What is the business cycle? In economics, business cycles are periods of economic expansion followed by a period of recession. Their timing and consequences are important for the welfare of the whole population as well as private institutions. But what are the effects of business cycles? In this article, we will look at some of the most prominent and influential examples of the business cycle. Let us now explore some of the implications of the business cycle. In short, this concept will help you understand the role of economic cycles in the economy.
During an expansion, many economic indicators move together. This is because the economy is growing rapidly. The number of employees is increasing, the number of new homes is being built, and the price of goods and services is high. At the same time, the price of stocks and commodities also increases. However, when the demand for goods and services drops, the economy is in recession. This is when companies and economies suffer from the worst financial crisis in recent history.
A business cycle can be triggered by a number of events. A technological innovation or war, for example, may lead to a business to grow rapidly. The process of economic growth is shaped by aggregate demand and supply. When the demand for goods and services decreases, the economy contracts. Conversely, when demand increases, the economy expands. This expansion occurs when consumers have confidence in the economy and are willing to spend money. Moreover, investors are more likely to invest in stocks, causing their stock prices to rise.
While the business cycle is cyclical and unpredictable, there are specific phases of the cycle that occur in every economy. In most cases, the economic activity reaches its peak during the expansion phase. The subsequent phase is characterized by a contraction. As a result, housing starts and employment numbers begin to fall. The contractionary phase marks the beginning of the contractionary phase. The business cycle peaks during the peak and then drops again during the trough.
The first stage of the business cycle is expansion. During the expansion stage, economic activity increases and employment is at its highest level. Prices rise and inflation are high. At the trough, the economy enters a correction or contraction phase. Then, it continues to grow slowly until it reaches its trough, when it becomes stagnant and the economy starts experiencing the recession. The business cycle is an important aspect of the modern economy.
The two phases of the business cycle are the peak and trough. The peak is the highest point of the cycle. During the expansion phase, the economy produces at its maximum capacity. As prices continue to rise, they will reach the trough, which is the first phase of the recession. Once the trough has occurred, the economy will enter a correction period. The trough is the bottom of the economic cycle.
The stages of the business cycle
In the figure above the straight line that is in the middle represents the line of steady growth. The business cycle is a loop around the straight line. Here is a more thorough description of each phase of the cycle
The first phase of the cycle of business expansion. In this phase there is an increase in economic indicators that are positive, like employment production, income earnings, wages demand, as well as the availability of products and services. Debtors generally pay their debts promptly The velocity that the supply of cash is very high and the investment rate is also extremely high. This cycle continues for so long as the economic conditions favor expansion.
The economy then hits the point of saturation, or peak and this is the next phase of the cycle. The limit of maximum growth has been reached. Economic indicators don’t increase and are at their maximum. The prices are at their highest. This is the turning phase in economic expansion. Consumers are likely to alter their budgets in this stage.
This is the period which occurs after an upswing in demand. Demand for both goods and services begins slowing down and continues to decline in this stage. Producers don’t notice the decline in demand right away and continue to produce that creates a condition that has excess supply in the market. Prices tend to decline. Every positive economic indicator, like output, income and wages. will consequently begin to decrease.
There is an increase in the rate of unemployment. The economy’s growth remains in decline and if it falls below the line of steady growth it is termed depression.
When the economy is in the state of depression when the economy is in the depressed phase, its growth rate is negative. It continues to decline until the cost of the elements, and the supply and demand of services and goods, decrease until they are at their lowest level. The economy eventually hits the point of the trough. This is the point of low point at which a economy. There is an extensive loss of the national budget and income.
Following the trough, the economy enters the phase of recovery. In this stage there is a shift in the economy and it starts to rebound from the slow growth. The demand starts to rise because of low prices and, as a result the supply starts to rise. The population gains an optimistic attitude towards investing and employment, and production begins expanding.
Employment starts to increase and, because of the accumulation of cash balances at banks The lending process also gives positive signs. In this stage the capital that has been depreciated is replaced, resulting in additional investments in the process of production. Recovery continues until the economic system gets back to a steady growth rate.
