4.4.1 Phases Of Business Cycle

Phases Of The Business Cycle

Expansion or growth in the economy is measured by the increase in real GDP, while contraction is measured by a decrease in real GDP. The term “cycle” suggests a regular and predictable pattern, but in reality, fluctuations in real output are both irregular and unpredictable. This irregularity makes each business cycle unique. Nonetheless, a typical sequence of events occurs over a business cycle: expansion, peak, contraction, trough, and recovery. This sequence is illustrated in the figure below.

    graph TD;
	    A[Expansion] --> B[Peak];
	    B --> C[Contraction];
	    C --> D[Trough];
	    D --> E[Recovery];
	    E --> A;

Expansion

An expansion is a period of significant economic growth and business activity during which GDP expands until it reaches a peak. An economic expansion is characterized by the following:

• Inflation, with stable prices of goods and services.
• Businesses adjust inventories and invest in new capacity to meet increased demand and avoid shortages.
• Corporate profits rise.
• New business start-ups outnumber bankruptcies.
• Stock market activity is strong with rising markets.
• Job creation is steady and the unemployment rate is steady or falling.

Peak

The peak of the business cycle is the highest point between the end of an expansion and the start of a contraction. Characteristics of a peak include:

• Demand outstrips the economy’s capacity to supply.
• Labour and product shortages lead to wage and price increases, causing rising inflation.
• Interest rates rise, bond prices fall, business investment decreases, and sales of houses and other significant consumer goods fall.
• Business sales decline, resulting in unwanted inventory accumulation and reduced profits.
• Stock prices generally begin to fall along with declining profits, reducing stock market activity.

Contraction

A contraction is a period of economic decline indicated by negative GDP growth. If it lasts for at least two consecutive quarters, it is termed as a recession. Characteristics of a contraction include:

• Economic activity declines, leading to a decrease in real GDP.
• Businesses face unwanted inventories and declining profits, resulting in reduced production, postponed investment, curtailed hiring, and possible layoffs.
• Business failures exceed start-ups.
• Falling employment reduces household income and consumer confidence.
• Consumers spend less and save more, cutting further into sales and deepening the contraction.
• Stock market prices fall further.

Did You Know?

We live in a global economy. Canada’s consumers and businesses are affected by other countries’ economies. For example, an economic downturn in the U.S. can lead to reduced Canadian exports, negatively impacting GDP. Canadian firms may struggle to repay loans, increasing lending risk and leading to higher interest rates charged by lenders, further diminishing profitability.

Trough

As contraction continues, falling demand and excess capacity limit businesses’ ability to raise prices and workers’ ability to demand higher wages. The cycle reaches its lowest point, or trough, characterized by:

• Falling interest rates, which trigger a bond rally.
• Declining inflation.
• Postponed consumer purchases resume, spurred by lower interest rates.
• Stock prices rally.

Recovery

During recovery, the GDP returns to its previous peak. This phase typically starts with renewed purchases of interest rate-sensitive items such as houses and cars. Characteristics of recovery include:

• Businesses increase production to meet new demand after reducing inventories during contraction.
• Cautious business attitudes result in limited rehiring, though widespread layoffs end.
• Significant new investment is rare.
• High unemployment persists, wage pressure remains subdued, and inflation decreases further.

Another expansion begins when the economy rises above its previous peak.

Key Takeaways

• The business cycle consists of five phases: expansion, peak, contraction, trough, and recovery.
• Each phase has distinctive characteristics and impacts the economy differently.
• External economic conditions, such as a major trading partner’s recession, can significantly affect the domestic economy.
• Understanding the phases helps in making informed investment and business decisions.

Glossary

• GDP (Gross Domestic Product): Total value of goods and services produced within a country.
• Inflation: Rate at which the general level of prices for goods and services rises.
• Recession: A significant decline in economic activity across the economy, lasting for at least two consecutive quarters.
• Interest Rates: The cost of borrowing money expressed as a percentage.
• Bond: A fixed income instrument representing a loan made by an investor to a borrower.

Frequently Asked Questions

What defines the peak phase in a business cycle?

The peak phase is characterized by maximum GDP growth. Indicators include maximum employment, high production levels, and increasing inflation rates.

How does a contraction phase affect unemployment?

During contraction, businesses reduce or cease hiring, and there may be layoffs, leading to higher unemployment rates.

Why does interest rate fall during the trough phase of the business cycle?

Interest rates often fall during a trough to stimulate borrowing and spending, which can help initiate an economic recovery.

What triggers a recovery phase in the business cycle?

Lower interest rates and increased consumer spendingoften trigger recovery. External factors such as governmental fiscal policies can also play a significant role.