Financial Literacy for Everyone
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Economy 101: Business Cycles

Free market economies such as ours in the United States move regularly through consecutive phases of expansion and contraction know as business cycles.

During the expansion phase of a business cycle, jobs are created and incomes generally rise. Eventually, this upward trend reaches a peak of economic activity on the other side of which is an economic downturn, the contraction phase of the cycle. During this phase, sales and incomes generally decline and unemployment increases. This downturn ends in a trough of economic activity we know as a recession - or possibly a depression - after which the cycle reenters the expansion phase and starts all over again.

What Causes Business Cycles?

What causes the economy's cyclical movement through expansion and contraction? This has long been a topic of contention between varying schools of economic thought. The most widely accepted theory was first proposed by British economist, John Maynard Keynes, whose ideas are the basis for the school known as Keynesian economics. Roughly speaking, Keynes said that the ebb and flow of the business cycle could be attributed to the tendency of consumers to vary the amount of income they put back into the economy with the amount they put away for future consumption - spending versus saving.

Expansion

During an economic expansion, increased prosperity and consumer confidence results in increased spending - consumers feel confident in the economy, and as a result they buy more. Spending spurs an increase in demand for goods and services which further fuels economic expansion, but the increased demand also triggers an increase in prices for these same goods and services. As prices rise, consumers cut back on their spending, and companies, who now have entirely too much supply, cut back on inventory, production, and oftentimes employees.

Contraction

During the contraction phase, as businesses slow down, we typically see a rise in unemployment, and a dip in consumer confidence. We reduce spending; putting what little we have away for what seems an uncertain future. Oftentimes with the help of federal government stimulus and the implementation of monetary policy by the Federal Reserve, the downward trend eventually levels out. Over time, consumers regain confidence, and the cycle begins anew.

Business Cycles Vary in Length

Though the name implies regularity, business cycles are not neat and predictable affairs. They are the result of countless economic decisions made by innumerable business and government agencies, and they can vary in length from one year to as many as twenty years. So while we cannot predict the longevity of current or future business cycles, the National Bureau of Economic Research (NBER), a widely-respected organization of prominent economists and the national authority on the subject, has charted peak to trough durations for business cycles dating back to the 1850's in their ongoing effort to better understand the economy.



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