Business Cycle

Made up of periods of expansion and contraction that is noticed in various economic sectors simultaneously.

Author: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Reviewed By: Patrick Curtis
Patrick Curtis
Patrick Curtis
Private Equity | Investment Banking

Prior to becoming our CEO & Founder at Wall Street Oasis, Patrick spent three years as a Private Equity Associate for Tailwind Capital in New York and two years as an Investment Banking Analyst at Rothschild.

Patrick has an MBA in Entrepreneurial Management from The Wharton School and a BA in Economics from Williams College.

Last Updated:November 14, 2023

What is a Business Cycle?

Business cycles are periods of economic activity that take place in every country. They are made up of periods of expansion and contraction that are noticed in various economic sectors simultaneously.

Recessions are characterized by general declines in economic activity levels, whereas increases in output, income, sales, and employment indicate expansions.

Although the patterns of economic activity in every recession and every expansion can differ, they have common traits that frequently reoccur in the history of economies. 

Hence, keeping an eye on and forecasting these movements can help construct economic and policy decisions for individuals and financial institutions.

All countries with capitalist economies experience business cycles. These normal cycles of expansion and contraction will occur in all such economies, but not necessarily at the same time.

Nevertheless, because of greater globalization, business cycles across nations synchronize more frequently than they did in the past.

The repetition of the cycles does not necessarily make them avoidable. Instead, several factors, including GDP, output, employment, aggregate demand, real income, and consumer spending, constitute the root cause of the variations.

Business Cycle Causes

Numerous forces that work together contribute to the economy's cyclical pattern of change. Internal economic variables could bring on these alterations. Additionally, other influences might cause an economy to flourish or sink.

Various variables influence the economic process, including interest rates, the credit cycle, the multiplier effect, and consumer confidence. 

A. Internal Causes

The internal causes of the cycle are those aspects of the economic system that shape the business cycle. The following are the main factors that influence the cycle:

1. Macroeconomic Policies

The macroeconomic policies that significantly impact the cycle are the monetary and other related policies put in place by a government.

Economic growth will result from policies that favor firms and investors; in contrast, policies that do not assist these groups but instead discourage investment, such as raising tax rates or eliminating subsidies, will cause a recession.

Therefore, the economy grows if monetary policies aim to increase economic activities by encouraging investment. Conversely, the economy will slow down or enter a recession if taxes or interest rates rise.

2. Changes in demand

According to economists, changes in demand result in changes in economic activity. This is because businesses start manufacturing more goods when demand in an economy rises to satisfy the demand.

More output, employment, income, and profits are produced. The economy will see a boom as a result. However, inflation may also result from excessive demand.

Conversely, as demand declines, so does economic activity. This could result in a bust, which, if it persists long enough, could even cause an economic depression.

3. Investment fluctuation 

In an economy, variations in investments will result in variances in output, just as variations in demand. 

Therefore, it follows logically that an increase in investments will result in economic growth, whereas a decrease will result in a trough or depression. 

The expectation of profits, the present interest rate, revenue generation, and a few other factors influence investing decisions.

4. Money supply 

Another viewpoint holds that economic cycles are only monetary events. Fluctuations in the money supply will therefore cause the trading cycles. Money entering the market more will lead to growth and expansion.

But an excessive money supply could also lead to inflation, which is bad. Still, the central bank has to tighten interest rates to bring inflation under control, and the economy will enter a recession due to the decline in the money supply.

B. External causes

The term "external causes of the business cycle" refers to variables or developments that occur outside of an economy but impact it.

War, Natural calamities or black swan events, New technology, Surge in population these causes can significantly impact the start and end of the new economic cycle. External Causes are described in detail in the coming points.

1. War

As the attention turns to the battlefield and other areas of the economy are overlooked, economic resources and available capital are used for producing weapons and supporting the army, which increases the demand for basic amenities among the general public. This slowed down the economy and was a major contributor to the 1930s Great Depression.

2. Technology 

Introducing new, innovative technology always helps the economy. New technological investments will result in more jobs, higher salaries, and greater profits. 

For instance, the development of the contemporary mobile phone led to a significant uptick in the telecom business.

3. Natural calamities

Such as drought, famine, or flooding significantly impact many economic inputs, including transportation, employment, and agriculture, which raise the price of associated goods already on the market. Such natural disasters could lead to depression.

4. Population Growth

Population growth that is too rapid strains an economy's resources, influencing both the availability and costs of goods. Therefore, it is imperative to strictly manage the population through various programs to keep the economy under control.

How Does the Business Cycle Work?

An economic expansion followed by a slump, another addition, and so on is a pattern known as a business cycle.

A boom occurs when there is a time of significant economic expansion, meaning that businesses start to produce more as a result of an increased demand, which necessitates capital investment in new machinery and personnel. 

