The concept of business cycles may not sound like the most reassuring thing in the world (unless you’re an economist). If you’re a small business owner, or the employee of a larger company, the economy may seem like a vast, unpredictable force. At the moment, it probably seems like your destruction is the likelier option. So why don’t the economists predicting a recession sound more terrified? It’s because they understand the concept of business cycles.
What exactly does the business cycle mean, and why can it be a source of optimism in this moment?
Business Cycle Definition
Let’s explore a business cycle definition. In its simplest sense, the concept of the business cycle refers to the fact that economic activity tends to move up and down over time in a non-random way. In some periods, the economy expands (growth). In other periods, the economy experiences a contraction of activity, also known as recession. Undergoing expansion or contraction has many correlated effects, which include fluctuation in productivity/output, revenues, employment rates, and inflation rates.
You probably already have an intuitive sense of the fact that the economy often swings in different directions. If you’re reading this, you probably remember the global financial crisis of 2008 and the ensuing Great Recession. And while the current looming recession probably feels far too soon, the decade since the Great Recession is actually the longest period of economic expansion in US history.
The whole idea of business cycles was first formally analyzed by Arthur Burns and Wesley Mitchell in their 1946 book, Measuring Business Cycles. The most important insight of their work was the fact that many economic indicators move together, as opposed to randomly. In times of economic expansion, productivity increases, employment rises, new construction increases, and inflation is also likely to rise, especially if the expansion is too fast paced. The effects are reversed in times of contraction.
Now that you’ve got a basic sense of what the business cycle refers to, let’s take a look at the different phases of the business cycle.
Phases of the Business Cycle
There are four phases of the business cycle:
The first phase of the business cycle is expansion. This starts at the end of a previous recession or downturn, once activity starts to increase again. Productivity (measured in GDP) begins to rise, unemployment begins to fall, and inflation starts to rise. Depending on the management of the economy, the expansion phase can last for a very long time. Until the recession that is now likely underway, the US economy underwent over a decade of expansion following the Great Recession.
The second phase is called the peak. Productivity has reached its maximum and is about to decrease. Employment has reached its maximum—possibly rising as high as full-employment. Inflation is also at a maximum and is soon to fall.
The third phase is the contraction. In this phase, which is also commonly known as a recession, business activity is decreasing, unemployment is rising, and inflation is falling. Typically, recessions last about 18 months, though they can be shorter or longer.
The fourth phase is called the trough. This is the end of the recession and the transition to another period of expansion, and a new business cycle. In the trough, productivity, employment, and inflation are all at a minimum.
Business Cycle Example
There have been 34 complete business cycles since 1854. Taking all of them into consideration, the average recession lasts for just under 18 months, while the average expansion lasts for at least double that, at almost 40 months. More importantly, the cycle does not imply a long-term stagnation. Rather, over the long-term, the economy obeys a general upward trend, even considering the regularity of recessions. As the National Bureau of Economic Research notes in their definition of a recession, “Expansion is the normal state of the economy; most recessions are brief, and they have been rare in recent decades.”
All those phases probably only make so much sense in the abstract. Let’s consider a hypothetical business, and what the different phases will likely look like considered from that business’ perspective. We’ll imagine a home construction company, since new construction goes up and down reliably with the business cycle.
Economic Expansion Phase
When the economy is in the expansion phase, the home construction business is very successful. Work keeps coming in, bringing more revenue. Other people are employed, and the banks are lending optimistically, so lots of people are purchasing new homes. As the demand increases, the company continues to hire more people to keep up with the demand. They also invest more money in upgrading their equipment and begin to charge higher prices. They also have to pay their workers more money because there is more competition from other construction companies.
Economic Peak Phase
When the economy hits its peak, things become ‘overheated.’ No matter what the construction company does, it is unable to keep up with demand. Because so many workers are employed, they can’t hire any more people, and they no longer have any need to invest in upgrading their equipment. Customers start to become dissatisfied as the business fails to meet everyone’s needs, since so many people are demanding construction.
Economic Contraction Phase
Soon the economy changes course and goes into a recession. The company experiences some initial relief as the demand for its services cools down, and it’s easier to keep up with the work now. They are also able to pay less of a premium for labor, since there is less competition. Unfortunately, the work orders keep dwindling and revenues are falling. The company starts to have trouble repaying the debts it accrued to invest in all its new equipment. It gets harder to secure new work as competitors begin to offer steep discounts, since there is less work to go around. The company is forced to cut its workers’ hours.
Economic Trough Phase
Finally the economy reaches its trough. Business is very slow for this hypothetical company since not enough people have the money to invest in new home constructions. The equipment the construction company invested in is just sitting idle, not bringing in any new revenue but still not paid off. The company would like to advertise to new customers to bring in more work, but they can’t borrow any more money because no banks will lend it to them.
Well-run businesses manage investments, hiring, and cash keeping in mind that a different phase of the business cycle may soon reveal itself. They keep enough cash around to ensure they can hire or invest near the trough and ensure they don’t overextend when the economy is expanding.
Obviously, the recession and trough phases of the business cycle paint a bleak portrait of what many companies will soon be going through given COVID-19. But the concept of the business cycle does offer cause for optimism. After all, all recessions are temporary, and the economy eventually expands once again. Furthermore, expansions tend to last longer than recessions.
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