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The business cycle, the ever-present rhythm of economic rise and fall, is a fundamental concept for anyone seeking to understand the health of a nation’s economy. This cyclical pattern, with its periods of expansion, peak, contraction, and trough, plays a significant role in shaping everything from employment levels to investment opportunities. By recognizing these stages and their impact on various economic factors, we gain valuable insights for informed decision-making, whether it’s planning a business strategy or navigating investment choices. Delve into this guide to unlock the secrets of the business cycle and gain a deeper understanding of the forces that drive economic prosperity and potential challenges.
What is the business cycle?
The business cycle refers to the periodic but irregular rise and fall of an economy’s output. We can trace the phase from economic activity indicators such as real GDP and industrial production growth. These phases include expansion, peak, contraction, and trough. They recur over time but with varying lengths. Also known as the economic cycle.
In addition to the four phases above, there are several related terms: recession, depression, economic recovery, and economic boom. A recession occurs when real GDP falls for at least two consecutive quarters. On the other hand, if a recession lasts more severe and longer, usually for more than eight quarters, we call it an economic depression.
A severe recession is called a great recession, as happened during the 2008-2009 crisis. Meanwhile, a severe depression, which we call the Great Depression, occurred in the United States between 1929 and 1939.
Meanwhile, the economic recovery is the initial expansion phase after exiting the trough phase, and the economic boom is the final expansion phase before the peak phase.
Why understanding a business cycle matters
Understanding the business cycle is important for several reasons. First, understanding business cycles helps businesses predict future conditions. Before drafting a budget, they predict where the economy will go in the future, whether expansion or recession. These predictions become important and basic information in preparing a business plan for the following year.
For example, if businesses predict the economy will expand, they expect their revenue to rise. They predict demand will grow strongly, prompting them to invest. They plan to purchase capital goods to increase production, hoping to maximize sales amid strong demand.
Second, the cycle affects other macroeconomic variables. So, it’s not just about the economy’s output rising and falling. However, it also has implications for variables such as unemployment, inflation, consumer demand, consumer confidence, and business investment. For example, during the expansion phase, the unemployment rate is low. In addition, consumers face strong job and income prospects, prompting them to increase spending. Consequently, demand for goods and services grows strongly.
Third, the cycle also affects interest rates, taxes, and the fiscal balance. Which monetary policy the central bank adopts depends on the current cycle. Likewise, the government considers cycles when preparing the budget.
The central bank and the government try to influence the economy to achieve macroeconomic goals such as high economic growth, low, stable inflation rates, or low unemployment rates. And their policies ultimately affect variables such as interest rates and taxes in the economy.
For example, the central bank will lower interest rates during an economic contraction. It aims to stimulate economic growth and avoid a recession. Low interest rates stimulate household spending and business investment because they can borrow more cheaply. As a result, the demand for goods and services increases, prompting businesses to increase their production.
Investment timing: why business cycles matter
Understanding the business cycle is crucial for making informed investment decisions. Here’s why:
Timing investments: The business cycle can signal the best times to buy or sell investments. During economic expansions, company profits tend to rise, leading to potentially higher stock prices. Investors may choose to buy stocks or other assets anticipating this growth.
Conversely, during contractions, profits may decline, potentially leading to falling stock prices. Investors aware of this might choose to sell or hold off on new investments until the economic outlook improves.
Matching risk tolerance with market conditions: The business cycle also influences investment risk. Expansions are generally associated with lower risk, as companies are more likely to be profitable.
Conversely, contractions can be riskier for investors, as companies might face financial difficulties. By understanding the current phase of the cycle, investors can adjust their investment strategies accordingly. For example, they might choose less risky assets like bonds during contractions and shift towards potentially higher-risk, high-reward stocks during expansions.
Identifying sector opportunities: Different sectors perform better at different points in the business cycle. For instance, consumer staples like food and beverages tend to be more resilient during downturns, while cyclical sectors like construction or materials might see a boom during expansions as infrastructure projects pick up. By understanding the cycle, investors can identify sectors that are likely to outperform based on the current economic climate.
