The business cycle and its four phases

What makes something a business cycle?

A business cycle is a recurring sequence of expansions and contractions in economic activity that affects broad parts of an economy. Four features define it:

• It occurs in economies run mainly by private businesses.
• Expansions and contractions alternate.
• They hit many sectors at about the same time.
• They recur, but are not periodic: a full cycle can last anywhere from a little over a year to about a decade.

The last point is the exam favorite. Think of the tides, not a train timetable: the same pattern returns, but never on a fixed schedule.

What are the three ways to measure the cycle?

Analysts use three definitions, and in practice they are often mixed up. They differ in what they track.

Business cyclerecurrent swings in activity across the economy

• Classical cycle Memorize level of output; falls in output are rare and short
• Growth cycle Memorize output relative to trend (the output gap); the mainstream view
• Growth rate cycle Memorize growth rate of output; turning points show first, no trend needed

Cycle	Tracks	Note
Classical cycle	The level of output	Absolute falls in output are rare and short. Least used.
Growth cycle	Output relative to its trend, the output gap	The mainstream definition. Peaks come earlier and troughs later than in the classical cycle.
Growth rate cycle	The growth rate of output	Turning points show up earliest. No estimate of the trend is needed.

The output gap is actual output minus potential output. A positive gap means the economy runs above its sustainable level, a negative gap means it runs below. The rest of this lesson uses the growth cycle, as most economists do.

Go deeper Why the growth-cycle view dominates

Output normally rises with population, capital and technology. The classical view mixes that long-run climb with short-run swings, and it turns only when output actually falls, which seldom happens. The growth cycle strips out the trend, so it isolates the fluctuation that businesses, central banks and investors care about. The cost is that it needs an estimate of trend output, which is itself uncertain.

What are the four phases?

Read each phase off the output gap, then add what happens to jobs and prices.

Phases of the cycleread off the gap between actual and potential output

• Recovery Memorize negative gap at its widest, then starts to narrow (trough)
• Expansion Memorize positive gap opens; the late stage is a boom
• Slowdown Memorize positive gap at its widest, then narrows (peak)
• Contraction Memorize negative gap opens; a recession if severe

Phase	Output gap	Activity	Employment	Inflation
Recovery	Negative, starting to narrow (trough)	Below potential, starting to rise	Layoffs slow; overtime before hiring; unemployment still high	Moderate
Expansion	Positive gap opens (boom late on)	Above-average growth	Firms move from overtime and temps to hiring; unemployment falls	Picks up modestly
Slowdown	At its widest, then narrows (peak)	Above average but decelerating	Hiring continues more slowly; unemployment falls at a slower rate	Accelerates further
Contraction	Negative gap opens (recession if severe)	Below potential	Hours cut, overtime ended, hiring frozen, then layoffs; unemployment rises	Decelerates, with a lag

Two details to hold on to:

• The boom . Late in an expansion, growth tests the limits of the economy. Confidence, profits and credit are strong, firms struggle to find qualified workers and bid up wages, and the central bank may step in against overheating.
• Lags. Output turns first. Hiring follows because firms use overtime and temporary staff until the upturn looks durable, and inflation follows hiring.

Exam tip When a question gives you jobs and prices, remember they lag. Decide the phase from the output gap first.

How do markets behave through the cycle?

Use it

Markets look ahead, so asset prices move before the data.

• Recovery. Risky assets are repriced upward as investors expect the recession to end. Equity markets typically bottom about three to six months before the economy does, well before indicators turn up.
• Expansion and boom. Confidence, profits and credit growth are strong. The central bank may lean against overheating.
• Slowdown. The riskiest assets have run up. Government bond prices are lower and yields higher, partly on fears of inflation.
• Contraction. Investors pay up for safety: government securities and companies with steady cash flows, such as utilities and producers of staples. A safe income is worth more when jobs feel insecure.

Go deeper Why safe income gains value in a contraction

When employment is falling, a household’s wage is at risk, so a dollar that arrives for certain is worth more to it than a dollar that might. Economists describe this as a rising marginal utility of safe income. It is why demand for government bonds and for the shares of steady dividend payers goes up exactly when growth is weak.

When does a recession begin and end?

A common rule of thumb: a recession has started when real gross domestic product (GDP) falls for two consecutive quarters. Its weakness is that a pattern of negative, slightly positive, negative growth would not count, though many analysts would call it a recession.

For that reason some countries have dating committees. They look at employment, industrial production and sales, not only GDP. Data arrive with delays and are revised, so the committee often announces a peak or trough well after it happened.

Go deeper Why dating committees announce so late

Preliminary data can be revised for years. A committee wants to be confident that a turn is real before it marks the date, so a peak is typically confirmed many months afterward. That is why analysts rely on indicators, covered in the lessons on leading, coincident and lagging indicators, to judge turning points in advance.