Many people love a roller coaster’s thrilling ups and downs. When it comes to the economy, however, most people would prefer to avoid a wild ride. In fact, most like a smooth ride with very few dips. This episode of The Economic Lowdown podcast series describes how the economy moves through phases of the business cycle, and the role the Federal Reserve System plays in smoothing some of the ride's bumps.
Learn more about the Q&A Resources for Teachers and Students »
More episodes:
- The Economic Lowdown Podcast Series
- The Economic Lowdown Video Series
Subscribe to the Economic Lowdown Podcast Series on:
Apple Podcasts
|
Spotify
|
Stitcher
|
TuneIn
Transcript:
Do you enjoy roller coasters? Some coasters are mild, kiddy rides that never really go that high. After a peak, they gently slope back down and then head back up. Other coasters are wild rides with long steep slopes. It’s a thrilling ride—well, for most of the riders, anyway.
However, when it comes to the economy, most people prefer that it not be a wild ride. In fact, most prefer a smooth ride with very few dips in the track.
Economists use the term business cycle to describe the ups and downs, or fluctuations, in an economy. More specifically, the term refers to the fluctuating levels of economic activity over a period of time measured from the beginning of one recession to the beginning of the next. The upward and downward movements indicate specific phases of the business cycle.
The upward slope of the business cycle is called economic expansion. An expansion is a period when economic output increases. That is, more goods and services are being produced in the economy.
As the economy expands, businesses, or “firms,” tend to use more resources—including labor. In other words, as firms increase output, they usually hire more workers. As a result, when output rises, employment tends to rise as well.
So, economic expansion usually means that two key economic indicators are increasing—economic output and employment. In practical terms, this means that the economy is producing more of the goods and services that we want and more people have jobs. More jobs mean more people with incomes to purchase goods and services. These are favorable outcomes. And you can likely see how more employment and income can help push the economy to even higher levels of output.
It would sure be nice if the economy would expand continuously, but all expansions come to an end. In economic terms, they reach a peak, which, like on a roller coaster ride, is the point just before the downward movement begins.
The downward slope of the business cycle is called economic contraction. A contraction is a period when economic output declines. During this phase, the economy is producing fewer goods and services than it did before. When fewer goods and services are produced, fewer resources are used by firms—including labor. As firms decrease their output, they will hire few or even no new workers and often lay off some existing workers. As a result, when output falls, employment tends to fall as well.
Economic contractions often become recessions. A recession is a significant decline in general economic activity extending over a period of time. A general rule of thumb is that two consecutive quarters of economic contraction constitute a recession.
Recessions result in economic hardship for many people and can have long-lasting effects. For example, losing a job due to recession can lead to high levels of debt or the loss of key assets such as a house or a car. In addition, if people are unemployed for long periods of time, they might find it difficult to keep their work skills sharp, and they might find it difficult to find another job.
Recessions are unpleasant, but fortunately they don’t last forever. In economic terms, they reach a trough, which is the point just before the upward movement begins.
The initial increase in output contributes to economic recovery, which is movement back to the level of output that existed before the recession began. If output continues to increase beyond this previous high mark, then the next expansion begins.
So, who decides when the economy has moved to a new phase of the business cycle?
The National Bureau of Economic Research—the NBER—is a group of economists who, in addition to doing economic research, examine data and identify the specific starting dates for the phases of the business cycle. To make their decision, they examine a variety of economic data. Of course, time is needed to collect and analyze data, so there is a time lag between when a business cycle phase begins and when the NBER announces that it has begun. In the past, the time between an actual change and the NBER announcement has been anywhere from 6 months to 21 months. The NBER Business Cycle Dating Committee prefers to wait long enough and see enough data to minimize any doubts about the turning point.
The term “cycle” in business cycle can be misleading because it implies regularity. For example, the rinse cycle on my dishwasher is predictable: It always begins 45 minutes after the wash cycle begins, and it always lasts 9 minutes.
There is nothing regular about the business cycle, though. Recessions and expansions are unpredictable and their lengths vary. For example, according to the NBER, the shortest U.S. expansion lasted only 10 months, from March 1919 to January 1920. The longest expansion lasted 120 months, or 10 years, from March 1991 to March 2001. The shortest recession on record lasted only 6 months, from January to July in 1980, while the longest recession was over 65 months, or 5 years. It lasted from October 1873 to March 1879 and is known as “The Long Depression.”
Do you ever wish for a world without recessions? Well, it isn’t likely. What is more realistic are economic expansions that last for long periods and recessions that are brief. And, according to data, the trend has actually moved in that direction: Over time recessions have become less frequent and lasted for shorter periods.
Helping to make those two things happen is part of the role of the Federal Reserve. The Federal Reserve has been mandated by Congress to promote maximum employment and price stability—it’s called the Fed’s dual mandate. During a recession, output is below capacity, and there are many unemployed workers. To help the economy grow, the Federal Reserve uses its monetary policy tools to decrease interest rates. Lower interest rates encourage consumers to borrow money—for example, to buy cars or homes, and businesses to invest and expand. This borrowing and spending will cause firms to increase their output to meet the growing demand. As output increases, firms will likely use more resources and hire additional workers. Eventually, more resources, more workers, and more output will move the economy from recession to expansion again. In this way, the Federal Reserve uses its monetary policy tools to promote “maximum employment”—one component of the dual mandate—and smooth the business cycle.
