Business Cycle: Its 4 Phases, Characteristics, and Effects

What’s it: 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. They are 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 we call the great depression happened in the United States between 1929 to 1939.

Meanwhile, the economic recovery is the initial expansion phase after exiting the trough phase. And the economic boom is the final phase of expansion before the peak phase.

Why is understanding the business cycle important?

There are several reasons why understanding the business cycle is important. First, understanding business cycles help businesses to 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.

What are the four phases in 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

This phase takes place after the trough but before the peak. During this phase, economic activity increases. Households face strong income and employment prospects. As a result, they are confident to spend more money on goods and services. Their shopping is also more diverse, not only for 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. They buy new capital goods such as machinery and factories to increase output.

At the same time, strong demand allows businesses to raise selling prices. So, finally, they hope to profit more by increasing output and raising selling prices.

As a result, the economy’s output increases. The economy is growing high. But, it 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. In addition, high demand in the labor market reduces the unemployment rate. Thus, they will 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. And if not prevented, it 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. And if they’re too aggressive, it 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

This phase occurs after the peak but before the trough. The economy grew negatively, with real GDP falling. Likewise, other economic indicators to 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. Instead, they save more. And 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. This situation forces 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. 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 happened yet. Nonetheless, 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 the economy is self-regulating and returns itself 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 fell, 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, for example, by 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.

What are the types of business 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. In other words, 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, then an increase in the second. This was 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. The cycle is caused by the lag time of information flowing to the business sector. There is a lag for businesses to make decisions about increasing or decreasing inventory. As a result, it 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. This cycle is associated with an investment in housing and building construction.

Kondratieff Siklus 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, which increase profit prospects. Better profit prospects justify the company to increase investment. That then leads to increased production and productivity. Later, technological innovations became commonplace, leading to a decrease in profit prospects by companies.

Business Cycle: Its 4 Phases, Characteristics, and Effects

Why is understanding the business cycle important?