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what is a business cycle

Comrehensive guide on what is a business cycle clearly outlines the structure, phases of the business cycle, impact on the economy and theories.

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Before we outline the details of what is a business cycle, it could be helpful to look at defintions of the foundation terms: ‘economy’ and ‘fluctuations’.

Economy: basically describes the overall state of a country’s economy and reflects its upswing and downturn. If the economy goes downhill, one speaks of an economic crisis, if it goes uphill and there is economic growth, then the term boom is used.

Fluctuations: These economic fluctuations result from an imbalance between supply and demand, which leads to an increased utilization rate of the production potential.

So… what is the business cycle?

Simply put, the fluctuations mentioned above can be broken down into the four business cycle phases (see section below), which have already been repeated several times in history.

The four described business cycle phases together then result in the business cycle. Private households, investments by companies, income and expenditure of the state as well as its import and export behavior have a decisive influence on the economic cycle, which means on the upswing and downturn in an economy.

Key facts about the business cycle

Definition of the economy:  macroeconomic activities
Definition of the business cycle:  ups and downs of an overall economy
4 phases of the business cycle:  boom, recession, depression, expansion
3 types of business cycle: Seasonal, business cycle, structural
Business cycle duration: 3 – 5 years

Business cycle is a central concept of the national economy and primarily provides information about the economic situation of a country.

In a “normal” economic environment , booms and downturns are perfectly normal. Different industries go through different economic phases independently of one another. In total, these are then considered across the entire economy and can be interpreted in the context of gross domestic product (GDP).

In order to be able to assess the business cycle of an economy, the utilization of the production potential is considered. That means: An economy has a certain amount of production capacities . These capacities can in use to varying degrees as indicated by the will demand in the market  affected is.

If the capacities are used to a limited extent , there is talk of a weak economy. When the workload is high , however, one speaks of a strong economy. Usually, however, no snapshot is taken, but a development is shown.

This describes the utilization in comparison to another period – for example the previous year.

This leads to the conclusion that the economy is developing in a certain direction. Since developments were found to be repetitive, individual business cycles were designed.

Low use of capacities = weak economy
Heavy use of capacities = strong economy

Phases of the business cycle

what is a business cycle (1)

In the theories of business cycles, the four economic phases listed above are also often named by other terms, including:

  • Upswing (expansion, recovery)
  • Boom (peak)
  • Downturn (recession, contraction)
  • Low phase (depression, trough)

The upswing phase or expansion is characterized by an increasing number of orders and higher utilization of production capacities. This goes hand in hand with falling unemployment , low price increases and rising interest rates, which are still at a low level.

In the economic cycle, the economic upturn reaches its peak during the boom . There is a  strong demand for goods and production capacities are fully utilized or almost overburdened. Hence, there is full or overemployment. Wages and salaries, as well as prices and interest rates, rise and there is a risk of  inflation . The growth of the gross domestic product (GDP) begins to level off and to decrease towards the end of the boom.

In the downturn , economic activity declines . Demand for goods, goods production, investments and profits are falling , while short-time working and  unemployment are  slowly rising . Prices and interest rates are high and are slowly beginning to decline. The general mood in the economy is pessimistic.

The low point reached the economic cycle in the depression . This is characterized by low capacity utilization and high unemployment. The income decline  and the demand for consumer goods will drastically. The stock prices fall , corporate profits and investments decrease and the price level decreases (deflation).

For example, if half of all motorists in the USA switch to bicycles, the bicycle industry will experience a boom from an economic perspective. On the other hand, the automotive and petroleum industries are falling into a depression.

Economics distinguishes 3 types of business cycle:

  • Seasonal cycles: only last a few months (winter in construction).
  • Economic fluctuations: Last several years. They result from an imbalance between supply and demand, which occurred after a time.
  • Structural fluctuations:  Can last up to 60 years. They result from a fundamental restructuring of an economic system. This could be due to changes in key industries. Structural fluctuations have a massive impact on the labor market.

The government of a country is hardly intervene if the economy in an expansion or a boom is.

recession is already viewed critically , a depression requires action on the part of politicians and the central bank . For the policy is to control  the means most used to the stimulus before slipping to a depression preserve . Direct subsidies and indirect subsidies in the form of tax breaks are the most common regulations.

On the part of central banks , interest rate cuts are the most popular means of providing liquidity and thus stimulating demand again .

Business cycle phase 1: upswing (expansion)

The economic upturn is often mentioned as the first phase . Such a development in the economy is of course best seen, and that is why the upswing is number 1. Here, upswing means that economic output grows and expands . Usually this phase comes after a crisis, so you can’t just create it from scratch.

When there is an upswing, private demand for consumer goods increases, and companies demand for capital goods. However, this is not a process that one state can accomplish on its own in a global world. Demand from abroad must also increase in order to be able to record an economic upswing for a country today.

