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: Two consecutive quarters of declining real gross domestic product (GDP). Real GDP is inflation-adjusted, and the exam uses this definition.
• Depression: Six consecutive quarters (18 months) of declining real GDP, using the test-prep definition adopted in this course. A depression is more severe and prolonged than a recession.

Exam Tip: Gotchas

• A recession is two consecutive quarters of declining GDP. The declines must be back to back. A single quarter of decline, or two separated declines, does not qualify.
• Use two consecutive quarters for a recession and six consecutive quarters for a depression. A four- or five-quarter decline clears the recession threshold but has not reached the depression threshold used here.

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 its highest level of the cycle, wages/manufacturing/savings at maximum
• GDP growth slows as the peak nears, and GDP has not yet started to fall
• Economy is overheating with little spare capacity
• Inflation pressure builds
• Jobs are plentiful, though new hiring has plateaued

Exam Tip: Gotchas

• Often confused: the level of GDP and its growth rate. At the peak, the level is at its highest and has not started to fall. Growth slows as the economy nears the peak. GDP falls only in contraction, which 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
• Define a recession as two consecutive quarters of declining GDP. Both quarters must be back to back.
• Use six consecutive quarters (18 months) of declining real GDP for a depression under this course's test-prep definition
• Remember that GDP is at its highest level at the peak and has not started to fall; growth slows as the peak nears, and 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