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What Is the Business Cycle?

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By Kimberly Amadeo. US Economy Expert

Kimberly Amadeo clarifies economic and business news. She explains how these trends affect you and, most important, the steps you need to take so you can profit now.

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Definition: The business cycle is the four phases of economic growth and subsequent decline. It's more commonly called the boom and bust cycle .

The goal of economic policy is to keep the economy in a healthy growth rate -- fast enough to create jobs for everyone who wants one, but slow enough to avoid inflation. Unfortunately, life is not so simple. Many factors can cause an economy to spin out of control, or settle into depression .

The most important, over-riding factor is confidence -- of investors, consumers, businesses and politicians. The economy grows when there is confidence in the future and in policymakers, and does the opposite when confidence drops.

The 4 Stages of the Business Cycle

There are four phases that describe the business cycle. At any point in time you are in one of these stages:

  1. Contraction - When the economy starts slowing down. It's usually accompanied by a bear market .
  2. Trough - When the economy hits bottom, usually in a recession .
  1. Expansion - When the economy starts growing again. It's usually signaled by a bull market .
  2. Peak - When the economy is overheated, and is in a state of "irrational exuberance ." This is when inflation rears its ugly head.

Who Determines the Business Cycle Stages?

The National Bureau of Economic Research (NBER) analyzes economic indicators to determine the phases of the business cycle. The Business Cycle Dating Committee uses quarterly GDP growth rates as the primary indicator of economic activity. The Bureau also uses monthly figures, such as

employment. real personal income, industrial production and retail sales .

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For this reason, the NBER has the final say on economic expansions and contractions, or business cycles.

What GDP Can You Expect in Each Business Cycle Phase?

In the Contraction phase, GDP  growth rates usually slow to the 1%-2% level before actually turning negative. The 2008 recession was so nasty because the economy immediately shrank 2.7% in the first quarter 2008, rebounded 2% in the second quarter, leading everyone to think the downturn was over. It fell another 2% in the third quarter, before plummeting a whopping 8.3% in the fourth quarter. The economy received another wallop in the first quarter of 2009, when the economy contracted a brutal 5.4%. (For more, see 2008 GDP Statistics )

In the Trough phase, GDP growth may still be negative, but it's not as bad. It's clear that the economy has turned a corner. According to the NBER. this occurred in the second quarter 2009, when GDP contracted a mere .4%.

In the Expansion phase, GDP growth turns positive again, and should be in the healthy 2-3% range. If the economy is managed well, it can stay in the Expansion phase for years. The current expansion phase started in the third quarter 2009, when GDP rose 1.3%. This was thanks to the stimulus spending from the American Recovery and Reinvestment Act. However, four years into the expansion phase, the unemployment rate was still above 7%. That's because the Contraction phase was so harsh.

The Peak phase is when the economy's expansion slows. It's usually the last healthy growth quarter before the recession starts. You usually don't know you are in a peak until it is too late. However, if the GDP growth rate is 4% or higher for two or more quarters in a row, you can bet the peak is not far off. In the 2008 recession, the peak occurred in the third quarter 2007. when the GDP growth was 2.7%.

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