Overall, grasping the business cycle empowers investors to make more informed decisions about when to invest, what level of risk to take on, and which sectors to target. This knowledge can help them navigate market fluctuations and potentially improve their investment returns over the long term.
The 4 phases of the business cycle
Economists divide the phases in a business cycle into four. They are in order:
- Expansion phase
- Peak phase
- Contraction phase
- Trough phase
Each phase has broad implications for variables such as economic growth, inflation rate, and unemployment rate.
Expansion phase
The expansion phase takes place after the trough but before the peak. During this phase, economic activity increases. Households face strong income and employment prospects, so they are confident about spending more money on goods and services. Their shopping becomes more diverse, not just limited to durable goods.
Strong household demand encourages businesses to increase production. Consequently, they operate at or near full capacity with increased productivity. In addition, some businesses increase investment, not just in new capital goods like machinery and factories, to boost output, but also in restocking their inventories. As consumer demand rises, businesses may find their existing stock levels insufficient. Restocking ensures they have enough goods to meet this growing demand.
At the same time, strong demand allows businesses to raise selling prices. So, ultimately, they hope to profit more by increasing output, raising selling prices, and fulfilling consumer needs through sufficient inventory.
As a result, the economy’s output increases, leading to high economic growth. However, this growth is also accompanied by upward pressure on the inflation rate.
In the labor market, businesses hire more workers to meet the need for increased output. They also offer higher wages to attract a qualified workforce, as long as their marginal cost justifies doing so. Additionally, high demand in the labor market reduces the unemployment rate. This means they will eventually find it difficult to recruit new workers without offering higher wages.
Peak phase
In the peak phase, the economy is testing its upper limit. The economy is at its highest level but grows slower than during the expansion phase. Consumer spending is still strong, but the percentage increase is lower than before.
Businesses are starting to slow down the pace of hiring. Therefore, the unemployment rate is still falling but at a decreasing rate. For example, the unemployment rate fell by half during an expansion, from 8% to 4%. However, when approaching the peak phase, the percentage only fell by 1%, from 4% to 3%. This situation occurs because businesses face a tight labor market. So, they find it difficult to find qualified workers.
A tight labor market pushes wages up. Because it is difficult to find a new, qualified workforce, businesses raise wages to compete with other potential employers.
Wage increases ultimately depress profitability. Businesses then pass high wage growth into selling prices. This situation eventually creates high inflation pressure, and prices of goods and services rise high. If not prevented, this overheats the economy and jeopardizes stability as the purchasing power of money falls.
To prevent excessive and uncontrollable inflation, the government tightened policies. For example, the government takes a contractionary fiscal policy by reducing spending or increasing taxes. Meanwhile, the central bank adopted a contractionary monetary policy by raising interest rates.
Those policies aim to curb inflation. However, another consequence is slowing economic growth. If they’re too aggressive, they could send the economy into contraction or even a recession, in which real GDP falls into negative territory.
During this period, businesses begin to reduce capital expenditures. This is because they predict strong economic growth will not last long. And they expect consumer spending to grow more slowly going forward, weakening the demand outlook. As a result, they chose to optimize their existing production capacity and inventory.
Contraction phase
Contraction phase occurs after the peak but before the trough. The economy grew negatively, with real GDP falling. Likewise, other economic indicators show output, such as industrial production, also declined.
During this phase, households face deteriorating income and employment prospects. As a result, they reduce spending on goods and services and save more. Durable goods suffered their worst in this period as consumers cut them first.
Businesses see their profit prospects fall due to weak demand. Inventories are starting to pile up, forcing them to reduce output and take efficiency measures to maintain profitability. They no longer order new equipment. Instead, they cut hours and froze hiring. As a result, output in the economy falls, and unemployment rises. In addition, the inflation rate has also slowed.
A sustained contraction phase can lead to a recession. Economic output fell successively, and the unemployment rate is rising. Meanwhile, inflation may be heading into negative territory (called deflation).
