The business cycle is the term we give for the expansion and contraction of an economy. This is measured through Gross Domestic Product (GDP). GDP is the output and sale of goods and services in any economy measured over a period of time (usually one year). Traditionally, GDP is aggregated into four broad categories, as measured by the Bureau of Economic Analysis of the U.S. Commerce Department. These categories are represented in the following equation:
The largest component of GDP is Consumption Expenditure. How comfortable consumers are opening their wallets every month has an outsized effect on the GDP and the business cycle. Here is the relative value of the components of GDP for 2020 (estimated, as of June 2020) in current dollars:
The business cycle can be visualized as a graph of the value of GDP over
time. Its fluctuations from its trend line are the expansions and recessions of the economy. I show a close-up of the period from 2000 to 2016 so you can see more clearly the fluctuations in actual GDP from the trend line. The graph also includes the last two recessions, March 2001 to November 2001, and December 2007 to June 2009.
Figure 16.1.U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis; October 1, 2021.
The blue is the trend line of GDP growing and the red is the actual real GDP. The deviation in the actual from the trend is the business cycle. The gray bars show the time of official recessions. Note that GDP is below the trend during recessions, meaning GDP has decreased. Recessions have both a popular definition and an official definition. The popular definition is a drop in economic activity (a drop in GDP) for two successive calendar quarters (six months). On the other hand, the National Bureau of Economic Research (NBER), a group of academic economists from around the U.S., is the official arbiter of when we are in a recession and when a recession is over. The NBER defines a recession as follows:
A recession is a significant decline in economic activity spread across the economy, normally visible in production, employment, and other indicators. A recession begins when the economy reaches a peak of economic activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion.
The terms peak and trough are an analogy to a wave on the ocean:
Figure 16.2. Business Cycle by Azitony has been modified by Fred Rowland and is used under a CC BY-SA 3.0 License.
There have been several business cycles in the economic history of the United States. Here is a graph of GDP and recessions (in gray bars):
Figure 16.3.U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis; October 1, 2021.
The graph covers 1940 to 2020, so the drops in GDP during recessions may look small. However, note that in the Great Recession, GDP dropped 4.1% and 8,500,000 employees lost their jobs. One the last line in the chart above, it states that since the end of WWII there have been 12 business cycles (recessions and expansions) including the Pandemic Recession. On average, recessions have lasted on average 11.1 months, while economic expansions have lasted on average 64.5 months (a little over five years).
Does this mean that we can predict recessions? If that were possible, we could all become millionaires. As you will see from the graph below, the stock market (the S&P 500 Index) drops 6 months to one year before a recession and begins trending upward again 6 months or less prior to the end of the recession. That means if we could predict a recession, we could predict the stock market.
Figure 16.4. S&P 500 1955-2020 by Fred Rowland is used under a CC BY-NC 4.0 License. Source: Yahoo Finance, 12/3/2020.
Unfortunately, the time between recessions and, to a lesser extent, the length of recessions is too variable to be able to accurately predict them. At an economic conference, I was able to ask Robert Hall, Chair of the National Bureau of Economic Research Committee on Business Cycles and professor at Stanford University, whether anyone can predict recessions. Dr. Hall said no one can predict recessions accurately. There are several characteristics of the business cycle that may not be immediately apparent from the graphs and charts above but are important to understand. Dr. Daron Acemoglu of MIT states these:
- Many aggregate macroeconomic variables move together in the business cycle. In the NBER’s definition of a recession, they lay out the most important economic variables they use to determine the business cycle: “…real GDP, real income, employment, industrial production, and wholesale-retail sales” (NBER.org).
- It is very hard, if not impossible, to predict the turning points in the business cycle. As I mentioned earlier, Dr. Hall said it is impossible to predict recessions. It is equally impossible to predict the turning point of a recession, when the economic expansion begins.
- There is a persistence to the rate of economic growth. If the economy is growing in one quarter, it will likely grow in the next quarter as well. Contrariwise, if the economy is in a recession in one quarter, it is likely to decline again in the following quarter (Acemoglu, Laibson, & List, 2018).
There are strong psychological reasons for the persistence of the rate of economic growth. Economists today call them expectations of the future by consumers and firms. John Maynard Keynes, the father of modern economics, called these expectations animal spirits. We now call them consumer sentiment and business expectations. The fact remains that humans tend to think the near future will be a replication of the current time period and so act accordingly (this is an important tenet of Behavioral Economics.) Further, there are important economic reasons for the persistence of the rate of economic growth, mainly the circular flow of the economy:
Figure 16.5. The Circular Flow by Bureau of Economic Analysis (BEA), U.S. Department of Commerce, October 2014 is in the public domain.
In this simple model, there are two agents: individuals (or households) and businesses (or firms). Individuals sell their labor to businesses and receive income (wages) in return. Businesses use this labor along with factories, equipment, and raw materials (physical capital) to make goods and services. Businesses sell the goods and services to individuals who use the income they received for selling their labor to pay the businesses for the goods and services that the individuals buy (expenditures).
The circular flow of an economy contributes to the persistence of the trend of economic growth (or decline). Recessions most often begin when consumers slow down their spending on goods and services. Historically, this has been caused by a financial crisis of some sort that causes consumers to run up their debts too high. Consumers slow down their spending. The sales of businesses decline due to the decreased spending, usually first as a decline in consumer durables (Consumer durables are items that last three years or more, such as automobiles and appliances). With the decline in sales, the businesses decrease making goods and services.
Consumers buying fewer goods and services means that businesses do not need as many workers as they currently have. Because a recession is a short-term phenomenon, firms do not sell their factories and equipment; they just lay off workers. These layoffs mean a decrease in aggregate income for consumers overall, and this decreases aggregate expenditure on goods and services, leading to further layoffs. The initial drop in consumer expenditures in goods and services usually leads to further drops in consumer expenditures due to layoffs, making the recession worse. The circular flow also helps explain the persistence of economic growth. Increased purchases of goods and services by consumers results in businesses expanding production and hiring more workers. Then the increased aggregate income of consumers results in more purchases of goods and services and the hiring of more workers to make those goods and services. During these economic fluctuations, the hiring and firing of workers do not happen instantaneously, but they can happen pretty quickly and historically have always moved together. Another way of saying this is that there are lags in the co-movement of these two variables.
The Pandemic Recession was an exception to the historical start of a recession (financial crisis or excessive consumer debt) because the government-mandated COVID-19 lockdown resulted in massive layoffs of workers, especially in the hospitality industry. As you will see in the chapter on the Pandemic Recession, the U.S. government enacted a huge fiscal and monetary policy stimulus in order to counter the economic effects of the lockdown. Despite that, consumers hoarded their money, the result of consumer sentiment.
This is another example of the persistence of the rate of economic growth. When the economy is going up, it continues going up. When it is going down, it tends to continue going down. Of course, the government can do a lot of things to keep the economy rolling and a lot of things to help bring the economy out of a persistent recession.