Business Cycle: What It Is, How to Measure It, and Its 4 Phases (2024)

What Is a Business Cycle?

Business cycles are a type of fluctuation found in the aggregate economic activity of a nation—a cycle that consists of expansions occurring at about the same time in many economic activities, followed by similarly general contractions. This sequence of changes is recurrent but not periodic.

The business cycle is also called the economic cycle.

Key Takeaways

Business cycles are composed of concerted cyclical upswings and downswings in the broad measures of economic activity—output, employment, income, and sales.
The alternating phases of the business cycle are expansions and contractions.
Contractions often lead to recessions, but the entire phase isn't always a recession.
Recessions often start at the peak of the business cycle—when an expansion ends—and end at the trough of the business cycle, when the next expansion begins.
The severity of a recession is measured by the three Ds: depth, diffusion, and duration.

Understanding the Business Cycle

In essence, business cycles are marked by the alternation of the phases of expansion and contraction in aggregate economic activity and the co-movement among economic variables in each phase of the cycle.

Aggregate economic activity is represented by not only real (i.e., inflation-adjusted) GDP—a measure of aggregate output—but also the aggregate measures of industrial production, employment, income, and sales, which are the key coincident economic indicators used for the official determination of U.S. business cycle peak and trough dates.

Popular misconceptions are that the contractionary phase is a recession and that two consecutive quarters of decline in real GDP (an informal rule of thumb) means a recession.

It's important to note that recessions occur during contractions but are not always the entire contractionary phase. Also, consecutive declines in real GDP are one of the indicators used by the NBER, but it is not the definition the organization uses to determine recessionary periods.

Business Cycle: What It Is, How to Measure It, and Its 4 Phases (1)

On the flip side, a business cycle recovery begins when that recessionary vicious cycle reverses and becomes a virtuous cycle, with rising output triggering job gains, rising incomes, and increasing sales that feedback into a further rise in output.

The recovery can persist and result in a sustained economic expansion only if it becomes self-feeding, which is ensured by this domino effect driving the diffusion of the revival across the economy.

Of course, the stock market is not the economy. Therefore, the business cycle should not be confused with market cycles, which are measured using broad stock price indices.

Measuring and Dating Business Cycles

The severity of a recession is measured by the three D's: depth, diffusion, and duration. A recession's depth is determined by the magnitude of the peak-to-trough decline in the broad measures of output, employment, income, and sales.

Its diffusion is measured by the extent of its spread across economic activities, industries, and geographical regions. Its duration is determined by the time interval between the peak and the trough.

An expansion begins at the trough (or bottom) of a business cycle and continues until the next peak, while a recession starts at that peak and continues until the following trough.

The National Bureau of Economic Research (NBER) determines the business cycle chronology—the start and end dates of recessions and expansions for the United States.

Stock Prices and the Business Cycle

The biggest stock price downturns tend to occur—but not always—around business cycle downturns (e.g., contractions and recessions). For example, the Dow Jones Industrial Average and the S&P 500 took steep dives during the Great Recession. The Dow fell 51.1%, and the S&P 500 fell 56.8% between Oct. 9, 2007 to March 9, 2009.

There are many reasons for this, but primarily, it is because businesses assume defensive measures and investor confidence falls during contractionary periods. Many events occur before people in an economy are aware they are in a contraction, but the stock market trails what is going on in the economy.

So, if there is speculation or rumors about a recession, mass layoffs, rising unemployment, decreasing output, or other indications, businesses and investors begin to fear a recession and act accordingly. Businesses assume defensive tactics, reducing their workforces and budgeting for an environment of falling revenues.

Investors flee to investments "known" to preserve capital, demand for expansionary investments falls, and stock prices drop.

It's important to remember that while stock prices tend to fall during economic contractions, the phase does not cause stock prices to fall—fear of a recession causes them to fall.

What Are the Stages of the Business Cycle?

In general, the business cycle consists of four distinct phases: expansion, peak, contraction, and trough.

What Does a Business Cycle Describe?

A business cycle describes the fluctuations in an economy over a period of time, generally the period from the start of one recession to the start of the next. This would include periods when the economy grows.

Are Business Cycles Predictable?

Generally, business cycles are not predictable. Economies are complex machines that function in a variety of ways and are intertwined in as many ways. The ability to predict how they will move is extremely difficult. There can be signs of changes in an economy, such as changes in inflation and production, but to predict an all-out change in the business cycle is very tough if not impossible.

The Bottom Line

The business cycle is the time it takes the economy to go through all four phases of the cycle: expansion, peak, contraction, and trough. Expansions are times of increasing profits for businesses, and rising economic output, and are the phase the U.S. economy spends the most time in. Contractions are times of decreasing profits and lower output and are the phase in which the least amount of time is spent.