To fulfill its “price stability” mandate—so, to keep prices low and stable—the Federal Reserve tries to keep inflation in check. The Fed wants to keep inflation around 2 percent. When inflation remains low and stable over time, businesses and individuals can plan their future investment and spending because prices remain fairly predictable. Such price stability promotes economic expansion, which, as we’ve discussed, also promotes employment. In effect, as the Federal Reserve pursues its dual mandate of maximum employment and price stability, it helps smooth some of the rough spots in the business cycle.
By design, a roller coaster has many ups and downs. However, when it comes to the economy, most people prefer a smooth ride with very few dips. It would be much easier to plan for the future if recessions were easy to predict, but they are not. Rather they are unpredictable and irregular. The Federal Reserve has a role to play in smoothing the rough spots out of the business cycle. The Fed uses its monetary policy tools to promote maximum employment and price stability in the economy. In other words, the Federal Reserve attempts to take some of the dips out of the economic ride to produce a smoother business cycle.
This podcast is brought to you by the Federal Reserve Bank of St. Louis. For more information, visit stlouisfed.org.
---
If you have difficulty accessing this content due to a disability, please contact us at 314-444-4662 or .
A white circle with a black border surrounding a chevron pointing up. It indicates 'click here to go back to the top of the page.'
Business cycles, which indicate the natural ebb and flow of the economy, often influence moves of the stock market. d3sign/Getty Images
A business cycle, sometimes called a "trade cycle" or "economic cycle," refers to a series of stages in the economy as it expands and contracts. Constantly repeating, it is primarily measured by the rise and fall of gross domestic product (GDP) in a country.
Business cycles are universal to all nations that have capitalistic economies. All such economies will experience these natural periods of growth and decline, though not all at the same time. However, given the increased globalization, business cycles across countries tend to synchronize more often than they did before.
Understanding the different phases of a business cycle can help individuals make lifestyle decisions, investors make financial decisions, and governments make appropriate policy decisions.
Stages of a business cycle
Think of business cycles like the tides: a natural, never-ending ebb and flow from high tide to low tide and back again. And the same way the waves can suddenly seem to surge even when the tide's going out or seem low when the tide's coming in, there can be interim, contrarian bumps — either up or down — in the midst of a particular phase.
The business cycle shows how a nation's aggregate economy fluctuates over time. Yuqing Liu/Business Insider
All business cycles are bookended by a sustained period of economic growth, followed by a sustained period of economic decline. Throughout its life, a business cycle goes through four identifiable phases: expansion, peak, contraction, and trough.
Expansion: Expansion, considered the "normal" — or at least, the most desirable — state of the economy, is an up period. During an expansion, businesses and companies steadily grow their production and profits, unemployment remains low, and the stock market performs well. Consumers are buying and investing, and with this increasing ›demand for goods and services, prices begin to rise too.
Several criteria determine whether the economy is in a healthy period of expansion: the GDP growth rate is in the 2% to 3% range, inflation is at the 2% target, unemployment is between 3.5% and 4.5%, and the stock market is a bull market.
Peak: The economy starts growing out of control once these numbers start to increase out of their healthy ranges. Any number of factors can throw the economy off balance. Companies may be expanding recklessly. Investors might become overconfident, buying up assets and significantly increasing their prices, which are not supported by their underlying value, creating an asset bubble. Everything starts to cost too much.
The peak marks the climax of all this feverish activity when the expansion has reached its end and indicates that production and prices have reached their limit. This is the turning point: With no room for growth left, there's nowhere to go but down. A contraction is forthcoming.
Contraction: A contraction spans the length of time from the peak to the trough. It's the period when economic activity is on the way down. During a contraction, unemployment numbers typically spike, stocks enter a bear market, and GDP growth is below 2%, indicating that businesses have cut back their activities.
When the GDP has declined for two consecutive quarters, the economy is often considered to be in a recession. Even after a recession is officially over, that doesn't mean that the economy has returned to its original shape and size.
Trough: IF the peak is the cycle's high point, the trough is its low point. It occurs when the recession, or contraction phase, bottoms out and starts to rebound into an expansion phase — and the business cycle starts all over again. The rebound is not always quick, nor is it a straight line, along the way toward full economic recovery. The most recent trough was in April 2020.
Though often used interchangeably, a business cycle is technically different from a market cycle. A market cycle specifically refers to the different growth and decline stages of the stock market, while the business cycle reflects the economy as a whole.
But the two are definitely related. The stock market is greatly influenced by the phases of a business cycle and generally mirrors its stages. During the contractionary phase of a cycle, investors sell their holdings, depressing stock prices — a bear market. In the expansionary phase, the opposite occurs: Investors go on a buying spree, causing stock prices to rise — a bull market.
In the US, business cycles are defined and measured by the National Bureau of Economic Research (NBER), a private nonprofit. NBER's Business Cycle Dating Committee is responsible for determining the start and end of a cycle.
