What Is a Business Cycle?

What Is a Business Cycle?

Let me explain to you what a business cycle really is. It's a type of fluctuation in the aggregate economic activity of a nation, where expansions in many economic activities happen at roughly the same time, followed by general contractions. This pattern repeats but isn't periodic in timing. You might also hear it called the economic cycle.

Key Takeaways

Business cycles consist of cyclical upswings and downswings in broad economic measures like output, employment, income, and sales. The phases alternate between expansions and contractions. Contractions can lead to recessions, but the whole phase isn't necessarily one. Recessions typically begin at the business cycle's peak when expansion ends and conclude at the trough when the next expansion starts. We measure a recession's severity by its depth, diffusion, and duration—the three Ds.

How a Business Cycle Works

Business cycles feature alternating phases of expansion and contraction in overall economic activity, with economic variables moving together in each phase. Aggregate activity isn't just about real, inflation-adjusted GDP as a measure of output; it also includes industrial production, employment, income, and sales—these are the main coincident indicators for determining U.S. business cycle peaks and troughs.

There's a common misconception that the contraction phase is always a recession or that two straight quarters of real GDP decline define one. Recessions do happen during contractions, but they might not cover the entire phase. The National Bureau of Economic Research (NBER) uses consecutive GDP declines as an indicator, but it's not their full definition for recession periods.

A recovery in the cycle starts when the recession's downward spiral reverses into an upward one, with rising output leading to job gains, higher incomes, and more sales that boost output further. For the recovery to turn into a lasting expansion, it needs to become self-sustaining through a domino effect spreading revival across the economy.

Remember, the stock market isn't the same as the economy, so don't mix up business cycles with market cycles measured by stock indices.

Measuring Business Cycles

We gauge a recession's severity by the three Ds: depth, diffusion, and duration. Depth comes from the size of the decline from peak to trough in output, employment, income, and sales. Diffusion measures how widely it spreads across activities, industries, and regions. Duration is the time from peak to trough.

An expansion runs from the trough to the next peak, while a recession goes from peak to trough. The NBER sets the official chronology for U.S. recessions and expansions, defining a recession as a significant, widespread decline in activity lasting more than a few months, visible in GDP, income, employment, production, and sales.

Dating Business Cycles

The NBER's Dating Committee announces recession dates well after they occur. For the 2007-2009 recession, they waited for data revisions in 2010 and announced the end in September that year. On average, U.S. expansions since 1945 have lasted about 65 months, while recessions averaged 11 months. Before World War II, expansions averaged 26 months and recessions 21 months. The longest expansion was from 2009 to 2020, at 128 months.

Stock Prices and the Business Cycle

Major stock price drops often align with business cycle downturns like contractions and recessions. During the Great Recession, the Dow fell 51.1% and the S&P 500 dropped 56.8% from October 2007 to March 2009. In contractions, businesses take defensive steps and investor confidence wanes. The stock market often signals economic issues before they're widely felt.

If rumors of recession, layoffs, or falling output spread, businesses cut workforces and budgets, investors shift to safe assets, and stock prices fall. It's the fear of recession that drives prices down, not the contraction itself.

How Will I Use This in Real Life?

Business cycles affect more than just companies—they impact the whole economy and your personal life, plans, saving, investing, and spending. They move from expansions to contractions, and contractions can surprise you. Most won't notice a contraction starting right away, but the stock market will show it, affecting your investments. It's not ideal to invest without advice during this time.

Contractions often become recessions, so prepare early: your job could be at risk, so build an emergency fund. Trim your budget to save or stretch that fund.

What Are the Stages of the Business Cycle?

The business cycle has four phases: expansion, peak, contraction, and trough.

What Does a Business Cycle Describe?

It describes economic fluctuations over time, usually from one recession's start to the next, including growth periods.

Are Business Cycles Predictable?

Generally, no. Economies are complex and interconnected, making predictions hard. Signs like inflation or production shifts appear, but forecasting a full cycle change is tough or impossible.

The Bottom Line

The business cycle covers the time through all four phases: expansion, peak, contraction, and trough. Expansions bring rising profits and output, where the U.S. economy spends most time. Contractions involve falling profits and output, the shortest phase.