The business cycle refers to the natural rise and fall of economic growth that takes place over time. The cycle is useful for analyzing the economy. If you know how to read and assess it, it can help you make better financial decisions.
Stages of the Business Cycle
Every business cycle has four recognizable phases: the expansion, peak, contraction, and trough, which don’t really occur at regular intervals. You can instead use some indicators.
The expansion phase lies between the trough and the peak. Obviously, this is where the economy is growing. The gross domestic product measures economic output, and it’s increasing. The GDP growth rate is usually in the healthy 2 to 3 percent range.
Unemployment reaches its natural rate of 4 to 5 percent, while inflation is near the 2 percent usual target. The stock market is enjoying a bull market. If the economy is managed well, the expansion phase can last for years, in which case it will be called the Goldilocks economy.
This phase nears the end when the economy overheats. That’s the time when growth is greater than 3 percent. Inflation is greater than 2 percent and may reach two digits. Usually, this is also the time for investor’s irrational exuberance, which then paves the way for asset bubbles.
The peak follows the expansion phase. It’s the transition month between the expansion phase into the contraction phase.
This phase starts with the peak and finishes with the trough. The economic growth weakens, with GDP slipping below 2 percent. When this figure falls in the negative territory, we call it a recession.
There are usually mass layoffs making the headlines, with unemployment rates beginning to rise. But this doesn’t usually happen until the end of the contraction phase since it’s a lagging indicator. Businesses wait until it is certain that the recession is over before they start hiring new workers.
It is also during this phase when the stock market falls into the bear market territory as the investors sell.
This is obviously the part when the stock market bottoms. The trough phase is the month in which the contraction phase transitions to the expansion phase.
Measuring the Business Cycle
The National Bureau of Economic Research checks on the business cycle stages by using the quarterly GDP growth rates. Among other figures it uses are employment, real personal income, retail sales, and industrial production.
However, you don’t get informed about what phase it is right now until after it has already started. The good thing is that you can check out the phase of the cycle by yourself by looking at the indicators.
Managing the Business Cycle
The task of managing the business cycle lies on the shoulder of the government. The legislators have the fiscal policies to influence the economy. When their goal is to end recession, they use expansionary fiscal policy. On the flipside, they use contractionary fiscal policy to prevent overheating in the economy.
Meanwhile, the country’s central bank uses monetary policies. It cuts interest rates in order to end a contraction or a trough, aptly being called an expansionary monetary policy. Other times, the central bank increases rates to manage expansion so that it doesn’t peak.