 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:
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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 .
The business cycle is a term used by economists to describe the increase and decrease in economic activity over time. The economy is all activities that produce, trade, and consume goods and services within the U.S.—such as businesses, employees, and consumers. Thus, the measured amount of productivity is what the business cycle refers to.
When businesses are increasing production, they need more employees. As a result, more people are hired, there is more money to spend, and businesses make more profits and can focus on growth. The rate at which production and consumption change positively is called "economic expansion." It continues until circumstances occur that cause production to slow. If business production slows, not as many employees are needed. As a result, consumers have less spending money, and businesses reduce spending on growth. The rate at which production and consumption as a whole change negatively is called "economic contraction." The duration of a business cycle is the period containing one expansion and contraction in sequence. One complete business cycle has four phases: expansion, peak, contraction, and trough. They don’t occur at regular intervals or lengths of time, but they do have recognizable indicators. It's important to understand that there are mini-fluctuations within an economic phase that can make it appear as if the economy is transitioning to another phase. The National Bureau of Economic Research (NBER) determines which cycle the economy is in using quarterly GDP growth rates. It also uses monthly economic indicators, such as employment, real personal income, industrial production, and retail sales.
While you'll hear speculation in the media about the state of the economy, there is no official notice of what cycle the economy is in until it's already in progress—or complete—and the NBER has had a chance to analyze the data and declare it. Three factors cause each phase of the business cycle: the forces of supply and demand, the availability of capital, and consumer and investor confidence. The most critical is confidence in the future—when consumers and investors have faith in the future and policymakers, the economy tends to expand. It does the opposite when confidence levels drop. An economic expansion is a period of growth throughout an economy. Because productivity is increasing, it is generally represented on a curve as an upward movement. The expansion phase is also known as the economic recovery phase because it occurs after the economy has contracted for a long period. Gross domestic product is the measurement that is most used to indicate economic output. During the expansion phase, it increases. Economists consider a GDP growth rate range of between 2% to 3% to be healthy.
The Federal Reserve's goal is to keep inflation, the measurement of the change in prices, at around 2%—also considered healthy by economists and officials. In an expansion, the stock market experiences rising prices, and investors are confident. Businesses receive more funding and make more, and consumers have more money to spend. An economy can remain in the expansion phase for years. The expansion phase nears its end when the economy begins to grow too fast. This is called "overheating"—the unemployment rate is well below the natural rate, and inflation is increasing. Stock market investors are in a state of "irrational exuberance" where they become overly enthusiastic about prices and believe they will continue to rise—this causes stock prices to rise to a point where they are very overvalued. The peak is the second phase of the cycle. It occurs when all of the expansionary indicators begin to level off. The economy might take weeks or a year to transition into the contraction phase. The GPD growth rate falls below 2% and continues to decline. The peak is displayed on a graph as the highest portion of the curve before moving downward. The third phase is the contraction stage. It begins after the economy peaks and ends when GDP and other indicators cease to decrease. In this stage, the economy does not experience growth; instead, it shrinks. When the GDP rate turns negative, the economy enters a recession. Businesses lay off employees, the unemployment rate rises above normal levels, and prices begin to decline. A contraction is generally portrayed on a graph as the part of the curve that is consistently decreasing. The trough is the fourth phase of the business cycle. The declining GDP begins to decrease its rate of negative change, eventually turning positive again. The economy begins a transition from the contraction phase to the expansion phase. A trough is displayed on a graph as the lowest point of the curve. The business cycle begins again when GDP begins to increase, and the curve moves upward consistently.
The business cycle's four phases can be so severe that they have been called the "boom-and-bust cycle." The government monitors the business cycle, and legislators attempt to influence it by implementing tax and spending changes. When the economy is expanding, taxes can be increased, and spending can be decreased. If it is contracting, the government can lower taxes and increase spending. This is called "fiscal policy." The Fed, the nation's central bank, influences the business cycle by targeting inflation and unemployment with targeted rates. It uses tools designed to change interest rates, lending, and borrowing by businesses, banks and consumers. This is called "monetary policy." The Fed lowers its target interest rates to encourage borrowing in attempts to end a contraction or trough. This is called expansionary monetary policy because they are attempting to push the business cycle back into the expansionary phase. To keep the economy from growing too quickly, the central bank raises its target interest rates to discourage borrowing and spending. This is called "contractionary monetary policy," because the bank is trying to contract economic output to keep expansion under control.
The goal of fiscal and monetary policy is to keep the economy growing at a sustainable rate while creating enough jobs for everyone who wants one and being slow enough not to increase inflation. The peak that preceded the 2008 recession occurred in the third quarter of 2007, when GDP growth was 2.4%. The 2008 recession was a rough one, because the economy immediately contracted by 1.6% in the first quarter of 2008. It rebounded 2.3% in the second quarter, an optimistic sign. However, it contracted 2.1% in the third quarter and then 8.5% in the fourth quarter. In the first quarter of 2009, it contracted by 4.6% . During 2008, the unemployment rate rose from 4.9% in January to 7.2% by December. The trough occurred at the end of the second quarter of 2009, according to the NBER. GDP only contracted by 0.7%. Unemployment, however, rose to 10.2% by October 2009 because it is a lagging indicator.
The expansion phase started in the third quarter of 2009 when GDP rose 1.5%. Four years into the expansion phase, the unemployment rate was still above 7%, because the contraction phase moved the economy so low that it took much longer to recover.
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Which of the following will occur when the economy moves into a recovery or expansion phase of the business cycle?
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