Economic Cycle: What It Means and 4 Phases of Business Cycles

The economic cycle, also known as a business cycle, refers to fluctuations of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (GDP), interest rates, total employment, and consumer spending can help to determine the current stage of the economic cycle.

Understanding the economic cycle can help investors and businesses determine when to make investments and when to pull their money out, as it has a direct impact on stocks and bonds as well as profits and corporate earnings.

Key Takeaways

• An economic cycle is the overall state of the economy as it goes through four stages in a cyclical pattern: expansion, peak, contraction, and trough.
• Factors such as GDP, interest rates, total employment, and consumer spending can help determine the current stage of the economic cycle.
• Insight into economic cycles can be useful for businesses and investors.
• The exact causes of a cycle are highly debated among the different schools of economics.

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4 Stages Of The Economic Cycle

Stages of the Economic Cycle

An economic cycle is the circular movement of an economy as it moves from expansion to contraction and back again. Economic expansion is characterized by growth. On the other hand, a contraction means a recession, which involves a decline in economic activity that spreads out over at least a few months.

The economic cycle or business cycle is characterized by four stages. The following breakdown describes what is happening in the economy during the different phases of the cycle.

Expansion

During expansion, the economy experiences relatively rapid growth, interest rates tend to be low, and production increases. The economic indicators associated with growth—such as employment and wages, corporate profits and output, aggregate demand, and the supply of goods and services—tend to show sustained uptrends through the expansionary stage. The flow of money through the economy remains healthy, cost of money is cheap because interest rates are low. However, the increase in the money supply may cause inflation to pick up during the economic growth phase.

Peak

The economy reaches the peak of a cycle when growth hits its maximum rate. At this economic high-water mark, prices and economic indicators may stabilize for a short period before reversing to the downside. Peak growth typically creates some imbalances in the economy that need to be corrected. As a result businesses may start to reevaluate their budgets and spending when they believe that the economic cycle has reached its peak.

Contraction

A correction occurs through a period of contraction when growth slows, employment falls, and prices stagnate. As demand begins to fall, businesses may not immediately adjust production levels, leading to oversaturated markets with surplus supply and exacerbating the downward movement in prices. During this stage, the economic indicators that were on an upward trajectory during the expansion phase begin to deteriorate. If the contraction continues, the recessionary environment may spiral into a depression.

Trough

The trough of the cycle is reached when the economy hits a low point, with supply and demand scraping the bottom before growth eventually begins to recover. The low point in the cycle represents a painful moment for the economy, with a widespread negative impact from stagnating spending and income. However, like the peak, the low point of the cycle provides an opportunity for individuals and businesses to reconfigure their finances in anticipation of a recovery. Some analysts refer to the recovery as a fifth stage in the cycle.

Measuring Economic Cycles

It’s important for investors and corporations to understand how these cycles work and the risks they carry because they can have a big impact on investment performance. Investors may find it beneficial to reduce their exposure to certain sectors and industries when the economy starts to contract and vice versa. Business leaders may also take cues from the cycle to determine when and how they’ll invest and whether they’ll increase or reduce employment levels.

You can use a number of key metrics to determine where the economy is and where it’s headed. For instance, an economy is often in the expansion phase when unemployment begins to drop and more people are fully employed. Similarly, people tend to prioritize and curb their spending when the economy contracts. That’s because money and credit are harder to come by as lenders often tighten up their lending requirements and interest rates are rising.

Businesses and investors need to manage their strategy over economic cycles—not so much to control them but to survive them and perhaps profit from them.

The National Bureau of Economic Research (NBER) is the definitive source of setting official dates for U.S. economic cycles. Relying primarily on changes in GDP, NBER measures the length of economic cycles from trough to trough or peak to peak.

U.S. economic cycles have lasted about five and a half years on average since the 1950s. However, there is wide variation in the length of cycles, ranging from just 18 months during the peak-to-peak cycle in 1981 to 1982 up to the expansion that began in 2009. According to the NBER, two peaks occurred between 2019 and 2020. The first was in the fourth quarter of 2019, which represented a peak in quarterly economic activity. The monthly peak happened in a different quarter altogether, which was noted as taking place in February 2020.

This wide variation in cycle length dispels the myth that economic cycles can die of old age or that they are a regular natural rhythm of activity akin to physical waves or swings of a pendulum. But there is debate as to what factors contribute to the length of an economic cycle and what causes them to exist in the first place.

Managing Economic Cycles

Governments, financial institutions, and investors manage the course and effects of economic cycles differently. Governments often use fiscal policy. To end a recession, the government may use expansionary fiscal policy, which involves rapid deficit spending. It can also try contractionary fiscal policy by taxing and running a budget surplus to reduce aggregate spending to stop the economy from overheating during expansions.

