What happens in the economy during the recessionary phase of the economic business cycle?

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• A business cycle is the periodic growth and decline of a nation's economy, measured mainly by its GDP.
• Governments try to manage business cycles by spending, raising or lowering taxes, and adjusting interest rates.
• Business cycles can affect individuals in a number of ways, from job-hunting to investing.

A business cycle, sometimes called a "trade cycle" or "economic cycle," refers to a series of stages in the economy as it expands and contracts. Constantly repeating, it is primarily measured by the rise and fall of gross domestic product (GDP) in a country.

Business cycles are universal to all nations that have capitalistic economies. All such economies will experience these natural periods of growth and decline, though not all at the same time. However, given the increased globalization, business cycles across countries tend to synchronize more often than they did before.

Understanding the different phases of a business cycle can help individuals make lifestyle decisions, investors make financial decisions, and governments make appropriate policy decisions.

Stages of a business cycle

Think of business cycles like the tides: a natural, never-ending ebb and flow from high tide to low tide and back again. And the same way the waves can suddenly seem to surge even when the tide's going out or seem low when the tide's coming in, there can be interim, contrarian bumps — either up or down — in the midst of a particular phase.

All business cycles are bookended by a sustained period of economic growth, followed by a sustained period of economic decline. Throughout its life, a business cycle goes through four identifiable phases: expansion, peak, contraction, and trough.

Expansion: Expansion, considered the "normal" — or at least, the most desirable — state of the economy, is an up period. During an expansion, businesses and companies steadily grow their production and profits, unemployment remains low, and the stock market performs well. Consumers are buying and investing, and with this increasing ›demand for goods and services, prices begin to rise too.

Several criteria determine whether the economy is in a healthy period of expansion: the GDP growth rate is in the 2% to 3% range, inflation is at the 2% target, unemployment is between 3.5% and 4.5%, and the stock market is a bull market.

Peak: The economy starts growing out of control once these numbers start to increase out of their healthy ranges. Any number of factors can throw the economy off balance. Companies may be expanding recklessly. Investors might become overconfident, buying up assets and significantly increasing their prices, which are not supported by their underlying value, creating an asset bubble. Everything starts to cost too much.

The peak marks the climax of all this feverish activity when the expansion has reached its end and indicates that production and prices have reached their limit. This is the turning point: With no room for growth left, there's nowhere to go but down. A contraction is forthcoming.

Contraction: A contraction spans the length of time from the peak to the trough. It's the period when economic activity is on the way down. During a contraction, unemployment numbers typically spike, stocks enter a bear market, and GDP growth is below 2%, indicating that businesses have cut back their activities. 

When the GDP has declined for two consecutive quarters, the economy is often considered to be in a recession. Even after a recession is officially over, that doesn't mean that the economy has returned to its original shape and size.

Read more: Recession vs depression

Trough: IF the peak is the cycle's high point, the trough is its low point. It occurs when the recession, or contraction phase, bottoms out and starts to rebound into an expansion phase — and the business cycle starts all over again. The rebound is not always quick, nor is it a straight line, along the way toward full economic recovery. The most recent trough was in April 2020.

Business cycles vs. market cycles

Though often used interchangeably, a business cycle is technically different from a market cycle. A market cycle specifically refers to the different growth and decline stages of the stock market, while the business cycle reflects the economy as a whole.

But the two are definitely related. The stock market is greatly influenced by the phases of a business cycle and generally mirrors its stages. During the contractionary phase of a cycle, investors sell their holdings, depressing stock prices — a bear market. In the expansionary phase, the opposite occurs: Investors go on a buying spree, causing stock prices to rise — a bull market.

How long does a business cycle last?

Business cycles have no defined time frames. A business cycle can be short, lasting a few months, or long, lasting several years. 

Generally, periods of expansion are more prolonged than periods of contraction, but the actual lengths can vary. Since the end of World War II, the average period of expansion in the US lasted 65 months, and the average contraction lasted about 11 months, according to the Congressional Research Service.

Most recently, the US hit a peak in February 2020, and before that was in a period of expansion that had lasted roughly 128 months, making it the longest in recorded history.

