Economic Cycle

What is the economic cycle?

The economic cycle, also known as the business cycle, refers to the natural fluctuation of economic activity over time, typically measured by the changes in gross domestic product (GDP) and other economic indicators such as interest rates, total employment and consumer spending.

The cycle comprises four main stages:

• Expansion

• Peak

• Contraction

• Trough

Adopt image from Link

Phases of the economic cycle

Economic expansion

The expansion phase is characterised by the rising economic activity and growth. It is the period when the economy moves out of the recession or trough and heads towards a peak.

Key characteristics of the expansion phase:

• Increasing GDP: Gross domestic product (GDP) which measures the total value of goods and services produced in an economy, grows during this period. When the economy produces more, the overall production/output increases.

• Decrease in unemployment: As consumer demands increase, firms hire more workers, leading to a drop in unemployment rates. Wages will then increase because labour demand rises, contributing to higher household income.

• Higher consumer spending: As employment increases, people will have more disposable income to spend which increases demand for goods and services and fuels further economic growth.

Peak

The peak is the point in the economic cycle that signals its maximum growth before a downturn begins.

Key characteristics of the peak phase:

• Maximum GDP growth: During the peak, GDP reaches its highest level, reflecting the economy’s full productive capacity. From thereafter, growth starts to slow down as the economy can’t expand indefinitely.

• Rising inflation: Inflation may become more noticeable as demand for goods and services exceeds supply. Higher wages, rising demand for raw materials and resource constraints will all push up the input costs and cause an increase in product prices.

•  Asset bubbles: The peak is often associated with inflated asset prices such as stocks, real estate or commodities. Speculative investments may drive asset values beyond their true worth. Investors may take on excessive risk in the belief that the price will keep going up.

Economic contraction

The contraction phase, also known as recession or downturn, is a period when economic activity declines after reaching the peak. The contraction phase can vary in length and severity, from mild slowdown to deep recession.

Key characteristics of the contraction phase:

• Declining GDP: One of the main indicators of a contraction is a decrease in GDP. Economic outputs slow as businesses reduce production due to low demand for goods and services. If the GDP contracts for two consecutive quarters, the country is technically entering a recession phase.

• Rising unemployment: As businesses face a decline in profitability, they may cut costs by reducing their workforce. Unemployment generally rises during this phase, resulting in lower household income and further reducing consumer spending.

• Government and central bank intervention: To counter the negative effects of a contraction, central banks may reduce interest rates to stimulate consumer spending and investment. Governments may introduce fiscal policy including tax cuts and increasing public spending to boost economic activity.

Trough

The trough is the lowest point in the economic cycle, marking the end of the contraction phase and transitioning to a new phase of expansion.

Key characteristics of the trough phase:

• Lowest GDP levels: At the trough, GDP growth may be flat or very slow. Economic output is significantly below potential, reflecting reduced production and consumer demand.

• High unemployment rates: Unemployment is typically at its peak during the trough. Businesses have laid off workers during the contraction and are hesitant to hire new workers due to low demand and economic uncertainty. This results in high joblessness, reduced household income and lower consumer spending.

• Lower business and consumer confidence: Confidence among consumers and businesses is generally at its lowest point during the trough. Consumers may delay discretionary purchases and businesses may refrain from investing in new projects, leading to further stagnation in the economy.

When the business movements are not cyclic

When the business movements are not cyclic

In many ways, economists do not think ‘business cycle’ is an appropriate term to use. Because ‘cycle’ seems to imply that there is some regularity in the timing and duration of upswing and downswing in economic activity. For that reason, some economists prefer the term business fluctuation over business cycle.

As the table shows below, contraction and expansion occur at irregular intervals and last for varying lengths of time. For example, the 1980 recession lasted just six months, while the 1981 recession lasted sixteen months.

References

Christina, D.R n.d., Business Cycles, The Library of Economics and Liberty, available at <https://www.econlib.org/library/Enc/BusinessCycles.html>.

Henry, G n.d., Business Cycle, Britannica Money, available at <https://www.britannica.com/money/business-cycle>.

Reserve Bank of Australia n.d., Economic Growth, Reserve Bank of Australia, available at <https://www.rba.gov.au/education/resources/explainers/economic-growth.html>.

Scott 2023, All About the Business Cycle: Where Do Recessions Come From?, Federal Reserve Bank of St. Louis, available at <https://www.stlouisfed.org/publications/page-one-economics/2023/03/01/all-about-the-business-cycle-where-do-recessions-come-from>.