Business Cycles
The business cycle provides the framework for understanding all other economic concepts. Every other topic in this unit relates to where we are in the cycle.
Core Definitions:
- Business cycle: Recurring pattern of expansion and contraction in economic activity
- Recession: Declining gross domestic product (GDP) lasting at least 6 months (2 consecutive quarters)
- Depression: Declining GDP lasting at least 18 months (6 consecutive quarters)
Exam Tip: Gotchas
- A recession requires 2 consecutive quarters of declining GDP (6 months), not just 1 quarter. A depression requires 6 consecutive quarters (18 months). The exam tests these specific thresholds.
The Four Stages:
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:
| Stage | Unemployment | Inflation | Interest Rates | Consumer Demand |
|---|---|---|---|---|
| Trough | High | Low/moderate | Low | Beginning to rise |
| Expansion | Decreasing | Increasing | Rising | Strong |
| Peak | Low | High | High | Slowing |
| Contraction | Increasing | Decreasing | Falling | Weak |
Detailed Stage Indicators:
Expansion (Recovery):
During expansion, 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:
At the 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.
Contraction (Recession):
During contraction, 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:
At the 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
Business Cycle and 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)