Policymakers launch expansionary policies (also known as loose economic policies) to prevent the situation from worsening. For example, the government adopts an expansionary fiscal policy by increasing spending or cutting taxes. On the monetary side, the central bank lowers interest rates or takes other loose monetary measures, such as lowering the reserve requirement ratio and conducting open market operations by buying government securities.
Those policies aim to stimulate economic growth by encouraging an increase in aggregate demand. For example, low interest rates lower borrowing costs, encouraging households to increase spending (financed by loans). If successful, the policy will lead the economy out of recession into a recovery phase before finally leading to an expansion phase.
Trough phase
The trough phase occurs when the economy’s output falls and is at its lowest point. As a result, real GDP growth will be at its highest negative percentage.
During this phase, the unemployment rate remains high. Businesses usually replace their permanent workers with temporary workers. New recruits haven’t arrived yet, but layoffs are slower than before.
Economists differ on how the economy gets out of this phase. While classical economists suggest no government intervention, Keynesian economists suggest otherwise.
Classical economists argue that the economy is self-regulating and returns to recovery. First, high unemployment rates push wages down. As a result, businesses face improvements in profitability as costs decline. As a result, they recruit new workers at lower costs. Then, the unemployment rate slowly falls, improving household income and employment outlook. The economy then moves towards recovery as demand becomes stronger.
On the other hand, Keynesian economists argue that the economy will not work by itself, as classical economists argue. Therefore, they advise the government to intervene through loose economic policies, such as increasing spending, cutting taxes, or lowering interest rates.
According to Keynesian economists, relying on the private sector to power the economy is impossible. This is because spending and investment decisions depend highly on the prevailing economic situation. Thus, due to a rational view, businesses and households save more because they face deteriorating profit and income prospects. In other words, the economy is not relying enough on the private sector to recover.
For this reason, the government should intervene. Unlike the private sector, the government’s budget does not depend on the economic situation. Rather, it depends on the government’s discretionary action. Thus, the government can intentionally increase spending or cut taxes to affect the economy.
Types of economic cycles
How long each phase lasts will vary over time. Related to this, economists provide an explanation through the following models:
Seasonal cycle: This cycle lasts one year, so the four phases above take place in one year. Some economic activities, such as agriculture, fluctuate throughout the year, mainly driven by weather factors. For example, the cycle may consist of a sharp decline in the first quarter and then an increase in the second, followed by a mild decline in the third quarter and an increase in the fourth.
Kitchin cycle: The Kitchin cycle lasts about 40 months or 3-5 years. It is caused by the lag time of information flowing to the business sector. Businesses have to wait to make decisions about increasing or decreasing inventory, which causes output fluctuations.
Juglar cycle: The Juglar cycle lasts about 8-11 years longer than the Kitchin cycle. In this model, investment in fixed capital plays a large role.
Kuznets cycle: The Kuznets cycle lasts about 15 to 20 years and is associated with investments in housing and building construction.
Kondratieff cycle: The Kondratieff cycle lasts an average of 50 to 60 years and has two feature phases. The first phase begins when technological innovations emerge, increasing profit prospects. Better profit prospects justify the company’s increasing investment, which then leads to increased production and productivity. Later, technological innovations became commonplace, decreasing companies’ profit prospects.
Keynesian vs. Classical Economics on the business cycle
Two prominent schools of thought offer contrasting explanations for these fluctuations: Keynesian economics and Classical Real Business Cycle (RBC) theory.
Keynesian economics focuses on aggregate demand. This theory argues that fluctuations in spending by households, businesses, and governments can cause recessions. During economic downturns, these entities spend less, leading to a decrease in production and employment. This creates a downward spiral as lower production leads to lower incomes, further dampening spending.
Keynesian economists advocate for government intervention through fiscal policy (increased spending on public projects) or monetary policy (lowering interest rates) to stimulate demand during recessions. This increased spending or lower borrowing costs should encourage businesses and consumers to spend more, pulling the economy out of a slump. However, the Keynesian model is primarily concerned with short-run economic fluctuations and achieving full employment in the near term.
