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Economic Cycle – What It Is And How It Works

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learnbonds-glossaryAn economic cycle refers to the natural fluctuations of the economy between periods of economic growth (an expansion or boom), and periods of stagnation or decline (a contraction or recession).

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Economic cycles are measured by considering the growth rates of macroeconomic variables like real GDP, interest rates, levels of employment and consumer spending. Analysts and investors closely follow economic cycles because they provide important clues about how financial assets, including equities, bonds and commodities, may perform in the future.

When the economy shifts from one phase to another within the cycle, investors’ perceptions on what is a fair price to pay for financial assets change, causing the financial markets to fluctuate.

An economic cycle is identified as a sequence of four phases:

  • Expansion: During expansion, the economy is experiencing positive and increasing economic output. Unemployment tends to fall, and there is upward pressure on prices as output increases. Although interest rates are relatively low at the initial stages of an expansion, they begin to rise as the economic growth gathers pace.
  • Peak: At this point, the economy has produced the greatest amount of output, and employment is generally at or near its highest level. Interest rates also rise because investors and the Federal Reserve are concerned about the rapidly accelerating inflation. Rising interest rates make new homes less affordable, which leads to a number of layoffs in the housing sector and other interest-sensitive segments of the economy.
  • Recession: During this phase, output decreases, unemployment rises, and personal incomes dip. Interest rates are generally highest at the beginning of a recession and fall throughout this phase as the federal government intervenes to revive growth.
  • Trough: This is the lowest point of the cycle. Unemployment is at its peak and production is at a low. There is very little upward pressure on prices as businesses begin to lower prices to attract bargain hunters. New home sales often rise as buyers lock in attractive prices and low mortgage rates.

In the United States, the National Bureau of Economic Research (NBER), an independent economic “think tank”, analyzes economic indicators to identify the various phases of an economic cycle. The NBER’s seven-member Business Cycle Dating Committee uses quarterly GDP data as the primary indicator of economic activity. The Committee also uses monthly employment, real personal income, industrial production and retail sales figures to determine the key phases of the cycle.

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Causes of economic cycle:

What causes economic cycles is a complex question, which has inspired many economic theories. According to one such widely followed theory, economic growth causes demand and prices for goods and services to rise. As goods and services become more expensive, demand falls, leading to a slowdown in economic activity. This will, in turn, cause goods and services to become cheap again, which begins a new phase of growth in economic activity. In addition to demand and supply, another possible cause of recessions and booms is the Federal Reserve’s monetary policy. The Fed strongly influences the quantity and growth rate of money in circulation, and thus the level of interest rates in the economy. The Federal Reserve lowers interest rates to lift the economy from a trough, and raises rates during an expansion to avoid asset bubbles.

 

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David Waring

David Waring

David Waring was the founder of LearnBonds.com and has been a major contributor to the extensive library of investing news and information available on the site. Until the launch of Learnbonds.com in late 2011 there was no single site on the internet catering exclusively to the individual bond investor. This was true even though more individuals own stocks than bonds. Learn Bonds was launched to fill that gap.

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