This wide variation in cycle length dispels the myth that economic cycles are a regular natural 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.
Important
Businesses and investors need to manage their strategy over economic cycles—not so much to control them, but to survive them and perhaps profit from them.
Strategies for Managing Economic Cycles
Governments, financial institutions, and investors manage the course and effects of economic cycles differently. During a recession, a government may use expansionary fiscal policy and rapid deficit spending. It can also try contractionary fiscal policy by taxing and running a budget surplus to reduce aggregate spending to prevent the economy from overheating during expansion.
Central banks may use monetary policy. When the cycle hits a downturn, a central bank can lower interest rates or implement expansionary monetary policy to boost spending and investment. During expansion, a central bank can employ contractionary monetary policy by raising interest rates and slowing the flow of credit into the economy.
During expansion, investors often find opportunities in the technology, capital goods, and 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 shouldn’t expand. You may be better off building up your cash reserves.
Overview of Economic Theory
Monetarism suggests that a government can achieve economic stability through the growth rate of its money supply. It ties the economic cycle to the credit cycle, where changes in interest rates reduce or induce economic activity by making borrowing by 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, are responsible for generating cycles. When 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. According to Keynesians, unemployment means less consumer spending, and the whole economy sours, with no clear solution other than government intervention and an economic stimulus.
What Are the Stages of an Economic Cycle?
An economic cycle, or business cycle, has four stages: expansion, peak, contraction, and trough. The average economic cycle in the U.S. has lasted roughly five and a half years since 1950, although these cycles can vary in length. Factors that indicate the stages include gross domestic product, consumer spending, interest rates, and inflation. The National Bureau of Economic Research (NBER) is a leading source for determining the length of a cycle.
What Happens in Each Phase of the Economic Cycle?
In the expansionary phase, the economy experiences growth over two or more consecutive quarters. Interest rates are typically lower, employment rates rise, and consumer confidence strengthens. The peak phase occurs when the economy reaches its maximum productive output, signaling the end of the expansion. After that point, employment numbers and housing start to decline, leading to a contractionary phase. The lowest point in the business cycle is a trough, which is characterized by higher unemployment, lower availability of credit, and falling prices.
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 affect the price of debt, influence consumer spending and economic activity. On the other hand, a Keynesian approach suggests that the economic cycle is caused by volatility or investment demand, which in turn affects spending and employment.
The Bottom Line
The economic or business cycle refers to the pattern of expansion and contraction 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 a trough, and then begins to expand once again.
GDP, interest rates, employment levels, and consumer spending can help define the economic cycle. Although there are different economic theories to explain what drives the economic cycle, the conditions associated with each stage can impact business and investment decisions.
