Business cycles chart the ups and downs of an economy, and understanding them can lead to better financial decisions

• A business cycle is the periodic growth and decline of a nation's economy, measured mainly by its GDP.
• Governments try to manage business cycles by spending, raising or lowering taxes, and adjusting interest rates.
• Business cycles can affect individuals in a number of ways, from job-hunting to investing.

A business cycle, sometimes called a "trade cycle" or "economic cycle," refers to a series of stages in the economy as it expands and contracts. Constantly repeating, it is primarily measured by the rise and fall of gross domestic product (GDP) in a country.

Business cycles are universal to all nations that have capitalistic economies. All such economies will experience these natural periods of growth and declines, though not all at the same time. However, given the increased globalization, business cycles tend to happen at similar times across countries more often than they did before.

Understanding the different phases of a business cycle can help individuals make lifestyle decisions, investors make financial decisions, and governments make appropriate policy decisions.

Stages of a business cycle

Think of business cycles like the tides: a natural, never-ending ebb and flow from high tide to low tide. And the same way the waves can suddenly seem to surge even when the tide's going out or seem low when the tide's coming in, there can be interim, contrarian bumps — either up or down — in the midst of particular phase.

All business cycles are bookended by a sustained period of economic growth, followed by a sustained period of economic decline. Throughout its life, a business cycle goes through four identifiable stages, known as phases: expansion, peak, contraction, and trough.

Expansion: Expansion, considered the "normal" — or at least, the most desirable — state of the economy, is an up period. During an expansion, businesses and companies are steadily growing their production and profits, unemployment remains low, and the stock market is performing well. Consumers are buying and investing, and with this increasing demand for goods and services, prices begin to rise too.

When the GDP growth rate is in the 2% to 3% range, inflation is at the 2% target, unemployment is between 3.5% and 4.5%, and the stock market is a bull market, then the economy is considered to be in a healthy period of expansion.

Peak: Once these numbers start to increase outside of their traditional bands, though, then the economy is considered to be growing out of control. Companies may be expanding recklessly. Investors are overconfident, buying up assets and significantly increasing their prices, which are not supported by their underlying value. Everything is starting to cost too much.

The peak marks the climax of all this feverish activity. It occurs when the expansion has reached its end and indicates that production and prices have reached their limit. This is the turning point: With no room for growth left, there's nowhere to go but down. A contraction is forthcoming.

Contraction: A contraction spans the length of time from the peak to the trough. It's the period when economic activity is on the way down. During a contraction, unemployment numbers typically spike, stocks enter a bear market, and GDP growth is below 2%, indicating that businesses have cut back their activities.

When the GDP has declined for two consecutive quarters, the economy is often considered to be in a recession.

Trough: As the peak is the cycle's high point, the trough is its low point. It occurs when the recession, or contraction phase, bottoms out and starts to rebound into an expansion phase — and the business cycle starts all over again. The rebound is not always quick, nor is it a straight line, along the way towards full economic recovery.

Business cycles vs. market cycles

Though often used interchangeably, technically a business cycle is different from a market cycle. A market cycle specifically refers to the different growth and decline stages of the stock market, while the business cycle reflects the economy as a whole.

But the two are definitely related. The stock market is greatly influenced by the phases of a business cycle and generally mirrors its stages. During the contractionary phase of a cycle, investors sell their holdings, depressing stock prices — a bear market. In the expansionary phase, the opposite occurs: Investors go on a buying spree, causing stock prices to rise — a bull market.

Who measures business cycles?

In the US, business cycles are defined and measured by the National Bureau of Economic Research (NBER), a private nonprofit. NBER's Business Cycle Dating Committee is responsible for determining the start and end of a cycle.

NBER primarily uses quarterly GDP growth rates to identify a business cycle, but it will also look at other economic indicators, such as real income, retail revenues, employment, and manufacturing output. Analysts and economists often see what they call "co-movement" in these variables, meaning the different measurements rise and fall together.

For example, if employment is up, production is likely up, as is consumer spending. Likewise, if employment is down, the other metrics are down and will eventually have an impact on GDP.

How long does a business cycle last?

Business cycles have no defined time frames. A business cycle can be short, lasting a few months, or long, lasting several years.

