Modern economies undergo intervals of economic expansion followed by economic recession as indicated by their gross domestic product or GDP. In macroeconomics, this process is called the business cycle. The different series of intervals transpiring in a given period or periods are collectively referred to as business cycles.
Furthermore, aside from expansion and recession, there are other phases or stages within a single business cycle. These are the expansionary, peak, contraction or recession, trough, and recovery stages. The recovery stage is followed by an expansionary stage, thus restarting the cycle. This article defines these different stages of the business cycle.
The Five Major Stages of the Business Cycle in an Economy
An expansionary stage is characterized by rising economic activity as indicated by real GDP. The monetary value of all the finished goods and services produced within the borders of the involved economy within a given period increases.
In addition, during this stage of the business cycle, economic activity is rising above the long-term trend in growth. Earnings and actual profits of firms tend to increase due to an increase in the demand for goods and services.
Employment also increases as firms expand their workforce to increase their production capabilities or expand their respective business interests. The prices of goods and services also increase due to the expansion of the consumer base and its purchasing power.
Considering the aforementioned, note that this stage can also be determined by employment rate, levels of demand and supply, business earnings, positive investment landscape such as upward trends in the stock market, and increase in wages and incomes,
The peak stage is the highest point of economic activity. The economy reaches its full and maximum potential. For example, the profits earned by firms at are their highest level. The employment rate is at its highest as well while the workforce is receiving the most optimal income the economy can provide.
However, this stage also marks the end of economic expansion. The economy fundamentally reaches a saturation point in which the maximum growth limit has been attained and there is no more room for further expansion. The economic indicators do not advance further because they are at their highest level. The economy is at its maximum capacity.
Firms then start to face constraints in their production capacity. Supply for production inputs such as labor and raw materials becomes harder to secure, thus leading to higher business costs and shortages in end-use supplies. Prices are at their highest and consumers start to rethink their budgets and change their consumption patterns.
In the recession stage of the business cycle, economic activity starts to fall. This is also known as economic contraction. Remember that the peak stage marks the end of the expansionary stage and the beginning of the reversal in the trend of positive economic growth.
The demand for goods and services starts to decline both rapidly and steadily. However, most firms are unable to notice the immediate decline in demand. They go on producing output as scheduled, thus creating excess supply.
Excess supply starts to saturate different markets. Prices tend to fall as a result due to low demand and high supply. Other economic indicators such as business profits, output, employment, and wage start to move on a downward trend.
The trough stage is the lowest point of economic activity and the business cycle. The growth rate of the economy is negative as indicated by declining GDP numbers and in some instances, declining GDP growth rate. The aggregate production of the entire economy fundamentally falls at levels far behind the levels experienced at the expansionary and peak stages.
Furthermore, at this stage of the business cycle, the profits of firms are more likely to be at their lowest possible point. Some firms reduce their operations by cutting down their production and/or downsizing their workforces while others even close their businesses. Unemployment is on the rise and overall consumption declines.
Some instances of the economic trough create a vicious cycle in which contraction in business operations results in unemployment which in turn, further depresses demand due to the reduced buying capacity of the overall consumer base across different markets. Hence, in these instances, some firms are forced to shut down due to unsustainability.
The overall investment environment becomes dampened. Negative sentiments across individual and institutional investors become pervasive. Stock prices tend to fall and stock markets undergo a downward trend. In some cases, the inflation rate remains low due to excess supply but in other cases, the rate jumps up due to low supply and low demand.
The business cycle then enters a recovery stage either due to the fact that the economy and its markets are self-correcting or because of relevant government interventions such as expansionary fiscal policy and monetary policy.
Note that economic activity starts to rise. Profits of firms start to stabilize due to a steady rise in demand for goods and services. To meet this current demand and the project demand, these firms start to ramp up their productions.
Several investors start to capitalize on the possibility of full recovery and long-term economic growth by pouring in capital to firms. Firms expand using fresh influx of capital. Employment rises. The economy soon enters the expansionary stage, thus starting a new cycle.
Varieties in the Cycle and a Note on Economic Depression
The aforementioned stages of the business cycle represent the usual pattern of economic progress as observed in most countries and throughout history. However, in some instances, some economies underwent prolonged expansionary phases that lasted for decades while others experience sudden albeit short-lived recessionary phases.
China has been experiencing prolonged economic prosperity albeit with some minor dips in its growth trajectory. However, some economists believe that it will be close to impossible for it to experience economic growth below zero given its size, the interdependence of other economies, and the capabilities of its government.
Recessions due to the natural business cycle seem to have become less common after the Second World War. Hence, instead of the usual give-stage cycle, economists have focused on so-called growth cycles consisting of periods alternating between above-trend and below-trend growth. This is marked by an upward growth trajectory with minor dips in between.
Note that there are different reasons or factors behind the varying experiences of different economies. Some economies experience recession and depression due to factors such as weak business institutions, specifics of the political climate and competency of governments, and unforeseen events such as a widescale armed conflict or public health crisis.
It is also important to note the difference between recession and depression. Essentially, depression is a severe recession characterized by a longer period of stagnation in economic activity, including stagnated business activities and a high unemployment rate. An economy undergoing recession and trough does not mean it will undergo depression.