Classical’s real business cycle theory, on the other hand, emphasizes the role of supply-side factors. This theory views business cycles as natural responses to real economic changes, such as technological advancements or resource discoveries. These changes affect the economy’s production possibilities, leading to adjustments in output and employment. For example, a major technological breakthrough might lead to a period of rapid economic growth as businesses adopt the new technology and increase production.
The classical RBC theory believes the economy is self-correcting and will naturally return to full employment without government intervention. In this view, recessions are a necessary period of adjustment as the economy adapts to new realities. Additionally, the classical model posits that these adjustments lead to long-run economic growth as the economy becomes more efficient and productive.
Economic policy throughout the business cycle
Business cycles, with their distinct phases of expansion, peak, contraction (recession), and trough, present unique challenges for policymakers seeking to maintain economic stability. By using a combination of monetary and fiscal tools, policymakers can influence economic activity and inflation throughout the cycle’s various phases. The specific policy approaches will vary depending on the economic context and the severity of the fluctuations, but the core objective remains: to promote sustainable economic growth and stability.
Here’s a breakdown of how economic policy can be tailored to address each phase and the reasoning behind these approaches.
Expansion phase
During economic expansion, the primary focus of policymakers is to maintain stable growth and prevent the economy from bubble. This can be achieved through a combination of monetary and fiscal policy tools. Central banks may consider gradually raising interest rates. This discourages excessive borrowing and investment activity, preventing inflation from spiraling out of control and ensuring sustainable economic growth in the long term. On the fiscal side, governments might adopt a more balanced budget approach, avoiding excessive spending that could further fuel inflation.
Peak phase
As the economy reaches its peak, policy focuses on ensuring a soft landing and preventing a sharp downturn. This is a delicate balancing act. Central banks may raise interest rates more aggressively to curb inflation and cool down the economy before it overheats. Similarly, governments might tighten fiscal policy through reduced spending or increased taxes. This helps to cool down demand in the economy and prevent a boom-and-bust cycle.
Contraction phase (recession)
When the economy enters a contractionary phase, the goal of policymakers is to stimulate economic activity and job creation to avoid a crisis like in 2008. Here, central banks will likely lower interest rates. This makes borrowing cheaper, encouraging businesses to invest and consumers to spend. This increased spending injects money back into the economy, boosting overall economic activity.
Additionally, governments may implement expansionary fiscal policy by increasing spending on infrastructure projects or social programs. This directly injects money into the economy and stimulates demand. Tax cuts can also be used to incentivize consumer spending and business investment.
Trough phase
The trough of the business cycle represents a period of economic weakness. Here, the focus of policy is to foster recovery and prevent the economy from relapsing into recession. Central banks may keep interest rates low to maintain easy access to credit and encourage borrowing for investment. Governments might continue with expansionary fiscal policy but gradually shift towards a more balanced budget as the economy recovers. This ensures long-term fiscal sustainability while still supporting the ongoing recovery.
Beyond policy tools: economic collapse and stagflation
Economic policy offers a toolbox for navigating business cycles, but extreme scenarios exist where these tools may fall short.
Economic collapse is a severe, prolonged downturn marked by widespread business failures, unemployment, and financial crisis. Unlike recessions, economic collapse can be triggered by a single event or confluence of factors, overwhelming the ability of monetary and fiscal policy to stimulate recovery. Rebuilding often requires a combination of policy intervention, structural reforms, and international cooperation.
Stagflation is a situation of high inflation, stagnant growth, and high unemployment, creating a policy conundrum. Traditional tools like lowering interest rates to boost growth can worsen inflation while raising them to fight inflation can further slow the economy. Stagflation’s complexity may necessitate a multifaceted approach beyond just monetary and fiscal policy.
In conclusion, while economic policy is vital for managing business cycles, extreme situations like economic collapse and stagflation might require policymakers to explore additional strategies and international collaboration to achieve stability.