Central banks may use monetary policy. When the cycle hits the downturn, a central bank can lower interest rates or implement expansionary monetary policy to boost spending and investment. During expansion, it can employ contractionary monetary policy by raising interest rates and slowing the flow of credit into the economy to reduce inflationary pressures and the need for a market correction.

During times of expansion, investors often find opportunities in the technology, capital goods, and basic energy sectors. When the economy contracts, investors may purchase companies that thrive during recessions such as utilities, consumer staples, and healthcare.

Businesses that track the relationship between their performance and business cycles can plan strategically to protect themselves from approaching downturns and position themselves to take maximum advantage of economic expansions. For example, if your business follows the rest of the economy, warning signs of an impending recession may suggest you shouldn’t expand. You may be better off building up your cash reserves.

Analyzing Economic Cycles

Different theories break down economic cycles in different ways. For instance, monetarism is a school of thought suggesting that governments can achieve economic stability when they target their money supply’s growth rate. It ties the economic cycle to the credit cycle. Changes in interest rates can reduce or induce economic activity by making borrowing by households, businesses, and the government more or less expensive.

The Keynesian approach argues that changes in aggregate demand, spurred by inherent instability and volatility in investment demand, are responsible for generating cycles. When business sentiment turns gloomy and investment slows, a self-fulfilling loop of economic malaise can result. Less spending means less demand, which induces businesses to lay off workers. Unemployed workers mean less consumer spending, and the whole economy sours, with no clear solution other than government intervention and economic stimulus, according to the Keynesians.

Finally, Austrian economists argue that the manipulation of credit and interest rates by the central bank creates unsustainable distortions in the relationships between industries and businesses that are corrected during a recession. Whenever the central bank lowers rates below what the market would naturally determine, investment gets skewed toward industries that benefit the most from low rates. However, the real saving necessary to finance these investments gets suppressed by the artificially low rates. The unsustainable investments ultimately generate a rash of business failures and declining asset prices that result in an economic downturn.

Current Stage of the Economic Cycle

There was speculation throughout 2022 about whether the U.S. and other world economies have entered recession territory. The attempts to pinpoint whether the economy has officially entered a contraction stage have emerged amid a confluence of conditions that are unfavorable for economic growth. Surging inflation, elevated commodity prices, and monetary tightening from central banks have all raised questions about exactly where we stand in the business cycle.

According to Fidelity Investments, as of the fourth quarter of 2022, the U.S. economy has not yet reached the contraction stage of the economic cycle. Instead, it remains in the late cycle of the expansion stage, with the risk of recession increasing but not yet at extreme levels. Meanwhile, the European economy appears to have entered a recession, while the Chinese economy remains in a contraction despite the government’s policies designed to jumpstart growth.

What Are the Stages of an Economic Cycle?

An economic cycle, which is also referred to as a business cycle, has four stages: expansion, peak, contraction, and trough. The average economic cycle in the U.S. has lasted roughly five and a half years since 1950, although these cycles can vary in length. Factors used to indicate the stages in the economic cycle include gross domestic product, consumer spending, interest rates, and inflation. The National Bureau of Economic Research (NBER) is a leading source for indicating the length of a cycle.

What Happens in Each Phase of the Economic Cycle?

In the expansionary phase, the economy experiences growth over two or more consecutive quarters. Interest rates are typically lower, employment rates rise, and consumer confidence strengthens. The peak phase occurs when the economy reaches its maximum productive output, signaling the end of the expansion. After that point, employment numbers and housing starts begin to decline, leading to a contractionary phase. The lowest point on the business cycle is a trough, which is characterized by higher unemployment, lower availability of credit, and falling prices.

What Causes an Economic Cycle?

The causes of an economic cycle are widely debated among different economic schools of thought. Monetarists, for example, link the economic cycle to the credit cycle. Here, interest rates, which intimately affect the price of debt, influence consumer spending and economic activity. On the other hand, a Keynesian approach suggests that the economic cycle is caused by changes in volatility or investment demand, which in turn affect spending and employment.

The Bottom Line

The economic cycle, or business cycle, refers to the cyclical pattern experienced by the economy. The economy remains in an expansion phase until it reaches its peak, reversing to the downside and entering a contraction, before it reaches a trough and begins to expand once again. Indicators such as GDP, interest rates, employment levels, and consumer spending can help shed light on where the economic cycle currently stands. Although there are different economic theories to explain what drives the economic cycle, the conditions associated with each stage can have a significant impact on business and investment decisions.