The business cycle is a period of time during which the economy expands, peaks, contracts, and bottoms out. Then the cycle repeats itself.
Business cycles are relevant on both a macroeconomic and a microeconomic level, which means your business experiences them along with the larger economy in which it operates. Understanding the business cycle can help you identify economic trends and changes and make informed decisions regarding your company’s finances.
Here’s a closer look at the business cycle, including how it works, how it can impact your business, and examples of the business cycle in action.
Key Points
• A business cycle refers to the natural fluctuations in economic activity over time, characterized by periods of expansion (growth) and contraction (recession) in an economy.
• The cycle typically has four phases: expansion (rising economic activity), peak (maximum growth), contraction (declining activity), and trough (lowest point before recovery).
• Economic indicators such as GDP, employment rates, industrial production, and consumer spending help track the business cycle’s phases.
• Business cycles vary in length, lasting from a few months to several years, depending on economic conditions and external factors.
• During slow times, businesses can rely on external funding to help keep their business afloat. This includes small business loans, grants, crowdfunding, and angel investors.
Business Cycle Defined
By definition, the business cycle represents economic growth and decline through distinct phases. These phases often occur in an identifiable pattern where one phase tends to follow the other. They typically include expansion, peak, recession, and trough.
Financial professionals and organizations measure the business cycle primarily by the increases and decreases in the gross domestic product (GDP), along with the influences of trade and production costs. A business cycle is completed when it goes through a single boom and a single contraction in sequence. The time period to complete this sequence is called the length of the business cycle.
Governments try to manage business cycles by spending, raising or lowering taxes, and adjusting interest rates.
How the Business Cycle Works
As consumer confidence starts to build, the economy experiences an expansion. 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. Economic expansion 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 money to spend and businesses reduce spending on growth. This results in an economic contraction. When the total output of an economy declines (recession) and ultimately bottoms (trough), we then enter the next cycle’s expansion phase.
The average business cycle in the U.S. is about six years.
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Stages of the Business Cycle
While there are four main phases in a business cycle, a business cycle can actually consist of six distinct stages, involving both high and low points.
There is no set length of time for each stage; some could be short-term, while others could last many years. In some cases, the stages of the business cycle may only be able to be identified in retrospect.
The stages of a business cycle can include:
1. Expansion
During a period of expansion, business is booming for the majority of companies. During this stage, companies will often hire more employees, take out different types of small business loans, and invest in growth. Believing that employment is steady and income assured, consumers will generally spend more, and supply and demand match up fairly evenly. Prices may start to rise now.
2. Peak
The peak stage is when the economy hits a saturation point. Production and prices have reached their limit and the market can’t bear any more increases. Consumers may cut back on their spending because they can’t afford to pay the increased prices. This is the turning point – with no room for growth left, there’s nowhere to go but down. A contraction is on the way.
3. Recession
Once that peak has been reached, the business cycle enters a contraction, or recession. At this stage, people don’t buy as many things. Often businesses do not notice the decrease in demand instantly and go on producing, which often creates a situation of excess supply in the market. Prices tend to fall and companies may pull back on hiring or investing in growth, and may even lay off employees, causing a rise in unemployment.
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4. Depression
If growth continues to decline, the economy can reach the depression stage. In this stage, the economy’s growth rate becomes negative. There is extensive depletion of national income and expenditure. Companies may lay off even more employees and find ways to drastically reduce spending. Production of products drops due to lack of demand, and prices continue to fall. The economy eventually reaches the trough.
5. Trough
This is the lowest point in economic loss. Prices may continue to drop, but they level off as the contraction phase bottoms out and starts to rebound into an expansion phase.
6. Recovery
At last, there is a turnaround in the economy as it begins to recover. Consumers and investors begin to feel more confident about the economy, and spending picks up since prices are still low.
Companies may start to spend on growth again, replacing depreciated capital and making new investments in the production process. Employment begins to rise and, due to accumulated cash balances with banks, lending also shows positive signs. Recovery continues until the economy returns to steady growth levels.
