Economic Growth

The Business Cycle

What Is the Business Cycle?

A business cycle is an interval of expansion and contraction in the economy.

Economic growth fluctuates. The levels of trade and production rise and fall over time. An interval of expansion and contraction in the economy is known as a business cycle. Business cycles are the up and down fluctuations in the economy around the long-term growth trend. In other words, while the economy tends to grow positively over time, there are short-run fluctuations around that trend. Sometimes the level of GDP in an economy expands, or grows larger, and other times it contracts, or grows smaller, because of fluctuations in economic activity. One business cycle can be viewed as a single period of expansion followed by a single period of contraction. Linearly, a business cycle takes the form of a wave-like pattern, with four phases: expansion, peak, contraction, and a trough. This constitutes one full business cycle.

  • Trough: The lowest stage in the economic business cycle is called a trough. The trough is the point at which GDP has fallen the farthest and there is the least amount of cumulative economic activity. Unemployment also reaches a high point, while spending reaches a low point. In a trough, the economy has bottomed out. The bright side to an economic trough is that it is always followed by an economic expansion. Unfortunately, it is impossible to tell when a trough will end, or even if the economy is just pausing in a contractionary period—in which case economic activity may continue to fall. The extent of the trough phase can only be seen after the fact, once the economy is observed to be expanding once again.
  • Expansion: In the expansion phase of a business cycle, the economy has begun to grow again after bottoming out in the trough stage. There is an upward trend in prices, and unemployment rates begin to drop. More money begins to circulate through the economy. This increased circulation is the result of individuals and firms being more confident about their economic prospects and less inclined to hold on to accumulated savings and resources because of the previous overall scarcity.
  • Peak: The peak phase represents the highest point of economic activity in the business cycle. The economy’s output is at its maximum allowable level, and the employment level is at full employment or higher. A larger inflationary increase in price levels is frequently observed during this phase of the business cycle.
  • Contraction: After the peak subsides, the contraction phase begins. During contraction, the upward pressure on pricing subsides. Unemployment begins to climb, and overall economic growth slows as spending begins to decline.

The Business Cycle

The business cycle is the regular expansion and contraction of the economy. It fluctuates around the long-term growth trend, in which total economic output (gross domestic product, GDP) rises.

The Nature of the Business Cycle

Economic research indicates that business cycles do not have a regularity in length, but the stages always occur in the same order (expansion, peak, contraction, and trough). The cycle is often referred to as a "boom or bust" cycle.

A recession is typically defined as two or more successive quarters during which gross domestic product decreases. The nonpartisan, nonprofit organization dedicated to economic research in the United States is the National Bureau of Economic Research, or NBER. The NBER assesses the state of the economy and determines the phase the economy is in at any given time as well as the beginning and end dates of previous phases. Recession is the term the NBER uses to describe the contraction phase of the business cycle; this usage differs from the more common definition of the word—two or more successive quarters during which GDP decreases. According to the NBER, the recessionary contractionary phase of the business cycle is characterized by “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

The most recent NBER figures indicate that from the mid 1850s to 2009, there were 33 full business cycles. The average length of a business cycle during that span, whether measured from peak to peak or trough to trough, is just over 56 months, or between four-and-a-half and five years. Eleven of those full business cycles took place between the years 1945 and 2009. The average length of a business cycle during those years was approximately 69 months. However, it is important to note that these cycles are not evenly divided between times of expansion and times of contraction. In fact, between 1945 and 2009 the average length of the expansionary phase in the business cycle was 58 months, while the average length of the contractionary recessionary phase was only 11 months. These statistics show that the stages of a business cycle occur in the same order (expansion, peak, contraction, and trough). Business cycles also demonstrate that the primary mode of the economy is expansion and that there exists an upward time trend in GDP over time.

When the expansion and contraction phases of the business cycle have been particularly volatile—tremendous gains in the economy followed by equally severe losses—this is can be referred to as a "boom and bust" cycle. These intense fiscal ups and downs have occurred in the United States for as long as economic records have been kept. In the late 19th and early 20th century, the booms and busts were dramatic oscillations; depressions were often expected after times of prosperity. One example is the Great Depression, the period of dramatic economic downturn from 1929 to 1939. Since the Great Depression, booms and busts have continued to occur in the United States but to a more moderate degree. Economists have differing perspectives on whether or not a nation should attempt to smooth out these fluctuations in the business cycle or just focus on long-term expansion of full employment GDP. Fiscal and monetary policies serve as the main tools to smooth out these business cycles. However, business cycles still exist despite a nation’s best efforts.

Economists differ as to why the expansion stage reaches a peak and then begins to contract again. One frequent explanation is that in the final period of many expansions, there is an excess of speculative activity. The growth of the economy leads investors to make risky investments. When some of these investments fail due to their excessive uncertainty, a domino effect can begin that drags the economy down with them. The economic climate begins to seem less positive, and therefore less spending and investment takes place.

For example, from 1995 to 2000, prior to the recessionary period of 2001, there was an outpouring of investment in Internet and technology stocks, referred to as the “dot-com bubble.” When many of these investments did not pay off, the economy contracted again and the bubble burst. Similarly, the recession of 2007-2009 came immediately after a period of high levels of speculative investments in the US housing market, whereupon some of these investments employed financial instruments that had only been recently created by banks and other financial institutions and were therefore largely unregulated.