Phases of Business Cycles

Do you remember the global economic crisis of 2008-2009 that started in the USA? Stock markets across the world saw sharp declines and the global economy was jolted. Many MNC’s and banks shut down overnight. This crisis was actually the depression phase of a business cycle. Let us learn more about the phases of business cycles.

Business Cycles

If you see back in history you will notice every country has at some point been through an economic crisis of their own. In fact, there are ups and downs in the economic history of every single economy and nation in the world. These cyclic fluctuations in economic activity are what we call business cycles or trade cycles.

So there are good phases of business cycles with economic growth and expansion of the economy, a rise in GDP etc. And there are slowdowns and negative phases of business cycles with rising unemployment, high inflation, low GDP, negative growth etc. These phases are cyclic in nature and occur periodically in every economy.

Phases of Business Cycles

(Source: EconomicDecisions)

1] Expansion or Boom

This phase is characterized by an increase in output and employment. There is also an increase in the demand in the market, capital expenditure, sales and subsequently an increase in income and profits. This cycle will continue till there is hundred percent utilization of available resources.

And the production level will be at the maximum capacity. The unemployment rates will be zero with the exception of voluntary unemployment and frictional or structural employment (which is temporary).

In this phase both the prices and cost increase at a somewhat faster rate. But generally, the public enjoy prosperity and a higher standard of living. The growth rate will eventually deaccelerate as the economy approaches its peak.

2] Peak 

As the name suggests this is the highest point of all the phases of business cycles. At this point the output is maximum, and the involuntary unemployment is basically zero. As the economy goes through expansion, inputs become rarer. Their demands increase and so does their prices.

This leads to an increase in the price of consumer goods as well. Income does not see a proportional increase. So consumers have to review their expenses and cut back on their consumption.

Aggregate demand in the market will stagnate. This will mark the end of the expansion phase. The growth of the economy stabilizes at the peak for a short period. Then it goes in the reverse direction.

3] Contraction 

At the peak of an economy, demand is stagnant. Then very soon, demand starts falling in certain sections of the economy. This is the start of the contraction phase of the trade cycle, which is the opposite of the expansion phase.

Even the investment levels and employment levels decrease along with the demand. Now there is a mismatch between demand and supply in the market. Once producers become aware of the shift in the economy they start disinvesting, scaling back operations, canceling orders for goods and labor etc.

This will start a domino effect. Now producers of capital goods and raw materials will also start canceling orders and holding off investment.

At this turning point in the economy, the prices of the goods also fall. Income levels decreases which decrease consumer spending as well. The outlook about the economy is pessimistic and we will see a contraction in economic activities across all sectors. We call this phase recession

4] Depression 

Depression is the lowest of the phases of business cycles. It is a severe form of recession. In this phase, we will see a negative growth rate in the economy. There is a continuous decrease in demand.

The companies that cannot dispose of their stocks keep reducing the prices. Some companies will be forced to shut down due to mounting losses. This will adversely affect employment rates.

The capital and money market also suffer greatly. The interest rate is at its lowest. After this phase, the economy will recover by additional investments, and the business cycle will continue.

Solved Example on Phases of Business Cycles

Q: The process of recovery is initially felt in the ____ market.

1. Capital Goods
2. Capital
3. Labor
4. None of the above

Ans: The correct option is C. After the through comes the recovery phase. Investors take advantage of the lower costs and start to invest again. Unemployment causes a lowering in wage rates, and investors take advantage of this. So the reversal will be first felt in the labor market.