What are “Stages of the Economic Cycle”?
The economic, or business cycle is characterized by alternating periods of expansion and contraction (i.e., fluctuations) in economic activity. An awareness of the characteristics of each stage of the economic cycle is critical because it serves as the starting point for top-down financial analysis. A financial analyst must understand the numerous economic indicators available and how they relate to the economic cycle. The real gross domestic product (GDP) and the unemployment rate are the two most important economic indicators related to the economic cycle. These two indicators are used to identify which stage of the cycle the economy is in.
There are four stages in the economic cycle: expansion (real GDP is increasing), peak (real GDP stops increasing and begins decreasing), contraction or recession (real GDP is decreasing), and trough (real GDP stops decreasing and starts increasing). The four stages of the economic cycle are illustrated in the diagram below.
Key Learning Points
- The economic, or business, cycle refers to the stages of expansion and contraction observed in market-driven economies
- Knowledge of economic cycles and their characteristics serves as the starting point for top-down financial analysis
- Real GDP and unemployment are the two key economic indicators used in the analysis of the economic cycle
- Economic cycle analysis is best suited to market-driven economies
Stages of the Economic Cycle – Main Elements
An expansion features growth in most sectors of the economy, with increasing employment, consumer spending, and business investment. As an expansionary stage approaches its peak, the rates of increase in spending, investment, and employment slow but remain positive, while inflation accelerates.
A contraction or recession is associated with declines in most sectors, with inflation typically decreasing. When the contraction reaches a trough and the economy begins a new expansion or recovery, economic growth becomes positive again, and inflation is usually moderate. Still, employment growth may not start to increase until the expansion has taken hold convincingly. A recession is generally defined as two consecutive quarters of negative GDP growth and, therefore, worse than a contraction.
A generally accepted rule is that two consecutive quarters of growth in real GDP are the beginning of an expansion, and two successive quarters of declining real GDP indicate the start of a contraction. Analysts and statistical agencies that date expansions and recessions often examine several different economic metrics such as real income, employment, and industrial production, when identifying turning points in the business cycle.
Below is a multiple-choice question to test your knowledge. Download the accompanying excel exercise sheet for a full explanation of the correct answer