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Pros and Cons of the Business Cycle as a Model
While tracking the larger business cycle in the country can be beneficial for your business financial planning, there are some drawbacks, as well. Here’s a look at the pros and cons of using the business cycle as a model when making business decisions.
| Pros | Cons |
|---|---|
| Helps business owners predict future conditions | Economic predictions don’t always come to pass |
| Can consider where economy is headed when drafting budget and business plan for following year | Business cycle modeling is not an exact science and open to interpretation |
| Can purchase capital goods and increase production in anticipation of increased demand | Researchers who gather data and study business cycle trends are capable of human error |
| Can lock in a low interest rate on refinancing before rates rise | In some cases, the stages of the business cycle can only be identified in retrospect |
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Market vs Business Cycles
Business cycles and market cycles may sound like the same thing but, technically, they are different. A market cycle refers to different growth and decline stages of the stock market, whereas the business cycle looks at the economy as a whole.
The two cycles are related, however. The stock market is affected by, and often mirrors, the phases of a business cycle. During the contraction stage of the business cycle, investors tend to sell their holdings, leading to a drop in stock prices. This is known as a bear market. During an expansion phase of the business cycle, investors often buy up stocks, causing prices to go up. This is known as a bull market. Eventually, the economy, and the market, will pick back up again, heading toward a bull market, and the cycle repeats.
| Business Cycle | Market Cycle |
|---|---|
| Refers the economy as a whole | Refers to the stock market |
| Has periods of expansion and contraction | Has periods of expansion and contraction |
| Defined by economic growth and recession | Defined by bull and bear markets |
| Influenced by consumer confidence | Influenced by investor confidence |
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Measuring Business Cycles
The National Bureau of Economic Research (NBER), a nonprofit organization, defines and measures business cycles in the U.S. The NBER actually has a Business Cycle Dating Committee that is responsible for determining the start and end of a business cycle.
NBER primarily relies on quarterly GDP growth rates to identify a business cycle. However, it will also look at other financial data, including income, retail sales, and manufacturing output.
The NBER does not release this information until analysts thoroughly evaluate it. This means you may not know when a new business cycle begins until well after it’s started. However, you can usually take note of a few key indicators (such as interest rates, total employment, and consumer spending) to see where you are in the business cycle.
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Example of the Business Cycle
One famous example of the business cycle is the Great Depression, which began in 1929. Before the economy began to contract, the GDP rate was high and unemployment was low, thanks to new developments like the airline industry. The expansion phase reached a peak, and then the economy began to decline — unemployment rose, GDP fell, and the Depression occurred. The economy hit the trough around 1933, after which it began to recover.
A more recent business cycle example is the Great Recession. The U.S. economy started an expansion period in 2000, and then, beginning in late 2007, it went through the largest economic downturn since the Great Depression. The downturn was triggered by the bursting of a housing bubble, which led to a global financial crisis. Following a trough in June 2009, the economy began to recover and expand, reaching a peak in February 2020.
The Takeaway
The business cycle refers to the rise and fall in economic activity caused by factors like interest rates, trade, production costs, and investments. A business cycle is completed when it goes through a single boom and a single contraction in sequence. The extreme points are the peak and the trough.
While economic forecasts and modeling aren’t perfectly reliable, combining information about business cycles with what you know about your particular industry and company can help you to prepare for shifts in the economy before or soon after these changes occur. For example, understanding where you are in a business cycle can also help you decide if it’s a good time to apply for a small business loan, make capital investments, or hire more employees.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How many stages are in the business cycle?
Generally, the business cycle consists of four phases: expansion, peak, contraction, and trough.
What are the stages of the business cycle?
The business cycle can include six stages: expansion, peak, recession, depression, trough, and recovery.
What is the purpose of the business cycle?
The purpose of a business cycle is to track economic activity and forecast the direction of the economy. The business cycle helps the government determine fiscal policy and guides the Federal Reserve in setting interest rates. It also influences how businesses and consumers spend, invest, and access credit.
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