NBER primarily uses quarterly GDP growth rates to identify a business cycle, but it will also look at other economic indicators, such as real income, retail revenues, employment, and manufacturing output. Analysts and economists often see what they call "co-movement" in these variables, meaning the different measurements rise and fall together.
For example, if employment is up, production is likely up, as is consumer spending. Likewise, if employment is down, the other metrics are down and will eventually have an impact on GDP.
How long does a business cycle last?
Business cycles have no defined time frames. A business cycle can be short, lasting a few months, or long, lasting several years.
Generally, periods of expansion are more prolonged than periods of contraction, but the actual lengths can vary. Since the end of World War II, the average period of expansion in the US lasted 65 months, and the average contraction lasted about 11 months, according to the Congressional Research Service.
Most recently, the US hit a peak in February 2020, and before that was in a period of expansion that had lasted roughly 128 months, making it the longest in recorded history.
The many variables in an economy fluctuate differently over time, causing shifts in the economy, and non-economic factors, such as natural disasters and disease, play a part in shaping the economy as well. "Essentially, market economies want to expand, but if they're hit by an adverse shock, they may contract," says Vincent Reinhart, chief economist and macro strategist at Mellon Investments.
In recent history, the subprime mortgage crisis of 2007 was one such shock, and the onset of the COVID-19 pandemic in 2020 was another creating a two-month recession.
What factors shape a business cycle?
From technological innovations to wars, a variety of things can shift a business cycle's phases. But, according to the Congressional Research Service, the key influence boils down to the aggregate supply and demand within an economy — economist-speak for the total spending that individuals and companies do. When that demand decreases, a contraction occurs. Likewise, when demand increases, an expansion occurs.
- In the beginning: The expansion happens because consumers are confident in the economy. They believe that employment is steady and income is guaranteed. As a result, they spend more, which leads to increased demand, which leads to businesses hiring more employees, and increasing capital expenditures to meet that demand. Investors allocate more capital to assets, increasing stock prices.
- Getting overheated: The expansionary phase hits a peak when the demand is greater than the supply, and businesses take on additional risks to meet increased demand and remain competitive.
- Scaling back: When interest rates rise quickly, inflation increases too fast, or a financial crisis occurs, an economy enters a contraction. The confidence that stimulated demand quickly evaporates, replaced with dwindling consumer confidence. Individuals save money rather than spend, reducing demand, and businesses cut production and lay off employees as their sales dry up. Investors sell stocks to avoid a drop in the value of their portfolios, which further drops stock prices.
- Hitting bottom: During the trough phase, demand and production are at their lowest point. But eventually, needs reassert themselves. Consumers slowly start to gain confidence as production and business activity start to improve, often spurred on by government policies and action. They begin to buy and invest, and the economy reenters the expansion phase.
The fact that business cycles move in natural phases doesn't mean they can't be influenced. Countries can and do try to manage the various stages — slowing them down or speeding them up — using monetary policy and fiscal policy. Fiscal policy is carried out by the government; monetary policy is carried out by a nation's central bank.
For example, when an economy is in a contraction, particularly a recession, governments use expansionary fiscal policy, which consists of increasing expenditures on government projects or cutting taxes. These moves provide increased levels of disposable income that consumers can spend, which in turn stimulates economic growth.
Similarly, a central bank — like the Federal Reserve in the US — will use an expansionary monetary policy to end a contractionary period by reducing interest rates, which makes borrowing money cheaper, thus stimulating spending, and eventually the economy.
If an economy is growing too fast, governments will employ a contractionary monetary policy, which involves cutting spending and increasing taxes. This reduces the amount of disposable income to spend, slowing things down. To employ a contractionary monetary policy, a central bank will increase interest rates, making borrowing more expensive and therefore spending money less attractive.
The bottom line
Even though they seem like something that only affects "the economy," business cycles have plenty of real-world implications for individuals. Recognizing the current cycle can influence people and their lifestyle decisions.
For example, if we're in a contraction phase, finding work often becomes more difficult. Individuals may take up less-than-ideal jobs just to ensure they are making an income, and and hope for a better position once the economy improves.
It may also influence spending, especially when making huge decisions like buying a home or a car. "You're going to have to be cautious in terms of using your savings now because you may need them later," says Reinhart.
Understanding the business cycle is also crucial for investors. Knowing which assets — especially stocks — perform well in the different phases of a business cycle can help an investor avoid certain risks and even grow the value of their portfolio in a contractionary phase.
For example, certain industries remain crucial regardless of the current business cycle such as healthcare and energy. On the other hand, it may be best to stay away from speculative assets and high-risk stocks. When making these investment decisions, it's a good idea to start by looking at a company's balance sheet, which will tell you a company's assets and liabilities. A strong balance sheet has more assets than liabilities, even when the market looks like it's headed into a contraction phase.
Individuals can't do much on their own to affect a business cycle, and weathering its down phases can be tough. Still, it might help you sleep better at night knowing "it's a cycle and that we won't be there forever," says Reinhart. "Understanding the business cycle gives you at least a reassurance that there are [sic] a rebound and recovery to follow."