This is the complete business cycle of growth and contraction. The extreme points are top and the bottom.
Explanations from economists
John Keynes explains that the development of business cycles as due to changes in demand that bring the economy into short-term equilibriums which differ from an equilibrium of full-employment.
Keynesian-based models are not always indicative of the existence of periodic business cycles, but rather the cyclical response to shocks through multipliers. The magnitude of these variations is dependent on the level of investment, which determines the magnitude of the aggregate output.
However, economists such as Finn E. Kydland and Edward C. Prescott, who are part of the Chicago School of Economics, contest the Keynesian theories. They believe that the fluctuation in the economic growth not the consequence of monetary fluctuations rather, they are the result of technological shocks, for example, innovations.
Measurement and Dating Business Cycles
The extent of a recession can be determined by three dimensions: depth diffusion and duration. The depth of a recession is determined by the size of the decline from peak to trough in broad measures of output as well as income, employment and sales. The extent of its spread is determined by the extent to which it dispersion across various industries, activities and geographical areas. The duration is measured by the time gap between its peak and lowest point.
Similar to the way the degree of expanding economy is decided by its how extensive it is, how widespread and long-lasting it proves to be. The three P’s are the 3D’s in recession.
The expansion starts at the bottom (or the bottom) of a cycle and continues to the next peak. On the other hand, recessions begin at the peak and continues to the next trough.
The National Bureau of Economic Research (NBER) is the body that determines the chronology of business cycles, which is the start and ending dates of expansions and recessions in the United States. In turn, the Business Cycle Dating Committee considers that a recession is “a significant decrease in the activity of the economythat lasts more than a couple of months. This is typically seen in real GDP real income as well as manufacturing, employment, and wholesale retail sales. “3
It is the Dating Committee typically determines recession date for the start and end of recessions years after the fact. For instance, following the conclusion of the recession in 2007-09, it “waited to announce its decision until the revisions to the National Income and Product Accounts were released between July 30 and July 27, 2010” and announced the June end of the 2009 recession on September. 20th 2010. 4 Since the committee’s inception since 1979, the typical time between the announcement of recession’s start and date of end have been 8 months for peaks and fifteen months in the case of the troughs. 5
Before the establishment of the Committee between 1949 and 1978, recession’s beginning and end dates were set by the NBER by Dr. Geoffrey H. Moore. He was the committee’s chief chairman from 1979 to his demise in the year 2000. He died in 1996. Moore founded The Economic Cycle Research Institute (ECRI) which, based on the same method employed to determine what is the current U.S. business cycle chronology establishes the chronologies of business cycles for other countries which include that of G7 along with the BRICS. 6 7 In studies that require international recession dates to be used as reference points, the most commonly utilized method is to refer to NBER dates from the U.S. and the ECRI dates for other economies. 8
U.S. expansions have typically been longer-lasting that U.S. recessions. Between 1854 and 1999 both were roughly the same length in terms of time, with recessions lasting 24 months , and expansions lasting 27 months in the average. The average duration of recessions dropped to 18 months in the period 1900-1945 and 11 months after World War II timeframe. The average time of expansions grew gradually by 27 months from 1854-1899, then to 32 months from 1900-1945 up to 45 months between 1945-82, and finally an average of 103 months during the 1982-2009 timeframe.
The severity of recessions has changed with time. They were usually extremely deep prior to the World WWII (WWII) the period which stretches all the way to in the early 19th century. As cyclical volatility dramatically decreased following WWII the duration of recessions fell dramatically. From the mid-1980s until the beginning of the Great Recession of 2007-09, a period often referred to as the great moderation–there was smaller reduction in cycles of volatility. In addition, since the time of the beginning during the Great Moderation the average length of time between expansions has roughly increased by a factor of two. Businesses Cycle Graph. Image created by Julie Bang (c) Investopedia 2019
The Many Varieties of Cyclical Experience
The pre-WWII experiences of many market-oriented economies was marked by severe recessions and robust recovery. But, the post-war recovery due to the devastation caused to several major economies due to the war led to strong trend growth that lasted for many decades.
