The Business Cycle

What Is the Business Cycle?

The Business Cycle is about how economies move between periods of growth and decline – the 128-month expansion of the 2010s to the short two-month downturn with COVID - and what the figures reveal as it happens.

The US economy in February 2020 had been growing steadily for a record 128 months, unemployment was at 3.5% (remarkably low for half a century), and people were spending and companies were making more money. However, only seven weeks later, the economy was plummeting. In the second quarter, the real Gross Domestic Product (GDP) dropped at an annualized rate of 31.4% - the biggest quarterly fall ever recorded. Between mid-March and mid-April, 22 million people lost their jobs. The NBER later said the economy peaked in February 2020 and hit its lowest point in April 2020, making the entire downturn a very brief two months. It was the shortest recession in American history, and this sudden change really shows what the business cycle is: economies don't grow smoothly. They go up, then fall, then get better, and this happens again and again, although not on a schedule and never with the same intensity.

We measure the business cycle by looking at changes in real GDP, that is, the value of all goods and services a country makes, adjusted for inflation. It has four stages: expansion (when output increases), peak (the highest point of growth), contraction (when output declines), and trough (the lowest point). After the trough, the cycle of expansion starts over. Each cycle is different in length and severity, and this is why it's so hard to predict what will happen and when to take action.

Expansion

During an expansion, real GDP is going up, companies are hiring, people are buying more, and businesses invest in things like new factories, equipment and expansions. As the economy nears, and occasionally exceeds, what's considered full employment (the rate consistent with the natural unemployment rate), unemployment goes down.

Expansions can be vastly different in how long they last. The expansion from June 2009 to February 2020 went on for 128 months, almost eleven years, breaking the previous record of 120 months during the tech boom of the 1990s. But others are much shorter. After the 1980 recession, expansion only lasted twelve months before the economy fell into the serious 1981-1982 slump. There's no set amount of time for how long a period of economic success will last.

As an expansion continues, more and more signs that things are getting too hot start to appear. Because there are fewer and fewer people available to work, employers have to offer higher wages, which increases costs. People and businesses borrow more money, and sometimes on terms that seem risky later on. Prices for things like houses, stocks and commercial property can become separated from their true value. None of this guarantees a downturn, but it makes one more likely.

Peak

The peak is the point when real GDP stops increasing and starts to decrease. No one officially announces it, it's only identified later, sometimes quite a while after it's happened. At the peak the economy is running at its maximum, or even beyond it, with pretty much all workers and resources being used.

Inflation is usually at its highest near the peak because total demand is pushing against the economy's ability to produce. The Federal Reserve frequently increases interest rates during this time to reduce demand, and this can actually cause the slide into contraction. From June 2004 to June 2006, the FOMC raised the federal funds rate 17 times in a row, from 1% to 5.25%, in an attempt to slow down an overly warm housing market. The recession which started in December 2007 was the worst since the Great Depression.

The National Bureau of Economic Research (NBER) is the unofficial, but generally accepted, organization which decides when business cycles begin and end in the United States. The Business Cycle Dating Committee decides when the economy has reached its high points (peaks) and low points (troughs) by looking at things like how many people are employed, how much money people and businesses are earning, how much is being made, and how much is being sold...and they usually make these announcements months later.

Contraction and Recession

When the economy starts to shrink, that's called a contraction. A recession is a significant shrinking of the economy, generally when real GDP goes down for two quarters in a row. Businesses then make less product, fire people, and put off investing in the future. Fewer durable goods are ordered, and goods build up in stores and warehouses.

As people lose their jobs, unemployment goes up and people become much less confident about the future. They spend less, which makes businesses bring in less money, so they fire more people and then people spend even less. This is a vicious cycle, and it's why a recession can seem to just keep going once it gets going.

However, not every contraction becomes a recession. A quick, short fall that corrects itself within a couple of months might not be severe enough. But when unemployment goes up a lot and production falls a lot, like in the last three months of 2008 or March/April 2020, the effect is felt in all areas of the economy. The recession from 2008 to 2009 wiped out $19.2 trillion in what people owned, mostly because house prices and stock values dropped. The 2020 recession was much shorter, but unemployment went from 3.5% to 14.7% in just one month.

