Business Cycles

Securities markets often move ahead of the cycle itself. Stock prices typically rise before expansion begins and fall before contraction sets in, while the Fed adjusts interest rates in response to where the economy sits in the cycle, raising rates to cool an overheating expansion and lowering them to support a contraction. The rest of this unit builds on where you are in this cycle.

Core Definitions:

• Business cycle: Recurring pattern of expansion and contraction in economic activity
• Recession: A significant, broad decline in economic activity. Two consecutive quarters of declining real GDP is a common shorthand used in exam questions, not the official required definition. The NBER's Business Cycle Dating Committee is the body that officially dates recessions, weighing depth, diffusion, and duration across several economy-wide measures rather than a fixed GDP-quarters rule, and it announces a turning point only after the fact
• Depression: An unusually severe, prolonged downturn. There is no official fixed number of declining quarters

Exam Tip: Gotchas

• Treat two declining GDP quarters as a common recession shorthand, not a legal or official threshold. Do not assign a fixed six-quarter (18-month) definition to a depression either; severity and duration matter more than a specific quarter count.
• The NBER's Business Cycle Dating Committee, not a GDP-quarters count, is the official body that dates recessions.

What Are the Four Stages of the Cycle?

The cycle moves through four stages in order: Trough → Expansion → Peak → Contraction

Memory Aid:

Trough (bottom) → Expansion (growing) → Peak (top) → Contraction (shrinking) = TEPC cycle (or think: Bottom → Up → Top → Down)

Stage Characteristics:

What Happens During Each Stage?

Expansion (Recovery): the economy is growing and gaining momentum.

• Increasing consumer demand, rising production
• Rising stock market and rising real estate prices
• Falling unemployment as companies add workers
• GDP and inflation both trend upward
• Corporate sales, manufacturing output, wages, and savings all increase

Peak: the economy is at maximum output.

• GDP at highest level, wages/manufacturing/savings at maximum
• Economy is overheating with little spare capacity
• Inflation pressure builds
• Jobs are plentiful, though new hiring has plateaued

Exam Tip: Gotchas

• At the peak, GDP is still positive. It is just growing slower. Contraction starts after the peak, not during it.

Contraction (Recession): the economy is shrinking.

• Declining productivity, falling wages and savings
• Rising unemployment, layoffs increase
• Consumers pull back on spending
• Falling stock market as corporate earnings fall
• Reduced consumer spending and weak demand
• GDP turns negative and inflation cools

Trough: the decline ends and recovery begins.

• GDP at lowest level, unemployment peaks, wages bottom out
• Economy readies for new expansion
• Early signs of spending on durable goods and housing appear
• The bottom has been reached and optimism slowly returns

How Does the Business Cycle Move Securities Markets?

• Stock prices tend to lead the business cycle (rise before expansion, fall before contraction)
• Bond prices generally move inversely to interest rates, which the Fed adjusts in response to cycles
• During expansion: Fed may raise rates to prevent overheating (contractionary policy)
• During contraction: Fed may lower rates to stimulate growth (expansionary policy)

What Should You Check on Exam Day?

• Know the four stages in order (trough, expansion, peak, contraction) and what unemployment, inflation, rates, and demand are doing in each
• Do not treat "two consecutive quarters of declining GDP" as an official legal definition of a recession; it is a common shorthand
• Know that the NBER's Business Cycle Dating Committee is the body that officially dates recessions, using depth, diffusion, and duration, and does so retrospectively
• Do not assign a fixed quarter count to a depression; it is defined by severity and duration, not a number
• Remember GDP is still positive at the peak; contraction starts after the peak, not before it
• Know that stocks lead the cycle and the Fed adjusts rates in response to where the cycle is