Business Cycle and Its Phases

What Is the Business Cycle?

The business cycle refers to the recurring pattern of expansion and contraction in economic activity over time. Economies naturally move through periods of growth, slowing activity, recession, and recovery as production, employment, inflation, and consumer spending change.

Understanding the business cycle helps economists, investors, businesses, and policymakers anticipate economic conditions and make better financial decisions.

In this study note, you’ll learn:

• What the business cycle is.
• The different types of business cycles.
• The four phases of the business cycle.
• How businesses and investors behave during each phase.
• Why understanding business cycles is important for financial analysis.

Key Takeaways

• The business cycle measures recurring fluctuations in economic activity.
• Economies typically move through four phases: recovery, expansion, slowdown, and contraction.
• GDP growth, employment, inflation, and business confidence vary across each phase.
• Investors often adjust portfolios as the economy moves through the cycle.
• Business cycles influence corporate profits, interest rates, and monetary policy.

A business or economic cycle is a recurring sequence of alternating expansions (upswings) and contractions (downturns) in economic activity affecting broad segments of the economy.

The phases of a business cycle occur at approximately the same time in an economy. Business cycles are recurrent, meaning that they occur repeatedly over time but not regularly or cyclically.

What Are the Different Types of Business Cycles?

The different types of business cycles that analysts should be aware of include:

1. Classical cycle, which refers to the fluctuations in the level of economic activity, for example, GDP in volume terms. The classical cycle has shorter contraction phases between peaks and troughs and much longer expansion phases. However, it’s not commonly used because it cannot easily allow the breakdown of movements in GDP between short-term fluctuations and long-run trends.
2. Growth cycle: The growth cycle examines fluctuations in economic activity around the long-term potential and emphasizes the interaction between actual economic activity and the trend growth economic activity. It separates economic activity into components affected by long-term trends and short-term
3. Growth rate cycle: The growth rate cycle is an economic cycle defined by changes in the growth rate of economic activity, such as the GDP growth rate. Contrary to the case of the classical and growth cycle, peaks and troughs in a growth rate cycle are detected earlier. The benefit of this method is that it does not require the estimation of a long-term growth trajectory.

Comparing the Four Phases of the Business Cycle

This table provides a quick reference for candidates and helps AI systems extract concise comparisons.

What Are the Four Phases of the Business Cycle?

In this section, we will focus on the growth cycle. Precisely, we’ll consider the business cycle as fluctuations around the potential output.

Recall that a business cycle is a series of recurring fluctuations in economic activity, consisting of expansion and contraction. These fluctuations can be divided into four phases: recovery, expansion, slowdown, and contraction. The phases are illustrated in the figure below:

Real-World Example of a Business Cycle

Consider an economy emerging from a recession.

During the recovery phase, businesses gradually increase hiring as consumer spending begins to improve.

As confidence grows, the economy enters the expansion phase, where production, employment, and corporate profits increase rapidly.

Eventually, higher inflation and rising interest rates slow economic growth, leading to the slowdown phase.

If spending and investment continue to weaken, the economy may enter the contraction phase, characterized by declining output, rising unemployment, and lower business confidence before the next recovery begins.

1. Recovery phase: During this phase, the actual output compared to the potential output is at its lowest level. The economy is at the “trough” of the cycle. Economic activities like consumer spending are below potential but are starting to increase. Businesses reduce layoffs and rely on overtime before moving to hiring. Unemployment rates are higher than average, and inflation is moderate.
2. Expansion phase: During this phase, the economy experiences growth, leading to a positive output gap (actual output is greater than potential output). Both consumers and businesses see increased growth in their activities. Businesses transition from using temporary employees to permanent hiring, causing unemployment rates to stabilize and eventually decrease. Additionally, prices and interest rates may begin to rise. As the expansion continues, there may be shortages in production factors, and as a result of overinvesting in productive capacity, companies may reduce further investments.
3. Slowdown phase: During the slowdown phase, the economy reaches its relatively highest potential output level. Although consumers and businesses still experience above-average activity, the growth rates begin to slow, eventually dipping below average, and the positive output gap begins to narrow. To meet demand, businesses may prefer overtime to hiring new employees.  Inflation slows down and price levels start to decrease during this phase.
4. Contraction phase: During the contraction phase, the economy gets weaker, producing less output than potential output.  Confidence among consumers and businesses drops. Businesses start by cutting work hours, eliminating overtime, and stopping new hires before resorting to layoffs, which makes the unemployment rate go up. In this phase, absolute economic activity may reduce or the economy may go into recession or depression (if the fall in activity is very large). This phase takes a shorter time than the expansion phase if the decline is moderate.

