What Are the Four Phases of the Business Cycle?

What Are the Four Phases of the Business Cycle?
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The economy is constantly changing. Things will be good and then suddenly, there's a problem with economic growth. With the current negative economic situation, you might wonder if it will ever end. But fluctuations like a down economy aren't random. There is a cycle and understanding this economic cycle can help you plan for – or at least be optimistic about – future positive economic activity.

Phases of the Business Cycle Measure Economy

A business cycle describes fluctuations in a nation’s aggregate economic activity. There are expansions in economic activity as well as contractions. There are four phases of the business cycle that have economic variables.

Economists refer to aggregate demand. This macroeconomics term encompasses the total demand for goods and services at any given price level. It’s measured in a given period. This aggregate economic activity is represented by the gross domestic product (GDP).

The GDP measures output like income, sales and employment. These indicators determine the dates of the U.S. business cycle's trough phases and peak phases. They ultimately measure economic growth or lack thereof. Business cycle changes are not necessarily periodic, but they are recurrent.

Keep in mind that the stock market may be influenced by the business cycle, but the stock market is not the economy. So don't confuse the business cycle with stock market cycles. Stock market cycles are measured by broad stock price indices.

Business Cycle Stages

There are four phases of a business cycle. These include the expansion phase, peak phase, contraction phase and trough phase.

The National Bureau of Economic Research (NBER) has a business cycle dating committee that measures and maintains the order of U.S. business cycles. By tracking the state of the economy, the NBER is able to identify economic recessions and expansions.

A recession takes place in the time between a peak phase and a trough phase. An expansion is when an economy is moving out of a recession and is transitioning from the trough phase to the peak phase.

A business cycle describes the fluctuations in a nation's aggregate economic activity.

Expansion Phase Means Growth

The expansion phase is when the economy is moving from the trough phase to the peak phase.

This occurs when the real gross domestic product (GDP) grows for two or more consecutive quarters. This puts the state of the economy in an economic expansion.

An economic expansion triggers consumer confidence and consumer spending. That's because the unemployment rate is low, and there's a rise in equity markets. The expansion phase is often referred to as an economic recovery.

An expansion phase is part of the cyclical path of the U.S. economy. During an expansion, the central bank has lower interest rates, which makes borrowing easier and less expensive. This allows business owners to build up inventories and expand. As a result, the unemployment rate is lowered even more. The real GDP rises, and per capita real income grows, too.

Peak Phase of Economy

Expansionary monetary policy, including the federal reserve lowering interest rates, leads to the peak phase of the economy. This is the highest point of the expansion phase. It is the top of the cycle. The state of the economy is hot, and the real gross domestic product is experiencing further growth.

Economic conditions provide for full employment and new housing builds. The expansion phase and the peak phase equate to the highest periods of expansion. But it is usually the turning point to a contraction phase. When the U.S. economy is in a peak phase, the federal reserve starts adjusting interest rates to slow the economy down.

The NBER measures and declares when there is a peak phase. Unfortunately, it is usually after the fact.

Contraction Phase Means Downturn

A contraction phase signals a downturn in the state of the economy. The unemployment rate increases and new housing builds cease. The federal reserve increases interest rates, which can lead to a housing crisis. Consumer spending takes a downturn, and consumer confidence diminishes.

When the aggregate state of the economy is in a decline for two or more quarters, it has entered a recession. A recession is a significant economic downturn.

Although the U.S. government uses fiscal policies and monetary policies to limit recessions, they are still possible following a peak.

One example of a contraction is the Great Recession. It occurred from 2007 to 2009. It encompassed the world in 2009. The Great Recession was a downturn that mimicked the Great Depression of the 1930s.

It was said to be caused by an inflated housing market, bad home loans and several other economic problems. It resulted in the expansion of the central bank. During the Great Recession, the U.S. GDP fell 4.3 percent and the unemployment rate doubled.

A contraction phase deflates wages as well as employment. Whereas business owners expand during expansion, with contraction, they pull back. This limits available goods and causes prices to rise.

Trough Phase Hits Bottom

The trough phase is the lowest point of the business cycle. Although some troughs are temporary, others can create economic hardship. For example, it often marks a high unemployment rate due to layoffs. And consumer confidence is at its lowest.

A trough is a recession. And it has negative GDP growth that lasts for several months. This can lead to a depression. Depression is an extreme recession that can last for years.

During a trough, the federal reserve will often lower interest rates in the hopes of motivating business owners to expand. Although the trough phase is at the lowest point of the contraction phase, it usually signals an impending upturn in the economy. It's designated as an economic turning point and can lead to expansion.

Predicting a Business Cycle

The business cycle is anything but predictable. Determining when a contraction will develop isn’t easy. According to Federal Reserve Bank of Atlanta economist Patrick Higgins: “Despite plenty of statistics, tools and models developed to track the economy, knowing exactly what might kill an expansion is elusive.”

Higgins goes on to explain that the downturn from a peak to a trough isn’t linear. It’s usually not until after a contraction happens that the determining factors can be explained.

Consumer spending is often a driving factor. So if the GDP slows down but remains positive, that doesn't mean a contraction is taking place.

Because more profound economic knowledge has helped policymakers develop monetary and fiscal policies that better nurture macroeconomics growth, business cycles have become longer.

Trade Cycle vs. Business Cycle

A business cycle shouldn’t be confused with a trade cycle. A business cycle is recurrent and rhythmic. Expansion turns to contraction and then is up again. But a trade cycle is self-reinforcing. It feeds on itself. It also is cumulative. It has a shorter and more gradual period of prosperity or expansion. In comparison, a depression, or contraction, is quick and long.

Trade cycles last for three or four years but can be longer. A trade cycle can affect different industries in different ways. It is usually characterized as international. And unfortunately, one country can pass its depression to another country. But prosperity can also be passed around to different countries.

Although it’s not the same as a business cycle, a trade cycle does have similar phases. They include economic boom, economic downturn and economic recovery.