The many variables in an economy fluctuate differently over time, causing shifts in the economy, and non-economic factors, such as natural disasters and disease, play a part in shaping the economy as well. "Essentially, market economies want to expand, but if they're hit by an adverse shock, they may contract," says Vincent Reinhart, chief economist and macro strategist at Mellon Investments.

In recent history, the subprime mortgage crisis of 2007 was one such shock, and the onset of the COVID-19 pandemic in 2020 was another creating a two-month recession. 

What factors shape a business cycle? 

From technological innovations to wars, a variety of things can shift a business cycle's phases. But, according to the Congressional Research Service, the key influence boils down to the aggregate supply and demand within an economy — economist-speak for the total spending that individuals and companies do. When that demand decreases, a contraction occurs. Likewise, when demand increases, an expansion occurs. 

How supply and demand drives the business cycle

• In the beginning: The expansion happens because consumers are confident in the economy. They believe that employment is steady and income is guaranteed. As a result, they spend more, which leads to increased demand, which leads to businesses hiring more employees, and increasing capital expenditures to meet that demand. Investors allocate more capital to assets, increasing stock prices.
• Getting overheated: The expansionary phase hits a peak when the demand is greater than the supply, and businesses take on additional risks to meet increased demand and remain competitive.
• Scaling back: When interest rates rise quickly, inflation increases too fast, or a financial crisis occurs, an economy enters a contraction. The confidence that stimulated demand quickly evaporates, replaced with dwindling consumer confidence. Individuals save money rather than spend, reducing demand, and businesses cut production and lay off employees as their sales dry up. Investors sell stocks to avoid a drop in the value of their portfolios, which further drops stock prices.
• Hitting bottom: During the trough phase, demand and production are at their lowest point. But eventually, needs reassert themselves. Consumers slowly start to gain confidence as production and business activity start to improve, often spurred on by government policies and action. They begin to buy and invest, and the economy reenters the expansion phase.

How governments influence business cycles

The fact that business cycles move in natural phases doesn't mean they can't be influenced. Countries can and do try to manage the various stages — slowing them down or speeding them up — using monetary policy and fiscal policy. Fiscal policy is carried out by the government; monetary policy is carried out by a nation's central bank.

For example, when an economy is in a contraction, particularly a recession, governments use expansionary fiscal policy, which consists of increasing expenditures on government projects or cutting taxes. These moves provide increased levels of disposable income that consumers can spend, which in turn stimulates economic growth. 

Similarly, a central bank — like the Federal Reserve in the US — will use an expansionary monetary policy to end a contractionary period by reducing interest rates, which makes borrowing money cheaper, thus stimulating spending, and eventually the economy.

If an economy is growing too fast, governments will employ a contractionary monetary policy, which involves cutting spending and increasing taxes. This reduces the amount of disposable income to spend, slowing things down. To employ a contractionary monetary policy, a central bank will increase interest rates, making borrowing more expensive and therefore spending money less attractive.

The bottom line

Even though they seem like something that only affects "the economy," business cycles have plenty of real-world implications for individuals. Recognizing the current cycle can influence people and their lifestyle decisions.

For example, if we're in a contraction phase, finding work often becomes more difficult. Individuals may take up less-than-ideal jobs just to ensure they are making an income, and and hope for a better position once the economy improves.

It may also influence spending, especially when making huge decisions like buying a home or a car. "You're going to have to be cautious in terms of using your savings now because you may need them later," says Reinhart.

Understanding the business cycle is also crucial for investors. Knowing which assets — especially stocks — perform well in the different phases of a business cycle can help an investor avoid certain risks and even grow the value of their portfolio in a contractionary phase.

For example, certain industries remain crucial regardless of the current business cycle such as healthcare and energy. On the other hand, it may be best to stay away from speculative assets and high-risk stocks. When making these investment decisions, it's a good idea to start by looking at a company's balance sheet, which will tell you a company's assets and liabilities. A strong balance sheet has more assets than liabilities, even when the market looks like it's headed into a contraction phase.

Individuals can't do much on their own to affect a business cycle, and weathering its down phases can be tough. Still, it might help you sleep better at night knowing "it's a cycle and that we won't be there forever," says Reinhart. "Understanding the business cycle gives you at least a reassurance that there are [sic] a rebound and recovery to follow."

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