If the trend is high–as China has proven over the past decade, it can be difficult for cyclical downswings of the same magnitude to bring growth rates below zero and plunge to enter recession. The same is true for recessions. Germany and Italy didn’t experience their first recession after WWII until the middle of the 1960s, which is why they experienced two decades of expansion. From 1950 to in the 70s France enjoyed a growth of 15 years, while the U.K. saw a 22-year expansion and Japan experienced a 19-year growth. Canada experienced a 23-year growth from the mid 1950s until the beginning of the 1980s. The U.S. enjoyed its longest expansion to that point in its history. It lasted almost nine years from the beginning of 1961 until the end the year the year 1969. 9
Since recessions in the business cycle have been less frequent economic experts have focused their attention on growth cycles that consist of periodic periods of below-trend and above-trend growth. However, monitoring growth cycles requires an understanding of the current trend, which can be challenging for forecasting the economic cycle in real-time. In the end, Geoffrey H. Moore, at the ECRI then developed use a different cyclical term, the growing rate cycle. 10
Growth rate cycles–also called acceleration-deceleration cycles–are comprised of alternating periods of cyclical upswings and downswings in the growth rate of an economy, as measured by the growth rates of the same key coincident economic indicators used to determine business cycle peak and trough dates. In this way this growth cycle (GRC) represents the primary variation of the classic business cycle (BC). However, it is important to note that GRC analysis is not dependent on the estimation of trends.
Utilizing a method similar to the method used to calculate business cycle chronologies, ECRI also establishes GRC chronologies for the 22 economies that include that of the U.S. 10 Since GRCs depend on transition points of economic cycles, they can be particularly helpful for investors who are aware of the interplay between the equity market and cycles of economic activity.
The pioneers of the classical business cycle analysis and growth cycle analysis shifted their focus towards the cycle of growth (GRC) that is composed of alternating periods of cyclical upswings as well as downswings in economic growth as determined by the rates of growth of the important indicators of economic growth that coincide to establish the peak and Trough dates.
Price of Stocks and the Business Cycle
The post-WWII era saw the largest price declines generally, but not always, were triggered by economic downturns (i.e. recessions). The exceptions are the crash of 1987, which formed part of a plunge of 35% or more of the S&P 500 that year, its pullback of 23% or more from 1966 as well as its more than 28% fall in the early part of the year 1962. 11
But, all of those major price drops in stocks took place during GRC downturns. While stock prices typically experience significant declines following recessions in the business cycle and upturns following recoveries from recessions There was a more one-to-one connection that was found between declines in the stock market and GRC downturns, and between upturns in stock prices and GRC upturns after WWI prior to the decade that preceded that Great Recession.
After in the Great Recession of 2007-09–while full-fledged declines in stock prices, with upwards of 20 percent within the most important averages didn’t occur until 2020 COVID-19 pandemic – smaller 10%-20percent “corrections” are clustered around four interspersed GRC downturns from May 2010 through May 2011, and March 2012 through January. 2013, from March through August. 2014 and from April 2014 through May 2016. The 20 percent plunge within the S&P 500 in late 2018 was also part of the fifth GRC recession that started at the end of April in 2017 and ended in the recession of 2020. 12
It is true that the threat of recession typically, though not always, triggers the possibility of a significant decline in stock prices. But the likelihood of a slowdown in the economy–specifically an GRC downturn can also cause smaller corrections and, at times, more significant downwards in the stock market.
For investors it is essential to be looking out for not just recessions in the business cycle, as well as the slowdowns in economic growth classified by the GRC as GRC downturns. Anyone who is interested in learning how to better understand business cycles and the stock market as well as other financial concepts might want to take a look at enrolling in one of the top investing courses that are available.