What is a Business Cycle?
A business cycle is a type of fluctuation in a country's overall economic activity that involves roughly simultaneous expansions of much of the economy, followed by a similar general contraction. This sequence is repetitive but not cyclical.
Business cycles are also called economic cycles.
Key Takeaways
- Business cycles consist of coordinated cyclical rises and falls in broad measures of economic activity such as output, employment, income, and sales.
- Alternating phases of the business cycle are expansion and contraction.
- Recessions often lead to economic downturns, but the entire phase is not necessarily a recession.
- Recessions often begin at a business cycle peak, which is the end of an economic expansion, and end at a business cycle trough, which is the beginning of the next economic expansion.
- The severity of a recession is measured by the three Ds: depth, spread, and duration.
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Understanding business cycles
Essentially, business cycles are characterized by alternating phases of expansion and contraction in overall economic activity, and by the co-movement of economic variables during each phase of the cycle. Overall economic activity is represented not only by real (inflation-adjusted) GDP (a measure of total output), but also by composite measures of industrial production, employment, income, and sales. These are the key contemporaneous economic indicators used to officially determine the dates of peaks and troughs in the U.S. business cycle.
A common misconception is that a contraction is a recession, and that two consecutive quarters of real GDP declines indicate a recession (an informal rule of thumb). It is important to note that while recessions occur during contractions, the entirety of a contraction is not necessarily a recession. And while consecutive declines in real GDP are one metric the NBER uses, it is not the definition the organization uses to determine a recession.
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Conversely, a business cycle recovery begins when the vicious cycle of recession reverses into a virtuous cycle, with increased output leading to more employment, more incomes and more sales, which in turn lead to more output.For a recovery to be sustained and produce a sustained economic expansion, it needs to be self-reinforcing, which is ensured by the recovery spreading throughout the economy through a domino effect.
Of course, the stock market is not the economy, so business cycles should not be confused with market cycles, which are measured using broad stock price indexes.
Measuring and Dating Business Cycles
The severity of a recession is measured by the three Ds: depth, spread, and duration. Depth of a recession is determined by the magnitude of the peak-to-trough decline in broad indicators such as output, employment, income, and sales. Spread is measured by the extent to which the recession spreads across economic activities, industries, and geographic regions. Duration is determined by the time interval from peak to trough.
An economic expansion begins at a trough (or bottom) in the business cycle and continues until the next peak, whereas a recession begins at that peak and continues until the next trough.
The National Bureau of Economic Research (NBER) determines the timeline of the U.S. business cycle, i.e., the start and end dates of recessions and expansions. Accordingly, the NBER's Business Cycle Dating Committee considers a recession to be “a significant decline in economic activity that is widespread throughout the economy, lasts for several months or more, and is typically visible in real GDP, real income, employment, industrial production, and wholesale and retail sales.”
The Committee typically determines the start and end dates of a recession long after the fact. For example, after the end of the 2007-2009 recession, the Committee “delayed making a decision until the revision of the national income and production accounts was completed.” [were] “It was announced on July 30 and August 27, 2010,” and on September 20, 2010, it announced the end date of the June 2009 recession.
11 months
The average length of a U.S. recession since World War II is about 11 months. The longest recession during this period was the Great Depression, which lasted 18 months.
U.S. economic expansions have generally lasted longer than recessions. From 1854 to 1899, recessions were about the same length, averaging about 25 months for recessions and 29 months for expansions. The average length of recessions then decreased to 18 months from 1900 to 1945 and to 11 months after World War II. Meanwhile, the average length of expansions gradually increased, from 29 months from 1854 to 1899 to 30 months from 1900 to 1945, 43 months from 1945 to 1982, and 70 months from 1982 to 2009.
Stock prices and the business cycle
The biggest declines in stock prices tend to occur during economic downturns (i.e. recessions or depressions), but they don't always happen. For example, the Dow Jones Industrial Average and the S&P 500 fell sharply during the Great Recession. Between October 9, 2007 and March 9, 2009, the Dow fell 51.1% and the S&P 500 fell 56.8%.
There are many reasons for this, but the main one is that during a recession, companies take defensive measures and investor confidence declines. A lot happens before people realize we're in a recession, but the stock market follows the trends of the economy.
So when there are speculations or rumors about a recession, mass layoffs, rising unemployment, declining production, or other signs, businesses and investors fear a downturn and begin to act accordingly. Companies take defensive strategies, cut staff, and budget for a declining revenue environment.
Investors flee to investments that are “known” to preserve capital, demand for expansionary investments falls, and stock prices fall.
Stocks tend to fall during economic downturns, but it's important to remember that it's not the recession that causes stock prices to fall – it's the fear of a recession that causes stock prices to fall.
What are the stages of a business cycle?
Generally speaking, a business cycle consists of four distinct phases: expansion, peak, contraction, and trough.
How long does a business cycle last?
According to a U.S. government study, the average business cycle in the United States takes about 6.33 years.
What was the longest economic expansion?
The economic expansion from 2009 to 2020 lasted 128 months, the longest on record.
Conclusion
A business cycle is the time it takes for an economy to go through all four stages of the cycle (expansion, peak, contraction, and trough). An expansion is a time when business profits increase and economic production rises, and is the stage that the U.S. economy takes the longest. A contraction is a time when profits decrease and production falls, and is the stage that takes the shortest.
