Business Cycle: What It Is & How to Measure It

Remember India's economic boom period between 2003 and 2008? The economy was expanding, and it experienced high growth levels due to factors like an increase in foreign investment. But then this boom period was followed by a slowdown due to the effects of the 2008-09 global financial crisis. The pattern has been a continuous rise and fall in the macroeconomic factors, and the phases keep shifting. These fluctuations are a result of the constantly changing business cycle stages. What is the business cycle definition and what are these stages? Let’s understand.

What is the business cycle?

The business cycle is the rise and fall of the economy over time. It results from the fluctuations in GDP around its long-term natural growth rate, reflecting periods of economic expansion and contraction. Financial experts and organisations also measure the business cycle by the impacts of trade and production costs, interest rate changes, and investment landscape changes. The business cycle shows the economy's high and low points over time.

A business cycle completes when it goes through one boom and one contraction. The time it takes to complete one round of this sequence is called the length of the business cycle. A boom is a period of rapid economic growth, while a recession is a time of slower economic growth. These phases are measured by the real GDP growth, adjusted for inflation. 

Features of business cycles:

• The business cycle phases occur periodically, though not at specific intervals. Their duration varies depending on the industry and economic conditions, lasting two to twelve years. 
• All major economic sectors feel the impact of business cycles. Capital goods and consumer goods industries are often hit hardest, with significant effects on investment and consumption of durable goods. Non-durable goods typically experience fewer issues.
• Business cycles are complex and dynamic with no uniform patterns or causes, making prediction and preparation nearly impossible.
• Business cycles affect more than just the production of goods and services; they also influence employment, interest rates, price levels, and investment activity.
• Business cycles are international in nature. Once they begin in one country, they spread to others through trade relations and global practices.

Phases of the business cycle:

1. Expansion

The expansion stage is the first in a business cycle. Here, you’ll see positive economic signs like rising income, employment, demand, supply, and profits. Investment activity picks up as companies grow and businesses and individuals repay loans on time.

2. Peak

The business hits its peak when the economy can't expand further and has reached saturation. At this point, wages, employment, and the cost of goods and services are at their highest. Economic indicators max out, and businesses and people often review their budgets, anticipating a slowdown.

3. Contraction

After the peak, the economy starts to contract. This stage has two phases:

4. Recession

A recession begins when economic activity declines after the expansion phase. It continues until GDP returns to the expansion's starting point. Demand usually drops quickly, but producers might not reduce output immediately, causing prices and salaries to fall.

5. Depression

When GDP falls below its pre-expansion level, the depression phase starts. Unemployment soars and economic growth grinds to a halt. A depression continues until the economy hits rock bottom.

6. Trough

The trough stage occurs when the depression phase reaches its lowest point. During this time, the economy may experience minimal growth, with supply and demand at their lowest.

7. Recovery

Recovery begins when the economy's GDP is at its lowest. This stage sees a rebound as unfavourable trends reverse. Rising demand increases supply, investment pick-up, and employment and output growth. The recovery phase lasts until the economy's growth stabilises, ending the current business cycle and starting a new expansion stage.

How is a business cycle measured?

Measuring the business cycle means measuring the intensity or magnitude of a phase of the business cycle. We can understand this measure separately for the recession and expansion phases. For recession, economists use the 3 D’s to gauge the severity of a recession:

• Depth: This examines how much employment, income, and sales rates are affected.
• Duration: This measures the time between the peak and the trough of the business cycle.
• Diffusion: This considers how widespread and lasting the recession's effects are on fiscal decisions, industrial development, and regions of a country.

For economic expansion, experts use the 3 P’s:

• Pronounced: This measures the broad impact of the economic boom on individuals and entities like corporations.
• Pervasive: This checks if a wide range of the country’s communities benefit from the expansion.
• Persistent: This measures the length of the expansion period, from the trough of the cycle to the next peak.

What causes the changing business cycle?

Whenever you hear about macroeconomic instability, economists often talk about business cycles and what causes them. One theory they mention is the real business cycle theory. This theory claims that economic instability is due to "real" factors affecting aggregate supply. 

The real business cycle theory is one of the modern views of macroeconomic instability. This theory suggests that business cycles result from technological changes and resource availability, influencing productivity and altering the long-run aggregate supply. According to this theory, economic fluctuations come from changes in technology and resources. So, the real business cycle theory mainly focuses on the economy's supply side since technology and resources are essential for production.

There are other different ideas about what causes changes in the business cycle. John Keynes believes business cycles happen because of changes in aggregate demand. These changes lead to short-term equilibriums that differ from full employment. On the other hand, Keynesian models don't always show regular business cycles but suggest cycles happen due to shocks. The level of investment affects how big these cycles are. However, economists like Finn E. Kydland and Edward C. Prescott from the Chicago School disagree with Keynes. They believe economic changes are due to technology shocks, like new innovations, not monetary changes. 

Can the business cycle impact my investments or wealth?

Before people in an economy realise they're in a downturn, various events unfold, with the stock market reacting afterwards. Though the recessions themselves don't cause stocks to fall— the fear of a recession triggers the drop. So, if there's talk of a recession, layoffs, rising unemployment, or lower output, it sparks concern among businesses and investors. Even most investors shift to safer options to safeguard their money, causing demand for growth investments to drop and stock prices to decline. Thus, a direct impact can be seen in the securities market, which makes it essential for you to manage your investments as the business cycle changes.

During a downturn, it's a good time to buy cheap stocks and commodities. They will likely bounce back, yielding higher returns than your initial investment. However, thorough research is necessary before adding any investment to your portfolio. During recovery, you can carefully select investments to catch stocks before they peak without overpaying. When the business cycle peaks, you can sell as your investments will likely fetch higher prices. But alongside the profit booking, consider shifting to safer investments like money market funds, treasury bonds, high-yield savings, or CDs to protect your gains. You can also choose to invest in business cycle funds that ride along the phases of the business cycle and adjust the allocations accordingly. 

Conclusion

Understanding the business cycle is crucial for you, whether you're working, buying assets, or investing. It helps you figure out when to buy, when to sell, and when to hold off. It also lets you get ready for tough times. You can adjust your investments if you see signs of a recession coming. On the other hand, if you or your advisor think things are starting to improve, you can decide on taking more risks with your investments. 

FAQs

Q1. Is the business cycle and market cycle different?

Ans. business cycle differs from a market cycle. A market cycle refers to the ups and downs of the stock market, while the business cycle relates to the overall economy.

Q2. How does the government manage or influence the business cycle?

Ans. Governments influence business cycles through fiscal and monetary policies. Fiscal policy adjusts government spending and taxes to stimulate or cool the economy. Meanwhile, monetary policy, managed by central banks like the RBI, controls interest rates to encourage or discourage borrowing and spending. These measures aim to manage economic phases like recession or rapid growth.

Q3. What are the characteristics of a business cycle?

Ans. Business cycles keep rotating regularly, and each cycle can last from as short as two years to as long as 10 to 12 years. They affect the entire economy rather than specific industries or regions, synchronising across sectors. Moreover, changes in business cycles impact not only output levels but also variables like employment, investment, consumption, interest rates, and prices.

Q4. What are the 4 phases of the business cycle?

Ans. The business cycle, meaning the phases of economic fluctuation, has four main phases- expansion, peak, contraction and trough.