Understanding the Business Cycle: Key Concepts, Measurement, and Its Four Stages

In macroeconomics, the business cycle refers to the fluctuations in economic activity that occur over time.

By understanding the ebb and flow of economic conditions, policymakers, businesses, investors—and even regular people—can make informed economic decisions.

After all, we’re all affected by economics. Employment, investment, interest rates, inflation—we all have to deal with these issues.

In this article, we’ll give you a succinct breakdown of the business cycle and its four phases: expansion, peak, contraction, and trough.

The business cycle describes the natural rise and fall of economic growth over time.

We have periods of growth followed by periods of declining economic production, which is then followed by periods of recovery and re-growth, which is then followed by another decline. The process repeats so on and so forth as it has for the whole of economic history.

These cycles are the result of… well, everything happening in the world. The economy is affected by changes in:

• Politics;
• Culture;
• Technology;
• Climate

The duration and magnitude of these cycles can vary significantly, often depending on how drastically the world is changing too.

For example, the Industrial Revolution led to massive economic growth. People went from horses to trains and from farms to factories and were able to produce at a quicker pace than before.

So did the advent of the internet. Businesses were suddenly trying to figure out e-commerce, digital marketing, or even how to use a static IP address for their benefit.

While the concept of business cycles is often used in the context of national economies, it can be applied to economies of any size, whether they be regional or sectoral economies or even industry-specific economies.

We analyze business cycles in order to better understand our economic conditions. With such analysis, we as a society can make informed decisions that aim to stabilize or stimulate economic growth.

A business cycle has four phases:

• Expansion;
• Peak;
• Contraction;
• Trough

They come one after the other, in that order, and repeat. Each phase has key characteristics and reflects broader economic conditions, which we’ll discuss below.

How to Measure the Business Cycle: Key Economic Indicators

To determine what phase we are currently in, measure the magnitude of these phases, as well as to predict when and how drastically we’ll move into the next phase, economists measure these key economic indicators:

1. Gross Domestic Product (GDP)

GDP tracks the total value of goods and services produced by a nation in a specific period of time. It’s the quickest and most general way of measuring economic output. Increasing GDP generally indicates expansion, while a decline indicates contraction.

2. Employment Rates

As more and more goods and services are created, more jobs are created, and more workers are hired. During periods of growth, employment rates go up but go down when it declines.

3. Inflation Rates

Inflation refers to the rise in the prices of goods and services. A moderate inflation rate is treated as a sign of healthy growth. For example, The Federal Reserve of the United States typically aims to keep the inflation rate at 2%.

Much higher rates may indicate that the economy is overheating and peaking and that a contraction may likely follow. A lower inflation rate may also indicate that we are in a contraction.

4. Interest Rates

Central banks often wish to stabilize the economy. To do this, they adjust interest rates to either stimulate a declining economy or cool down an overheating one.

Lower interest rates encourage people to borrow and invest, often leading to expansion. However, if banks think inflation and growth are becoming too excessive, they will often raise them.

5. Consumer and Business Confidence

Consumer confidence refers to how willing they are to spend money. This signals broader trends of how optimistic consumers are about the economy.

The more money there is in circulation, the more it stimulates and grows the economy. If people are afraid to spend their money, it is often a sign of contraction.

6. Business Investment

Business investment can be seen as the business counterpart to consumer confidence. When businesses are confident about their profit potential, they invest in new equipment, technology, and other capital goods. This reflects their positive view of the economy.

While economists look at other factors, these are the main ones they examine.

By assessing these factors, they can determine where we currently stand in the business cycle and predict what may come next.

Below, we’ll outline each phase and explain what each indicator may look like during each phase.

1. Expansion

As named, during an expansion, the economy is growing. The economy is essentially getting more and more productive. This is shown by the following indicators.

• Rising GDP

Economic output and productivity increase steadily during expansion, with more goods and services being produced to meet demand, thus increasing the GDP of countries.

• Decreasing Unemployment

As businesses grow, more workers are hired to meet demands, and unemployment rates lower. Note that wages also rise in such a time. With higher labor demands, workers ask for higher wages.

• Increasing Consumer Spending

When the average consumer feels good about the overall economy, they also feel confident about their personal financial stability. They are therefore more willing to spend their money.

• Low to Moderate Inflation

Moderate inflation is indicative of growth, as prices also increase. However, the key here is that the inflation rate is relatively low. Higher rates are signs of economic overheating.

• Business Investment

Like consumers, businesses are willing to spend more money to invest in growing their company.

The expansion phase is underlined by a general attitude of optimism among people. Other indicators involve stock markets rising, corporate profits increasing, and credit becoming more accessible.

 

2. Peak

The peak is the highest level—and the end—of the expansion phase. This is as high as economic growth and output reach before declining. It’s essentially the turning point from an expansion to a contraction.

During this phase:

• GDP growth plateaus

The GDP stops growing, though it remains at a high level.

• Full Employment

At this point, most businesses are fully staffed and no longer hiring. Very few people are unemployed. And because the economy is no longer growing, very few job openings also pop up.

• Inflation Pressures

Inflation may rise to higher levels. This is because there is more demand than supply can keep up. Prices therefore increase.

• Rising Interest Rates

To combat high inflation rates, banks may also begin raising interest rates.

• Decreasing Confidence

Both businesses and consumers may start to feel less confident about spending money. Because of this, the amount of money in circulation plateaus.

Other indicators of the peak phase are economic imbalances, such as asset bubbles, where the prices of real estate, stocks, or other assets rise beyond their original value due to more speculative investments.

 

3. Contraction

As the peak ends, economic growth declines. That is why recessions often occur during contractions.

Here’s what key indicators look like during a contraction.

• Falling GDP

Businesses reduce production as demand also decreases.

Economic output declines as businesses reduce production in response to decreasing demand.

• Rising Unemployment

While businesses may reduce their production operations, the needs of everyday people remain the same. People always seek to earn wages to feed themselves, but due to fewer jobs being available, unemployment rises.

• Lower Consumer Spending

Partially due to a lack of job opportunities, people cling to their savings and spend less money on non-essentials. This further exacerbates the economic decline.

• Deflationary or Disinflationary Pressures

Inflation slows down to a crawl. The inflation rate is growing incredibly slowly or prices even plateau—when this happens, it’s called a disinflation.

In fact, prices may even fall (deflation). With decreasing demand, businesses may reduce prices to attract new customers.

• Declining Investment

Like consumers, businesses now focus on saving money and cancel or postpone investment and expansion projects.

Like an expansion, a contraction can be mild or severe, depending on many variables. For example, most recently, the global COVID-19 pandemic literally shut the world down, heavily decreasing economic activity and growth.

As a response, governments and banks implement fiscal policies like lowering interest rates. This encourages people to borrow money to start businesses or spend, hopefully re-stimulating the economy to healthier levels.

 

4. Trough

The trough is the business cycle’s rock bottom. It’s where economic production is at its lowest. Key characteristics of this phase include:

• Lowest GDP

The GDP is at its lowest—though it has stopped declining.

Economic output hits its lowest level before beginning to recover.

• High Unemployment

Since the economy is at rock bottom, jobs are still few and far between

• Weak Consumer and Business Confidence

Both consumers and businesses remain extremely cautious. Spending and investment are at a minimum.

• Interest Rates and Inflation

Central banks may implement even more aggressive policies to stimulate growth, such as further lowering interest rates to encourage people to borrow and invest.

While a trough is bleak, the good news is that the trough is the counterpart of the peak.

Though marking the bottom of the business cycle, a trough also signifies the end of the contraction phase. It’s the transition point from a contraction to a recovery back to an expansion.