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What is a Business Cycle?

Definition: A business cycle, also called economic cycle, is a period of changing economic activity comprised of expansions and contractions as measured by real GDP. In other words, itís a period of time where the economy grows, peaks, shrinks, and bottoms out. Then the cycle repeats itself.

What Does Business Cycle Mean?

What is the definition of business cycle? A standard cycle has four main phases: expansion, peak, recession, and trough. As consumer confidence starts to build, the economy experiences an expansion. Employment, sales, production, income, and other economic indicators increase. Then some type of economic event happens and indicators start to lag. This is the peak.

Consumers typically become concerned about their finances and start saving more money and spending less, creating a recession. The same indicators that increased in the expansion now start to decrease. This continues until it hits rock bottom and rebounds. You can think of this like a wave of economic activity. The wave comes in, peaks, and descends until the next one comes in.

The average business cycle in the US is about six years. Weíve had approximately 11 business cycles since 1945. Investors and economists analyze these cycles to prepare for future investment, changing current investments, and even unemployment.

Letís look at an example.

Example

The business cycle since the year 2000 is a classic example. The expansion of activity happened between 2000 and 2007 was followed by the great recession from 2007 to 2009.

It started with the easy access to bank loans and mortgages. Since new homebuyers could easily afford loans, they purchased them. More and more homebuyers kept purchasing homes resulting in an increase in demand for homes. Thus, home prices started to increase.

The Federal Reserve continued to lower the interest rate and the Federal Government put specific guarantees on mortgages, allowing banks to lend money even cheaper. Since the government guaranteed the banksí money, they couldnít lose their money and started lending to anyone. They started allowing people to take two and three mortgages on a single home because the housing prices kept increases. People used this money to buy boats and cars thus increasing economic activity even more.

Since expansions and other phases in the economic cycle are measured in real GDP, this inflation gave a false impression of expansion, which led to over speculation. The peak of activity was in December 2007. At this point, people noticed what happened and housing prices started to fall. Additionally, the federal funds rate increased to combat excess borrowing causing interest payments on mortgages to increase. The increased interest rates coupled with the plummeting home prices left many homeowners with sub-prime loans that they would eventually default on.

The economy contracted from late 2007 until 2009 when it bottomed out and began to rebound thus completing the entire cycle.

Summary Definition

Define Business Cycles: Business cycle means the ups and downs or expansions and recessions of economic activity over a period of time.

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