Understanding the Business Cycle | CFA Level I Economics

In this lesson, we’ll discuss the four phases of the business cycle, and how resource use, housing sector activity, and external trade sector activity vary as an economy moves through the business cycle.

What Are Business Cycles?

According to Burns and Mitchell’s seminal 1946 definition, a business cycle represents fluctuations in aggregate economic activity within nations that engage in business enterprises. These cycles encompass phases of economic expansions and contractions, affecting various economic indicators. Notably, business cycles are recurrent but not periodic, varying in duration and intensity.

Types of Business Cycles

• Classical Cycle: Focuses on overall fluctuations in economic activity, typically measured by GDP. These cycles oscillate around the economy’s long-term potential or trend growth level, with expansions generally outlasting contractions.
• Growth Cycle: Concentrates on fluctuations around the long-term trend growth, highlighting the deviation of actual economic activity from its trend growth. This type provides insights into short-term economic dynamics.

• Growth Rate Cycle: Involves fluctuations in the growth rate of economic activity, with the growth rate cycling between positive (expansion) and negative (contraction) phases.

In practice, economists may refer to any of these definitions when discussing business cycles, with the CFA Institute showing a preference for the growth cycle concept.

Phases of the Business Cycle

The business cycle has four phases:

• Recovery or Trough Phase: GDP stops decreasing and begins increasing.
• Expansion Phase: Real GDP is increasing.
• Peak Phase: Real GDP stops increasing and begins decreasing.
• Contraction or Recession Phase: Real GDP is decreasing.

Business cycles can be thought of as fluctuations around the trend growth of an economy. Let’s explore each phase in more detail.

Recovery Phase

During the early expansion or recovery phase, companies stop laying off workers, consumer and business spending slowly pick up, and inflation remains moderate. Businesses are typically cautious in hiring, so unemployment remains high. Housing and consumer durables are some sectors that see an increase in demand.

Expansion Phase

In the expansion phase, business activity accelerates quickly. Unemployment rate falls as businesses increase hiring to meet rising demand. Consumer spending increases broadly, and businesses also invest in new projects. Inflation picks up modestly as prices often lag behind demand.

Peak Phase

At the peak phase, business activity starts to decelerate. Businesses slow their rate of hiring, and the unemployment rate continues to fall but at a decreasing rate. Spending is still increasing, but the rate of spending starts to slow. Inflation accelerates during this stage.

Contraction Phase

Following the peak, the contraction phase begins, during which business activity declines. Businesses start laying off workers, causing the unemployment rate to rise. Both consumer and business spending fall, and inflation decelerates, albeit with a lag.

One key aspect of business cycles is that they recur, but not at regular intervals. Past business cycles have been as short as a year or longer than a decade. A common rule of thumb is to consider two consecutive quarters of growth in real GDP as the beginning of an expansion and two consecutive quarters of declining real GDP as indicating the beginning of a recession.

Resource Use Fluctuations Throughout the Business Cycle

There are three key components of resource use fluctuations throughout the business cycle: inventory, labour, and physical capital.

Inventory

Inventories are an important business cycle indicator. Firms try to balance between keeping enough inventory on hand to meet sales demand, but do not want to keep too much of their capital tied up in inventory.

• At the start of a recovery, the inventory-to-sales ratio is normal, as firms have reduced production levels due to low demand during a recession.
• During the expansion phase, the inventory-to-sales ratio increases toward normal levels as firms increase output to meet rising demand.
• When an expansion approaches its peak, sales growth slows, and unsold inventories accumulate, causing the inventory-to-sales ratio to rise above its normal level. Firms respond by reducing production, leading to a subsequent contraction in the economy.

As an analyst, be on the lookout for abnormal increases in inventory levels. If the increase is planned, it could mean firms are anticipating higher demand soon. If the increase is unplanned, it could be an early sign of a recession forming.

Labour

Firms typically refrain from making significant workforce adjustments in response to the business cycle due to the costs involved and the potential damage to employee loyalty and morale. Instead, firms manage early pick up in demand by adding overtime hours to the current workforce and only start hiring more if the increase in demand becomes unmanageable.

Similarly, early stages of a slowdown are managed by reducing overtime hours. Only if the recession is expected to be deeper and longer will the firm consider downsizing the workforce.

Physical Capital

Adjusting production levels by frequently buying and selling plant and equipment is costly for firms. They first adjust their production levels to increased demand by using their existing physical capital more intensively. As an expansion persists, firms will increase their production capacity by investing more in plant and equipment. When demand starts to slow, firms will not necessarily sell plant and equipment outright. If the contraction is likely to persist, they can reduce their physical capacity by spending less on maintenance or retiring equipment that is near the end of its useful life.