Business cycle
A business cycle is a cycle of fluctuations in the gross domestic products (GDP)
around its long term natural growth rate. The business cycle is also known as
the economic cycle or trade cycle.
A business cycle is completed when it goes through a single boom and a single
contraction in sequence. The time period to complete this sequence is called
the length of the business cycle.
Stages of the Business Cycle
All business cycles are characterized by several different stages, as seen
below. These stages are
1. Expansion.
2. Peak.
3. Recession.
4. Depression.
5. Trough.
6. Recovery.
Expansion
This is the first stage. When the expansion occurs, there is an increase in the
positive economic indicators such as employment, incomes, production,
profits, demand and supply of goods and services etc. People generally pay
their debts on time. The economy has a steady flow in the money supply and
investment is booming. This process continues as long as economic
conditions are favourable for expansion
Expansion may be caused by several factors. The factors may be external
to the economy such as weather condition or technical change or by internal
factors such as fiscal policies, credit availability, and regulatory policies.
Global conditions may also influence it. A well managed economy can remain
in the expansion phase for years, that is called a goldilocks economy
Peak
The second stage is a peak when the economy hits a snag, having reached
the maximum level of growth. Prices hit their highest level, and economic
indicators stop growing. Many people start to restructure as the economy's
growth starts to reverse. This stage marks the reversal point in the trend of
economic growth
Recession
These are periods of contraction. This is the slowdown of economy During a
recession, unemployment rises, production slows down, and sales start to
drop because of a decline in demand, and incomes become stagnant or
decline. All the positive indicators start to fall.
Depression
Economic growth continues to drop while unemployment rises and production
plummets. Consumers and businesses find it hard to secure credit, trade is
reduced, and bankruptcies start to increase. Consumer confidence and
investment levels also drop.
Trough
This is the negative saturation point for an economy. There is an extensive
depletion of national income and expenditure. This period marks the end of
the depression, leading an economy into the next step recovery.
Recovery
In this stage, the economy starts to turn around. Low prices spur an increase
in demand, employment and production start to rise, and lenders start to open
up their credit coffers. This stage marks the end of one business cycle.
Difference between Recession and Depression
A recession is the contraction phase of the business cycle. A common rule of
thumb for recessions is two quarters of negative GDP growth while a
Depression is a prolonged period of economic recession marked by a
significant decline in income and employment
The National Bureau of Economic Research (NBER) determines business
cycle using quarterly GDP growth rates. It also uses monthly economic
indicators such as employment, industrial production, retail sales and the
government manages the business cycle
Economists and the Business Cycle
Some economists believe that the business cycle is a natural part of the
economy. But there are others who believe that central banks indirectly control
the cycle by intervening with monetary policy. When the economy is
expanding too quickly, central bankers will step in and tighten the money
supply and raise interest rates.
Conversely, if the economy is slowing down too quickly, they will lower rates
and increase the money supply. Critics believe that if central bankers stop
intervening, it would all but rid the economy of these cycles.
Investors and the Business Cycle
Investors may be able to use the business cycle to profit from the market by
choosing the right stocks at the right time.
For example, an investor may choose to invest in commodities and technology
stocks at the end of the business cycle because they may be cheap, and then
sell them during the early part of an expansion.
When the economy is overheating and has reached its peak, the investor may
decide to put his or her money into utilities, consumer staples, and healthcare.
These sectors tend to outperform the market during recessions because
demand doesn't decrease even during times of instability, and because of
their cash flows and dividend yields.
The Business Cycle and Markets
Recessions can extract a tremendous toll on stock markets. Most major equity
indexes around the world endured declines of over 50% in the 18-month
period of the Great Recession, which was the worst global contraction since
the 1930s Depression. Global equities also underwent a significant correction
in the 2001 recession, with the Nasdaq Composite among the worst-hit. The
index plunged by almost 80% from its 2001 peak to its 2002 low.
Importantly, recessions due to credit bubbles bursting are far worse on income
and consumption than from stock market speculative bubbles bursting
