Definition of 'Business Cycle

The recurring and fluctuating levels of economic activity that an economy experiences over
a long period of time. The five stages of the business cycle are growth (expansion), peak,
recession (contraction), trough and recovery. At one time, business cycles were thought to
be extremely regular, with predictable durations, but today they are widely believed to be
irregular, varying in frequency, magnitude and duration.

Four Phases of Business Cycle

Business Cycle (or Trade Cycle) is divided into the following four phases :-
1. Prosperity Phase : Expansion or Boom or Upswing of economy.
2. Recession Phase : from prosperity to recession (upper turning point).
3. Depression Phase : Contraction or Downswing of economy.
4. Recovery Phase : from depression to prosperity (lower turning Point).

Diagram of Four Phases of Business Cycle

The four phases of business cycles are shown in the following diagram :-




The business cycle starts from a trough (lower point) and passes through a recovery phase
followed by a period of expansion (upper turning point) and prosperity. After the peak point
is reached there is a declining phase of recession followed by a depression. Again the
business cycle continues similarly with ups and downs.
Explanation of Four Phases of Business Cycle
The four phases of a business cycle are briefly explained as follows :-
1. Prosperity Phase
When there is an expansion of output, income, employment, prices and profits, there is also
a rise in the standard of living. This period is termed as Prosperity phase.
The features of prosperity are :-
1. High level of output and trade.
2. High level of effective demand.
3. High level of income and employment.
4. Rising interest rates.
5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of capital) and investment.
Due to full employment of resources, the level of production is Maximum and there is a rise
in GNP (Gross National Product). Due to a high level of economic activity, it causes a rise
in prices and profits. There is an upswing in the economic activity and economy reaches its
Peak. This is also called as a Boom Period.
2. Recession Phase
The turning point from prosperity to depression is termed as Recession Phase.
During a recession period, the economic activities slow down. When demand starts falling,
the overproduction and future investment plans are also given up. There is a steady decline
in the output, income, employment, prices and profits. The businessmen lose confidence
and become pessimistic (Negative). It reduces investment. The banks and the people try to
get greater liquidity, so credit also contracts. Expansion of business stops, stock market
falls. Orders are cancelled and people start losing their jobs. The increase in
unemployment causes a sharp decline in income and aggregate demand. Generally,
recession lasts for a short period.


3. Depression Phase
When there is a continuous decrease of output, income, employment, prices and profits,
there is a fall in the standard of living and depression sets in.
The features of depression are :-
1. Fall in volume of output and trade.
2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.
In depression, there is under-utilization of resources and fall in GNP (Gross National
Product). The aggregate economic activity is at the lowest, causing a decline in prices and
profits until the economy reaches its Trough (low point).
4. Recovery Phase
The turning point from depression to expansion is termed as Recovery or Revival Phase.
During the period of revival or recovery, there are expansions and rise in economic
activities. When demand starts rising, production increases and this causes an increase in
investment. There is a steady rise in output, income, employment, prices and profits. The
businessmen gain confidence and become optimistic (Positive). This increases
investments. The stimulation of investment brings about the revival or recovery of the
economy. The banks expand credit, business expansion takes place and stock markets are
activated. There is an increase in employment, production, income and aggregate demand,
prices and profits start rising, and business expands. Revival slowly emerges into
prosperity, and the business cycle is repeated.
Thus we see that, during the expansionary or prosperity phase, there is inflation and during
the contraction or depression phase, there is a deflation
The Stages of the Business Cycle

There are four stages that describe the business cycle. At any point in time you are in one
of these stages:
1. Contraction - When the economy starts slowing down.
2. Trough - When the economy hits bottom, usually in a recession.
3. Expansion - When the economy starts growing again.
4. Peak - When the economy is in a state of "irrational exuberance."
Who Determines the Business Cycle Stages?

The National Bureau of Economic Research (NBER) analyzes economic indicators to
determine the phases of the business cycle. The Business Cycle Dating Committee uses
quarterly GDP growth rates as the primary indicator of economic activity. The Bureau also
uses monthly figures, such as employment, real personal income, industrial production and
retail sales.
What GDP Can You Expect in Each Business Cycle Phase?

In the Contraction phase, GDP growth rates usually slow to the 1%-2% level before actually
turning negative. The 2008 recession was so nasty because the economy immediately
shrank 1.8% in the first quarter 2008, grew just 1.3% in the second quarter, before falling
another 3.9% in the third quarter, and then plummeting a whopping 8.9% in the fourth
quarter. The economy received another wallop in the first quarter of 2009, when the
economy contracted a brutal 6.9%.
In the Trough phase, GDP growth may still be negative, but it's not as bad. It's clear that
the economy has turned a corner. According to the NBER, this occurred in the second
quarter 2009, when GDP contracted a mere .7%.
In the Expansion phase, GDP growth turns positive again. In the 2008 recession, this
wasn't until the third quarter 2009, when the GDP grew 1.6%. This was thanks to the
stimulus spending from the American Recovery and Reinvestment Act.
In the Expansion phase of the business cycle, the GDP growth rate will be in the healthy 2-
3% growth range. If the economy is managed well, it can stay in the Expansion phase for
years.The expansion phase started in the third quarter 2009, and is still continuing --
although it is too slow to create enough jobs to lower the 9% unemployment rate. That's
because the Contraction phase was so harsh.
The Peak phase is when the economy's expansion slows. It's usually the last healthy
growth quarter before the recession starts. You usually don't know you are in a peak until it
is too late. However, if the GDP growth rate is 4% or higher for two or more quarters in a
row, you can bet the peak is not far off. In the 2008 recession, the peak occurred in the
fourth quarter 2007, when the GDP growth rate was 1.9%.
What Causes the Business Cycle?
The business cycle is affected by all the forces of supply and demand. When consumers
are confident, they buy now knowing there will be income in the future from better jobs,
higher homes values and increasing stock prices. Even a little healthy inflation can trigger
demand by spurring shoppers to buy now before prices go up. As demand increases,
businesses hire new workers, which further stimulates more demand. This is the Expansion
phase.
If demand outstrips supply, then the economy can overheat. This created the housing asset
bubble in 2005. It's still the Expansion phase, but if demand isn't cooled down with higher
taxes (fiscal policy) or higher interest rates (monetary policy), then the Peak is not far off.
In the Contraction phase, confidence is replaced by fear or even panic. Consumers sell
their homes, and stop buying. Businesses lay off workers, and hoard cash. Confidence
must be restored to before the Trough can be hit, and the economy re-enters a new
Expansion phase.
Examples:
The National Bureau of Economic Research (NBER) is the official arbiter of economic
expansions and contractions, or business cycles.