During an expansion, unemployment stays low, and the stock market does well. In addition, due to increased consumer spending and investment, prices for products and services also start to rise.

More money is spent as more jobs are created. So businesses ultimately make more money and expand even more. That is how business grows.

Contrarily, in a contraction period, businesses may cut production and employees if demand declines. As a result, people become anxious and cut back on their expenditures. As a result, companies may also limit growth as they become more frugal with their spending.

It is a time when economic activity is declining. Indicating that firms have scaled back their operations are rising unemployment rates, equities entering a bear market, and GDP growth below 2% during a contraction.

A recession may result from the economy's stagnant growth. Cycles in the economy may only last a few years. The bike's length is based on how long it takes for each of its four stages to be finished.  

Stages of the Business Cycle

An extended period of economic expansion is followed by an extended period of economic contraction, which serves as the endpoint for all cycles. A financial process includes four distinct stages that can be identified: expansion, peak, squeeze, and trough. They are explained in more depth in the coming section.

1. Expansion

This stage happens when the economy as a whole is expanding. Expansion is typically depicted on the curve as an upward trend because it is rising. The expansion phase is frequently referred to as the economic recovery phase since it follows a period of economic contraction.

The gross domestic product is the metric used to measure economic production. Throughout the growing phase, it increases. As a result, economists consider a GDP rate between 2% and 3% healthy.

The capital market experiences growth during this period, and investors are optimistic. Consumers have more cash to spend, businesses make more money, and both are growing. As a result, an economy may continue to grow for many years during the expansion phase.

The expansion phase is about to end when the economy expands too quickly. When the unemployment rate is far below the natural rate and inflation rises, this is referred to as "overheating." 

When stock market investors exhibit "irrational exuberance," they become overly excited about prices and believe they will keep rising, pushing up stock prices to a hugely inflated level. Then comes the next stage, peak, explained in the next point.

2. Peak

In this stage, all indications of expansion show signs of exhaustion, then the peak comes.

The economy could take months or sometimes years to enter the contraction stage. GDP decreases and stays below 2%; the peak on the graph is shown as the highest point of the curve before it descends.

3. Contraction

It starts when the economy is strongest and frequently ends when the GDP and other indicators like production, pricing, saving, and investment begin to decline. At this moment, the economy is decreasing.

The economy enters a recession when the GDP rate declines. Companies fire many employees, the unemployment rate shoots above average, and prices fall. You can see contraction on a graph that is the part of the curve declining.

4. Trough

In the fourth stage, the falling GDP starts to slow down and alter positively again. The shift of the economy from the recession phase to the expansion phase starts. 

The lowest point of a curve is shown as a trough on a graph. When the GDP begins to rise, The cycle starts again when the GDP increases and curves steadily advance upward.

Examples of Business Cycle

The internal causes of the cycle are those aspects of the economic system that shape the business cycle. External causes refer to developments that occur outside of an economy but have an impact on it. 

For example, when the great recession in the late 2000s hit, The U.S. economy was in the expansionary stage of the economic cycle. Still, during the recession, GDP fell badly, inflation increased, and unemployment increased. Two of the examples are explained below in detail.

1. Internal Cause example

The third quarter of 2007 saw GDP growth of 2.4%, which was the peak before the recession of 2008. Because the economy fell into a recession in the first quarter of 2008, it was a difficult one. However, It recovered 2.3% in the second quarter, which is a promising development.

Nevertheless, it shrank by 2.1% in the third quarter and 8.5% in the fourth. It shrank by 4.6% in the first 2009 quarter.

The unemployment rate increased in 2008, going from 4.9% in January to 7.2% in December. However, according to the NBER, the trough was reached after the second quarter of 2009.GDP only shrank by 0.7% in 2014. 

However, because it is a lagging indicator, unemployment increased to 10.2% by October 2009.

The growth phase began when GDP increased by 1.5% in the third quarter of 2009. Because the contraction phase drove the economy so low that it took much longer to recover, the unemployment rate was still above 7% four years into the expansion period.

2. External Cause example

One of Africa's most developed economies is Nigeria. Yet, despite this, the Covid 19 Pandemic caused Nigeria's economy to decline by over 1.92% in the second and third quarters of 2020. 

Reuters claims that this ruined the country's GDP, which had recovered from 2016's decline to grow by about 2.2% in 2019.

The global decline in crude oil demand and prices was the cause of this trade cycle change. In addition, several nations were severely affected by the COVID lockdown and its restrictions.

Numerous industry sectors saw a slowdown, including manufacturing, aviation, trade, hospitality, and transportation. Even though these factors were outside these businesses' control, they had to bear the loss.

Business Cycle FAQs

Researched and authored by Rishabh Bhoria | LinkedIn

Reviewed and Edited by Raghav Dharmarajan

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