- The business cycle is made up of a series of fluctuations in the gross domestic product (GDP), a measure of the monetary value of goods and services made in our country.
- This cycle consists of six stages, with the peaks and troughs the most extreme.
- Governments try to manage their nation’s business cycle and economy by taking actions such as adjusting interest rates, spending money or raising or lowering taxes.
The business cycle refers to the expansion and contraction of the economy, or gross domestic product, or GDP (a measure of the monetary value of goods and services made in our country).
There are several stages to the business cycle, which we will detail below.
We can use the business cycle to better understand what’s going on and what to expect from our economy.
Inside this article
How do business cycles work?
A business cycle is a pattern of an economic boom followed by a bust followed by a boom, and so on.
A boom happens when there is a period of rapid economic growth, as in, businesses start seeing more demand and in turn start producing more, which requires capital to buy equipment and hire new workers. As new jobs are created, more money is spent. Businesses end up making more money and growing even more. That’s an expansion.
A contraction is the opposite. When demand slows, businesses may eliminate production and jobs. As a result, people get worried and stop spending as much money. Businesses similarly become more cautious about spending and may limit growth.
If the economy experiences stagnated growth, that can lead to a recession.
What are the stages of business cycles?
Let’s take a closer look at the different stages of the business cycle work.
The business cycle begins with the expansion stage. We see this through economic indicators like companies reporting greater profit, an increase in demand for employees, higher wages and lower unemployment.
The second stage of the business cycle is known as the peak. This is when the maximum limit of growth is attained and prices are at a peak.
“The peak is characterized by widespread economic optimism surrounding things like income, employment, output—and the price level all tend to rise,” says Ankush Sharma, chief executive officer of DataToBiz, a data analytics firm.
At this stage, the reversal point in economic growth begins and average consumers like us to start to tighten our budgets.
In other words, what goes up, must come down.
Enter the dreaded recession stage.
During a recession, demand for goods and services begins to rapidly decline and stays on a steady decline. Businesses may not be immediately aware of this decline, and may continue to produce goods, which can lead to an excess supply and prices falling even further. Those positive economic indicators mentioned earlier also begin to fall. Fewer jobs are created and may be eliminated. Factory production may be paused and wages may begin to weaken.
While a feared term, a recession is a completely normal part of the business cycle and can help rebalance the economy.
A very severe recession can become a depression. Basically, things just keep getting worse.
Supply and demand hit their lowest point. GDP growth goes negative as contraction hits a zenith.
“The trough indicates that GDP has stopped falling and has begun to rise,” Sharma says.
If there’s one thing we can count on, it’s that everything will change.
And following the trough, we get to the blessed recovery phase. This is when GDP growth starts to return to positive territory.
Employment starts to pick up and consumers start to feel more relaxed financially and return to spending.
How do governments try to influence the business cycle?
Governments step in to try and manage their nation’s business cycle and economy, trying to rein the economy in when it seems to be overheated, and support it when it’s in the dumps.
Among the actions they can take are adjusting interest rates–making borrowing more or less expensive–and raising or dropping tax rates.
“Government policy has always had a significant impact on economic growth, the formation of new businesses and the success of financial markets,” Gu says. “To prevent excessive economic growth, the central bank adjusts its target interest rate to discourage borrowing and spending. This is referred to as ‘contractionary monetary policy’ since the bank is attempting to reduce economic output to control expansion.”
Frequently Asked Questions
How long does the business cycle last?
There is no set timeline for business cycles. They can be as short as a few months or as long as several years—with periods of expansion tending to be longer than periods of contraction.
What are the most important stages of the business cycle?
While all parts of the business cycle play an important role in the economy, the extreme stages are the peak and the trough.
What is an example of the business cycle?
The Great Recession of 2008 serves as a clear example of the business cycle. That recession, the worst since World War II, started with a housing bubble that burst because of too many high-risk mortgages. Financial institutions couldn’t handle all those bad loans. The stock market crashed and many businesses lost tremendous amounts of money and failed. Unemployment soared and a lack of credit with cautious investing hurt the economy.
Eventually, the U.S. passed the American Recovery and Reinvestment Act of 2009, which bailed out the banks and helped stimulate economic growth.