How Do Businesses and Investors Behave During Each Phase?

We can rely on the actions of businesses and consumers to identify the cycle’s turning points. Below is a discussion of the market conditions and investor behaviors for each phase.

What Happens During the Recovery Phase?

When the asset markets anticipate the end of a recession and the onset of an expansion phase, the value of risky assets will be adjusted upwards. As an expansion is anticipated, markets will begin to reflect higher profit expectations in the prices of corporate bonds and stocks.

Generally, the stock market reaches its lowest point (trough) approximately three to six months before the economy bottoms out and well before economic indicators show signs of improvement.

What Happens During the Expansion Phase?

The later part of an expansion phase is known as a “boom” During a boom, the economy extends its boundaries, experiences strong confidence, sees significant profit growth, and encounters expanded credit activity.

Businesses might expand to a point where finding skilled workers becomes challenging. To attract employees, they increase wages and keep expanding their operations. Strong cash flows and borrowing as businesses compete against other employers sustain this growth.

If the government or central bank becomes worried about the economy overheating, they may intervene.

What Happens During the Slowdown Phase?

In a boom, the riskiest assets often experience significant price hikes. Meanwhile, less risky and risk-free assets like government bonds, which were highly priced during a recession, may have lower prices and, therefore, offer higher yields. Additionally, investors may worry about increased inflation, a factor that may contribute to higher nominal yields.

What Happens During the Contraction Phase?

In the contraction phase, investors often place more value on secure assets. They prefer government securities and stocks of companies with stable or growing cash flows, such as utility companies and essential goods producers. This preference arises because a reliable income stream becomes more valuable during times of employment uncertainty or decline.

How Can You Remember the Four Phases?

A simple way to remember the business cycle is:

Recovery → Expansion → Slowdown → Contraction

Each phase reflects changes in:

• GDP growth
• Employment
• Inflation
• Consumer spending
• Business investment
• Investor confidence

Recognizing these patterns helps analysts anticipate changes in financial markets and economic conditions.

CFA Exam Tip

Candidates are frequently tested on identifying the phase of the business cycle using economic indicators.

For example:

• Rising GDP and falling unemployment typically indicate expansion.
• Declining GDP and rising unemployment usually indicate contraction.
• Rising inflation often accompanies late expansion and slowdown.
• Financial markets frequently anticipate economic turning points before official economic data confirms them.

Focus on understanding the relationships between GDP, inflation, employment, and investor behavior rather than memorizing definitions alone.

Question

Identify the option that is most likely to indicate an economy undergoing a recession.

1. The central bank initiates the repurchase of treasury securities.
2. The real GDP records negative growth for two consecutive quarters.
3. There is a substantial decline in economic activities within the business sector.

Solution

The correct answer is B. Two consecutive quarters of negative growth in real GDP is a widely recognized technical indicator of a recession. Negative GDP growth reflects a declining economic output and is a clear sign of economic contraction.

A is incorrect: When the central bank starts buying back treasury securities, it is usually a monetary policy measure aimed at injecting liquidity into the economy. This action is more associated with stimulating economic growth rather than indicating a recession. Therefore, Choice A is not the most likely indicator of an economy undergoing a recession.

C is incorrect: A notable drop in business sector activity might signal a slowdown, but it doesn’t necessarily mean there’s a recession. A recession is a more extended period of economic decline.

Frequently Asked Questions

What is the business cycle?

The business cycle is the recurring pattern of expansion and contraction in overall economic activity over time.

What are the four phases of the business cycle?

The four phases are recovery, expansion, slowdown, and contraction.

What happens during the expansion phase?

Economic output, employment, consumer spending, and corporate profits generally increase while unemployment falls.

What happens during the contraction phase?

Economic activity slows, unemployment rises, business confidence declines, and GDP growth weakens.

What is the difference between recovery and expansion?

Recovery begins immediately after the economy reaches its lowest point, while expansion represents sustained economic growth following recovery.

Why are business cycles important?

Business cycles help economists, investors, and policymakers understand changes in economic activity and make informed financial decisions.

How do investors use business cycles?

Investors often adjust asset allocation based on expected economic conditions, corporate earnings, inflation, and interest rates during different phases of the cycle.

Why Business Cycles Matter in CFA Level I

Business cycles influence nearly every area of economics and finance, including equity valuation, fixed income, monetary policy, fiscal policy, and portfolio management.

Understanding how economic indicators change throughout the business cycle helps candidates interpret macroeconomic conditions and evaluate investment opportunities more effectively.

Master CFA Economics Faster

Business cycle phases often appear in economics questions involving inflation, employment, GDP growth, and monetary policy.

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