Trough and Recovery

The trough is the absolute worst point. Real GDP has stopped going down, but isn't yet increasing in any significant way, and unemployment is at its highest. Companies have reduced their number of employees, used up their stocks of goods, and cut back on anything that isn't absolutely necessary.

But the trough is also where the economy starts to get better. People who have been holding back on buying things start to do so, and interest rates, which the Federal Reserve frequently lowers during a contraction, make borrowing money cheap. Government spending programs put money into the economy. The very first signs of improvement aren't huge; things like a small increase in how much is being sold at stores, a slowing down of job losses (rather than people actually being hired), and manufacturers feeling a bit more optimistic.

The trough of the Great Recession was in June 2009, and it wasn't until early 2014 that employment levels returned to what they were before the recession. The COVID recession's trough was April 2020, and the economy recovered much faster thanks to $5 trillion in government aid and interest rates near zero. After the trough, the cycle starts all over again with a period of growth.

Leading, Coincident, and Lagging Indicators

Economists and people making government policy look at three types of clues (indicators) to understand where the economy is in the cycle and, importantly, where it's likely to go.

Leading indicators change before the economy changes. For example, stock prices tend to fall several months before a recession officially begins, and go up before the economy starts to recover. Building permits show how much construction will be done in the future. Since 1955, the difference between the interest rate on a 10-year Treasury bond and a 2-year Treasury bond (the yield curve spread) has gone 'negative' before every recession in the US - though the time between it going negative and the recession beginning is different each time. New orders for goods consumers will use for a long time also count as leading indicators. Leading indicators are helpful, but not perfect; as economists like to joke, the stock market has "predicted" nine of the last five recessions.

Coincident indicators move at the same time as the economy. Real GDP, how much is being made in factories, the total number of people with jobs, and people's income all go up when the economy is growing and down when it's shrinking. They tell you what's happening with the economy right now.

Lagging indicators change after the economy has already changed. Unemployment continues to rise for months after GDP starts to grow again, as businesses are slow to hire. How long people are out of work on average, the amount of money loaned to businesses for commercial and industrial purposes, and how much consumer credit there is compared to income all reach their highest point some time after a recession is over and things are getting better. Knowing which indicators fall into each of these categories is a key part of the exam.

Connection to AD/AS and Policy

The business cycle is very clearly shown in the AD/AS model. When the economy expands, aggregate demand shifts to the right along the short-run aggregate supply curve, meaning more is produced and prices will likely go up, especially if the economy is already near its maximum. A period of contraction happens with a leftward shift of aggregate demand, and this can be caused by people losing confidence in spending, companies investing less, or the Federal Reserve making it harder to borrow money. Something bad happening to supply, like the oil shortages in 1973 or the problems with getting goods in 2021 and 2022, will move the SRAS to the left. These can create stagflation - the unpleasant combination of prices rising and production falling.

Governments use fiscal policy (changing how much they spend or taxing) and monetary policy (changing interest rates, often through the Fed buying bonds) to lessen the ups and downs of the business cycle. Both increasing government spending or cutting taxes, and lowering interest rates via the Fed buying bonds (expansionary policies) are meant to make recessions shorter by pushing AD to the right. Reducing government spending, raising taxes, or increasing interest rates (contractionary policies) are done to stop the economy from growing too fast and causing problems near the peak of the cycle by moving AD to the left.

The biggest difficulty is when to act. Policies don't happen immediately. By the time the National Bureau of Economic Research officially says a recession has begun, the downturn might be several months along. The time it takes to recognize the problem, get a law passed, and then actually put the policy into effect means that any help coming from the government could arrive after the economy has already begun to recover on its own, possibly speeding up growth when it doesn't need to, rather than helping during a decline. Because of this, the Federal Reserve carefully looks at indicators that show where the economy is headed and sometimes changes interest rates before anything has actually happened, based on predictions of the future.