Business Cycle (Definition, Example) | Top 5 Phases of Business Cycle

Business Cycle Definition

Business Cycle is defined as a series of repetitive upward and downward growth cycles in the pace of the company or economic activities of a country and guides the policymakers in the decision-making process. Just because the cycles are repetitive doesn’t mean they can be avoided. In the larger scheme of things, cycles are just a part of theoretical knowledge a company tries to use in decision making.

Phases of Business Cycle

In general, every business cycle has multiple phases and depending on the country we can try to define business cycles. But let us take an example of the UK and try to define common phases of a business cycle that we can use across the world.

Expansion
Peak
Recession
Depression
Recovery

Source: National Institute of Social and Economic Research, UK

These phases are not entirely shown in the picture as themselves because of the reason that it is just the slope of the curve that is different. In an expansion stage, the slope is positive – like the one from a trough to peak (in the above figure). Using such rough estimates, we can interpret the slope of the curves.

#1 – Expansion Stage

In this stage of the business cycle, there will be a rise in employment, wages, GDP and economy.
Everything goes right – stock prices raise, people pay back their installments on time and investment will be on the rise.

#2 – Peak Stage

How long will the economy raise? Till the sentiment starts to turn the other side. People start believing that stock prices are a bit overvalued and will turn away from investing.
People, companies, and governments will start to restructure their financial patterns to run with the cycle.
The economy is at its best stage, but things will look weary. They are not really bad yet, but they might be. The government will try to take corrective actions to keep the work flowing.

#3 – Recession Stage

After reaching a peak, if things don’t come under control things take a turn to the worse side.
Economies reduce in size, companies cut back investments.
As a result, people will start losing their jobs and the demand and sales reduce even further. Before things become very bad, the government should get involved and try to cool down things.

#4 – Depression Stage

If the recession stage is not controlled via proper measures, more people will start losing jobs, they will start paying their loans which is going to affect the economy more.
Companies will start losing their income and will start going bankrupt.
Governments are in a stage of very stringent regulations to take the situation into control. They reduce the interest rates of borrowing so that more money flows into the economy.

#5 – Recovery Stage

As the government pushes more money into the economy, people start getting jobs and as a result, income, again. People start spending again.
This pushes the economy to a better stage and into the growth stage again.

Example of Business Cycle

What are we going to use as a proxy to look at the business? Can we use the GDP? Or should we use market capitalization? Is it better to use payroll growth? Or the unemployment rate?

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There is no right answer to this question. We can use anything and they are all inter-related. Though there might be lags in some and some might be used as predictors – we can use any of these as long as it can be properly explained and stated. So, let us look at how the USA’s GDP has risen and fallen over the years and see if we can pinpoint the recessions, depressions, growths, and peaks.

Before jumping into the example of a business cycle, it is fair to point out that these cycles won’t exactly look like what we spoke. And all of this is post-fact analysis. Once we look back, everything seems to be obvious.

As the growth increases, the probability of recession coming up further increases. 1980, 1990, 2000, 2010. These are the years where probability was at a peak and it fell down to a bare minimum level. If we go back and look at the financial history of the USA, we can see that these are the points in history where recessions happened. And we can also see that the recessions of 1980, .2000 and 2010 had a high effect on the economy than that of 1990 one.

In 1980, the great recession hit the USA. In 2000, people started valuing software companies like crazy – at one position Cisco and Oracle were valued at growth rates such that, if those growth rates are to be true, the net revenue of the company will be greater than USA’s GDP. This is when the software fall happened. The probability of recession was high, and then the economy collapsed.

The case of 2008-10 was a more recent one with more information on it – people who have looked at software collapse started putting their money in houses. Financial companies went crazy in giving out loans and when the house prices reduced, people found no sense in paying back high amounts for a low-priced house. This led to a worldwide recession and we all know the results of that.

Limitations

Companies like Goldman Sachs are great at analyzing, but not at predicting. When 2008’s recession struck, Goldman was one of the first companies that needed bailing out. They bet that the economy will keep on raising and they failed to gauge the market. This goes to explain the limitations of a business cycle – people need to be aware of the fact that the future is not predictable. No matter how many variables we put in there is always an unknown. Still, we can always be aware of what might come up next and try to be prepared for that.

Conclusion

Looking at these business cycles is such a theoretical device. It tries to explain to us the way in which the economy works and how that can be used in decision making. Now that we know business cycles, can we predict the next recession? Probably no. But, we can always get prepared for it, knowing that it might come.