8.3: Business Cycle Stages

If you think of the business cycle as a dynamic process that grows and contracts on a continuous basis, then you’re doing just fine. The business cycle is dynamic, fluid, and most importantly, continuous. This may come as a surprise, but you and all the other market participants are in a business cycle right now!

The business cycle has four distinct stages:

• Stage 1: Trough to Recovery
• Stage 2: Recovery to Expansion
• Stage 3: Expansion to Peak
• Stage 4: Peak to Contraction

Figure 4

Stage 1: Trough to Recovery

Let’s examine the business cycle one stage at a time. In the simplified example above, Stage 1 shows economic activity contracting. This contraction could have been caused by a sudden downturn in demand that led to a reduction in production levels. With excess goods on-hand, firms lay off workers, reduce production, and cut prices. The economy is in a state of recession (we will discuss recessions in greater detail in the next section). Falling prices help stop the contraction by reviving demand and economic activity bottoms out (trough turning point).

Stage 2: Recovery to Expansion

With demand rising, firms slowly start to increase production and rehire workers. We are now in Stage 2. With more and more people back to work, incomes start to rise, and demand starts to increase without the aid of price cuts.

Stage 3: Expansion to Peak

In Stage 3, the economy is ‘hitting-on-all-cylinders’. Increasing incomes lead to increasing demand, which leads to increased pressure on production, which leads to increased bank activity to finance production expansion, which leads to an increased need for workers which leads to another increase in incomes.

Stage 4: Peak to Contraction

Since firms and households have access to the credit market, they can borrow money and spend more than they earn. And since lending activity increases during the expansion stage of the business cycle production levels become dependent on the continued availability of credit. In Stage 4 consumers’ debt burden becomes so heavy that they must reduce their consumption. This leads to a fall in demand and inventories of unsold goods, once again, start to build. Economic activity has peaked (peak turning point) and the contraction part of Stage 4 begins.

The causes behind each stage discussed in this unit have been hypothetical. There are numerous causes for the ebbs and flows of economic activity. The only aspect of business cycles that never changes is that each one is different in some way from the last (business cycles are like snowflakes; similar in some ways but each one is unique).