What Is a Business Cycle?
Business cycles are a type of fluctuation found in the aggregate economic activity of a nation—a cycle that consists of expansions occurring at about the same time in many economic activities, followed by similarly general contractions. This sequence of changes is recurrent but not periodic.
The business cycle is also called the economic cycle.
Key Takeaways
- Business cycles are composed of concerted cyclical upswings and downswings in the broad measures of economic activity—output, employment, income, and sales.
- The alternating phases of the business cycle are expansions and contractions.
- Contractions often lead to recessions, but the entire phase isn't always a recession.
- Recessions often start at the peak of the business cycle—when an expansion ends—and end at the trough of the business cycle, when the next expansion begins.
- The severity of a recession is measured by the three Ds: depth, diffusion, and duration.
:max_bytes(150000):strip_icc()/Investopedia-terms-business-cycle-eb0d2a616c914caf87c35491ed78ae2e.jpg "Business Cycle: What It Is, How to Measure It, the 4 Phases (1)")
Understanding the Business Cycle
In essence, business cycles are marked by the alternation of the phases of expansion and contraction in aggregate economic activity and the co-movement among economic variables in each phase of the cycle. Aggregate economic activity is represented by not only real (i.e., inflation-adjusted) GDP—a measure of aggregate output—but also the aggregate measures of industrial production, employment, income, and sales, which are the key coincident economic indicators used for the official determination of U.S. business cycle peak and trough dates.
Popular misconceptions are that the contractionary phase is a recession and that two consecutive quarters of decline in real GDP (an informal rule of thumb) means a recession. It's important to note that recessions occur during contractions but are not always the entire contractionary phase. Also, consecutive declines in real GDP are one of the indicators used by the NBER, but it is not the definition the organization uses to determine recessionary periods.
:max_bytes(150000):strip_icc()/businesscycle-013-ba572c5d577c4bd6a367177a02c26423.png "Business Cycle: What It Is, How to Measure It, the 4 Phases (2)")
On the flip side, a business cycle recovery begins when that recessionary vicious cycle reverses and becomes a virtuous cycle, with rising output triggering job gains, rising incomes, and increasing sales that feedback into a further rise in output. The recovery can persist and result in a sustained economic expansion only if it becomes self-feeding, which is ensured by this domino effect driving the diffusion of the revival across the economy.
Of course, the stock market is not the economy. Therefore, the business cycle should not be confused with market cycles, which are measured using broad stock price indices.
Measuring and Dating Business Cycles
The severity of a recession is measured by the three D's: depth, diffusion, and duration. A recession's depth is determined by the magnitude of the peak-to-trough decline in the broad measures of output, employment, income, and sales. Its diffusion is measured by the extent of its spread across economic activities, industries, and geographical regions. Its duration is determined by the time interval between the peak and the trough.
An expansion begins at the trough (or bottom) of a business cycle and continues until the next peak, while a recession starts at that peak and continues until the following trough.
The National Bureau of Economic Research (NBER) determines the business cycle chronology—the start and end dates of recessions and expansions for the United States. Accordingly, its Business Cycle Dating Committee considers a recession to be "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."
The Dating Committee typically determines recession start and end dates long after the fact. For instance, after the end of the 2007–09 recession, it "waited to make its decision until revisions in the National Income and Product Accounts [were] released on July 30 and Aug. 27, 2010," and announced the June 2009 recession end date on Sept. 20, 2010.
11 months
The average length of recessions in the U.S. since World War II has been around 11 months. The Great Recession was the longest one during this period, reaching 18 months.
U.S. expansions have typically lasted longer than U.S. contractions. From 1854–1899, they were almost equal in length, with contractions lasting about 25 months and expansions lasting about 29 months, on average. The average contraction duration then fell to 18 months in the 1900–1945 period and 11 months in the post-World War II period. Meanwhile, the average duration of expansions increased progressively, from 29 months in 1854–1899 to 30 months in 1900–1945, 43 months in 1945–1982, and 70 months in 1982–2009.
Stock Prices and the Business Cycle
The biggest stock price downturns tend to occur—but not always—around business cycle downturns (e.g., contractions and recessions). For example, the Dow Jones Industrial Average and the S&P 500 took steep dives during the Great Recession. The Dow fell 51.1%, and the S&P 500 fell 56.8% between Oct. 9, 2007 to March 9, 2009.
There are many reasons for this, but primarily, it is because businesses assume defensive measures and investor confidence falls during contractionary periods. Many events occur before those in an economy are aware they are in a contraction, but the stock market trails what is going on in the economy.
So, if there is speculation or rumors about a recession, mass layoffs, rising unemployment, decreasing output, or other indications, businesses and investors begin to fear a recession and act accordingly. Businesses assume defensive tactics, reducing their workforces and budgeting for an environment of falling revenues.
Investors flee to investments "known" to preserve capital, demand for expansionary investments falls, and stock prices drop.
It's important to remember that while stock prices tend to fall during economic contractions, the phase does not cause stock prices to fall—fear of a recession causes them to fall.
What Are the Stages of the Business Cycle?
In general, the business cycle consists of four distinct phases: expansion, peak, contraction, and trough.
How Long Does the Business Cycle Last?
According to U.S. government research, the business cycle in America takes, on average, around 6.33 years.
What Was the Longest Economic Expansion?
The 2009-2020 expansion was the longest on record at 128 months.
The Bottom Line
The business cycle is the time is takes the economy to go through all four phases of the cycle: expansion, peak, contraction, and trough. Expansions are times of increasing profits for businesses, rising economic output, and are the phase the U.S. economy spends the most time in. Contractions are times of decreasing profits and lower output, and is the phase the least amount of time is spent in.
