Business Cycle and Its Phases

A business or economic cycle is a recurring expansion and contraction in economic activity affecting broad segments of the economy. Specifically, a business cycle has the following features:

• A business cycle depends on the enterprise.
• Business cycles have anticipated sequences of phases, alternating from expansions and contractions (or upswings and downturns).
• The phases of a business cycle occur at approximately the same time in an economy.
  Business cycles are recurrent. This implies that they occur repeatedly over time but not regularly or cyclically.

Types of Business Cycles

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

1. Classical cycle: The classical type of cycle shows fluctuations in economic activity, such as GDP. It has shorter contraction phases between peaks and troughs and longer expansion phases. However, it’s not commonly used due to its inability to distinguish short-term fluctuations from long-term trends.
2. Growth cycle: The growth cycle examines fluctuations around the long-term trend and emphasizes the interaction between actual economic activity and the trend. It separates economic activity into components affected by long-term trends and short-term variations.
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 are detected earlier. The benefit of this method is that it does not require the calculation of a long-term growth trajectory.

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.

Note 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 can be illustrated in the figure below:

1. Recovery phase: During the recovery phase, the economy goes through a trough, and the negative output gap starts to narrow. Both consumers and businesses experience activity levels below their potential, but there is a noticeable increase in these activity levels. Businesses reduce layoffs, rely on overtime, and then transition to hiring, stabilizing unemployment. Inflation remains at a moderate level during this phase.
2. Expansion phase: During this phase, the economy experiences growth, leading to a positive output gap. 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 companies might reduce further investments due to overcapacity in productive resources.
3. Slowdown phase: During the slowdown phase, the economy reaches its peak relative to potential output, with a reduced positive output gap. Although consumers and businesses still experience above-average activity, their growth rates begin to slow, eventually dipping below average. Businesses continue to hire, but at a slower rate, leading to a further reduction in the unemployment rate, although the decline is less rapid. Inflation also picks up pace during this phase.
4. Contraction phase:  During the contraction phase, the economy gets weaker, producing less than it could. 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, inflation decreases, but it takes some time. A recession happens when the overall economic activity shrinks, and if this reduction is substantial, it can become a depression.

Leads and Lags in Business and Consumer Decision-making

To identify the cycle’s turning points, we rely on the actions of businesses and consumers. Now, let’s describe the market conditions and investors for each phase.

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.

Expansion Phase

After an economy firmly establishes an expansion phase, it often enters an even more vigorous stage known as a “boom.” During the boom, the economy extends its boundaries, experiences strong confidence, sees significant profit growth, and encounters expanded credit activity.

In this scenario, 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.

Slowdown Phase

In a boom, the riskiest assets often experience significant price hikes. Meanwhile, risk-free assets like government bonds, which were in high demand during a recession, may have lower prices and, therefore, offer higher yields. Additionally, investors may worry about increased inflation, which can lead to higher nominal interest rates.

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.

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.