Business Cycle

The business cycle is the recurring pattern of expansion and contraction in an economy's overall activity: output, employment, incomes, spending and profits rise together for a period, then fall together, then recover. Economists, central banks, governments, companies and investors all track where an economy sits in the cycle, because it shapes tax revenue, hiring, borrowing costs and asset prices.

The cycle is measured against a long-run trend of growth, so a "contraction" can mean outright decline or simply growth well below trend. It is closely tied to Recession, the downturn phase, and to the output gap, the distance between actual and potential output. In the United States the turning points are dated by a private research body, the National Bureau of Economic Research (NBER); other countries rely on statistical offices, central banks or academic committees.

Think of a busy high street over several years. For a while shops are full, owners hire extra staff, landlords raise rents and new cafés open. Then customers start holding back, a few shops close, staff are let go, and those people spend less, so other shops feel it too. Eventually prices and rents fall far enough, and enough confidence returns, that people start spending and opening businesses again.

The economy as a whole behaves the same way. Good times feed on themselves for a while, and so do bad times. The cycle is the name for this repeating swing. No two swings are the same length or depth, which is why it is a pattern rather than a timetable.

Most descriptions use four phases. They are easiest to see in quarterly gross domestic product and monthly payroll data:

• Expansion. Output and employment grow, unemployment falls, business investment rises and credit grows.
• Peak. Activity reaches its highest point; capacity is stretched, and inflation pressure is often building.
• Contraction. Output, jobs and spending decline across many sectors at once. A deep and long contraction may become an economic depression.
• Trough. Activity bottoms out and the next expansion begins, often helped by lower interest rates and government support.

The NBER describes a recession as a significant decline in activity that is spread across the economy and lasts more than a few months, judged on depth, diffusion and duration. Its chronology, which runs back to the 1850s, puts the most recent US peak in February 2020 and the trough in April 2020. Since the Second World War, US expansions have lasted years while contractions have averaged around ten to eleven months; the expansion from June 2009 to February 2020 was the longest on record. The euro area has a similar dating committee run by the Centre for Economic Policy Research. In the UK and much of the press, two consecutive quarters of falling real GDP is used as a rule of thumb, though it is not an official definition.

Quarterly growth is usually reported at an annualized rate in the US, so that a quarter's change can be compared with yearly figures. The calculation is:

• $g$ is the annualized growth rate, in per cent.
• $Y_t$ is real GDP in the current quarter.
• $Y_{t-1}$ is real GDP in the previous quarter.

If real GDP rises from 1,000 to 1,005 in a quarter, the quarterly change is 0.5%, and the annualized rate is $(1.005^{4} - 1) \times 100 \approx 2.0\%$. Most other economies quote the plain quarter-on-quarter or year-on-year change instead, so headline numbers are not always comparable. Because early estimates are revised, and because indicators such as jobs or incomes react at different speeds, analysts combine leading indicators, lagging indicators and real-time data to judge the phase.

There is no single accepted explanation, and the main schools emphasize different drivers:

• Demand-side views.Keynesian economics stresses swings in spending, especially investment, driven by expectations and confidence, amplified by the multiplier effect.
• Monetary views.Monetarists point to unstable growth in the money supply and policy mistakes by central banks.
• Real business cycle theory. Associated with Finn Kydland and Edward Prescott, who shared the 2004 economics Nobel, this view treats fluctuations as efficient responses to shocks in technology and productivity.
• Credit and financial cycles. The Austrian school and writers such as Hyman Minsky link booms to cheap credit and rising debt; researchers at the Bank for International Settlements describe a longer "financial cycle" in credit and property prices that can last 15 to 20 years.

Shocks from outside the economy, such as oil-price spikes, wars and pandemics, can trigger turning points in any of these frameworks. Earlier writers proposed regular cycles of fixed length (the short Kitchin inventory cycle, the 7–11 year Juglar cycle, and Kondratiev's long waves), but modern economists generally treat these regularities as loose at best.

Governments and central banks try to smooth the cycle rather than abolish it. Monetary policy cuts rates in downturns and raises them when the economy runs hot, often guided by rules such as the Taylor rule. Fiscal policy works partly through automatic stabilizers, such as falling tax receipts and rising unemployment benefits in a slump, and partly through discretionary stimulus. After the 2008 crisis, regulators also added macroprudential tools, such as countercyclical capital buffers, aimed at the credit side of the cycle. The fact that the cycle has not disappeared, despite periods such as the Great Moderation when it seemed tamed, is a reminder of how hard those tools are to time; see also boom and bust and overheating.

• National Bureau of Economic Research: US Business Cycle Dating
• Bank for International Settlements: The financial cycle and macroeconomics (Working Paper 395)