Generally, periods of expansion are more prolonged than periods of contraction, but the actual lengths can vary. Since the end of World War II, the average period of expansion in the US lasted 65 months, and the average contraction lasted about 11 months, according to the Congressional Research Service.

Most recently, the US hit a peak in February 2020, and before that was in a period of expansion that had lasted roughly 128 months, making it the longest in recorded history.

The many variables in an economy fluctuate differently over time, causing shifts in the economy, and non-economic factors, such as natural disasters and disease, play a part in shaping the economy as well. "Essentially, market economies want to expand, but if they're hit by an adverse shock, they may contract," says Vincent Reinhart, chief economist and macro strategist at Mellon Investments.

In recent history, the subprime mortgage crisis of 2007 was one such shock, and the onset of the COVID-19 pandemic in 2020 was another.

What factors shape a business cycle?

From technological innovations to wars, a variety of things can trigger a business cycle's phases. But, according to the Congressional Research Service, the key influence boils down to the aggregate supply and demand within an economy — economist-speak for the total spending that individuals and companies do. When that demand decreases, a contraction occurs. Likewise, when demand increases, an expansion occurs.

How supply and demand drives the business cycle

• In the beginning: The expansion happens because consumers are confident in the economy. They believe that employment is steady and income is guaranteed. As a result, they spend more, which leads to increased demand, which leads to businesses hiring more employees and increasing capital expenditures to meet that demand. Investors allocate more capital to assets, increasing stock prices.
• Getting overheated: The expansionary phase hits a peak when the demand is greater than the supply, and businesses take on additional risks to meet increased demand and remain competitive.
• Scaling back: When interest rates rise quickly, inflation increases too fast, or a financial crisis occurs, an economy enters a contraction. The confidence that stimulated it quickly evaporates, replaced with dwindling consumer confidence. Individuals save money rather than spend, reducing demand, and businesses cut production and layoff employees as their sales dry up. Investors sell stocks to avoid a drop in the value of their portfolios.
• Hitting bottom: During the trough phase, demand and production are at their lowest point. But eventually, needs reassert themselves. Consumers slowly start to gain confidence as production and business activity starts to improve, often spurred on by government policies and action. They begin to buy and invest, and the economy enters a new expansion phase.

How governments influence business cycles

The fact that business cycles move in natural phases doesn't mean they can't be influenced. Countries can and do try to manage the various stages — slowing them down or speeding them up — using monetary policy and fiscal policy. Fiscal policy is carried out by the government; monetary policy is carried out by a nation's central bank.

For example, when an economy is in a contraction, particularly a recession, governments use expansionary fiscal policy, which consists of increasing expenditures on projects or cutting taxes. These moves provide increased levels of disposable income that consumers can spend, which in turn stimulates economic growth.

Similarly, a central bank — like the Federal Reserve in the US — will use an expansionary monetary policy to end a contractionary period by reducing interest rates, which makes borrowing money cheaper, thus stimulating spending, and eventually the economy.

If an economy is growing too fast, governments will employ a contractionary fiscal policy, which involves cutting spending and increasing taxes. This reduces the amount of disposable income to spend, slowing things down. To employ a contractionary monetary policy, a central bank will increase interest rates, making borrowing more expensive and therefore spending money less attractive.

The financial takeaway

Even though they seem like something that only affects "the economy," business cycles have plenty of real-world implications for individuals. Recognizing the current cycle can influence people and their lifestyle decisions.

For example, if we're in a contraction phase, finding work often becomes more difficult. Individuals may take up less-than-ideal jobs just to ensure they are making an income, and hope to find better positions once the economy improves.

It may also influence spending and making long-term plans. "You're going to have to be cautious in terms of using your savings now because you may need them later," says Reinhart.

Understanding the business cycle is also crucial for investors. Knowing which assets — especially stocks — perform well in the different phases of a business cycle can help an investor avoid certain risks and even grow the value of their portfolio in a contractionary phase.

Granted, individuals can't do much on their own to affect a business cycle, and weathering its down phases can be tough. Still, it might help you sleep better at night knowing "it's a cycle and that we won't be there forever," says Reinhart. "Understanding the business cycle gives you at least a reassurance that there are a rebound and recovery to follow."

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