The GNP/GDP will also rise during this economic trend. Production in companies is increasing and more jobs are being created. Analogously , the share prices of companies listed on the stock exchange are rising . However, the stock market now manages to rise even when the economy stagnates and only the central banks create money.

The upturn agrees with both a positive mood among market participants and positive expectations for the future. The boom or expansion is characterized by the fact that production and sales increase.  The unemployment rate is falling,  companies are expanding and more contracts are being placed.

The upswing (expansion) is characterized by the following criteria:

  • Unemployment is falling
  • Inventories are falling
  • Production rises again
  • Stock market prices rise
  • Deflationary price developments show slight signs of inflation
  • Increase in household consumption

Business cycle phase 2: boom

The second phase takes the form of a boom. Production capacities are fully utilized and the companies are making impressive  profits and sales .

However, there are always bottlenecks  in production . As a result of these shortages increase automatically the prices and thus usually also the wages . In turn, higher wages result in higher production costs.

In a globalized world , however, this is somewhat out of date : Today, production takes place where it is cheap and where there are tax advantages. Only the research and development of manufacturing companies usually remains in their own country.

Therefore, the classic business cycle in the globalized business world is partially outdated .

Conversely, this means that individual companies can certainly achieve a boom.

The peak of the boom is characterized by the following features:

  • No further price increases
  • Stagnation in sales
  • Smaller companies are disappearing from the market
  • Concentration and consolidation processes through takeovers

Business cycle phase 3: downturn (recession)

A boom is followed by a recession . Higher costs during the boom cause prices to rise while demand slowly falls again.

The cost pressure on companies increases and simultaneously shrink the profits . Theoretically, this means that share prices will also fall. Unemployment , short-time work and falling incomes are the result.

The downturn (recession) is characterized by the following characteristics:

  • High stocks
  • No investment
  • Decrease in overtime, increase in short-time work
  • Declining stock market prices
  • Rise in unemployment, lack of demand
  • Stagnating prices, hardly any wage increases

Business cycle phase 4: low phase (depression)

In the last phase of the economic trend the depression occurs. Companies are fighting against high costs with sharply falling sales. As a result, companies’ equity also shrinks . At the same time increase the interest on capital and companies go more often in bankruptcy . At the height of the  Depression  , money becomes “ cheaper” again because there is little demand for economic credit.

Few want to invest in a depression. As a result, prices level out again and there is a balance between supply and demand. Non-functioning systems die out and at the same time make room for new things.

During a depression, market participants are consistently pessimistic, but see positive signals in the future. The lowest point of performance is reached with the economic low, the depression.

An economic downturn is characterized by the following phenomena:

  • Massive rise in unemployment
  • Stock market prices are falling rapidly
  • There are deflationary tendencies in the price formation process
  • Investments no longer take place
  • Interest rates are falling to a low point
  • Increase in the shadow economy

How long is a business cycle?

The business cycles described often have a duration of 3 to 5 years . They are characterized by an imbalance between supply and demand. However, other economic fluctuations with different cycle lengths have been described in economic theories.

The so-called Kondratieff business cycles assume a duration of 40 – 60 years. This is less about supply and demand than about basic innovations that can give the economy a sustainable boost. The invention of the steam engine is considered one such innovation that has led the economy into a long-lasting boom.

However, very short-term business cycles are also possible. These are mostly due to seasonal fluctuations in supply and demand. For example, there can be seasonal fluctuations in the construction industry. 

What types of business cycles are there?

The economics distinguishes three types of economic cycles .

Seasonal fluctuations

Seasonal fluctuations are clearly one of the trends that only last a few months. Long-term trends do not classically fall under this term.

Seasonal trends always affect parts of an economy . For example, the asparagus season influences asparagus farmers and consumers who like to have asparagus on their plates.

Seasonal business activity has a broader impact on the entire retail sector during the Christmas season. Winter sports resorts and gastronomy are dependent on snow for their trend economy. In years with little snow, sales in the catering sector are also lower in these regions. Likewise, outdoor restaurants and other businesses that are dependent on fine weather have economic difficulties in cold summers.

Characteristics of seasonal fluctuations:

  • Seasonal changes in demand
  • Few, individual branches of the economy are affected
  • Predictable – entrepreneurs can adjust to this

Economic fluctuations

Economic fluctuations are of a medium-term nature. In contrast to the seasonal fluctuations, they affect the entire economic life and are therefore more difficult to handle.

Economic fluctuations are caused by imbalances between aggregate demand and aggregate supply. They are also influenced by delays in adjustment . The economic fluctuations are rhythmically recurring changes , the phases of which last between 1 and 4 years .

Characteristics of economic fluctuations:

  • Periodic (repetitive) fluctuations
  • Include several years
  • Not as regular as seasonal fluctuations
  • Are not predictable
  • Affect the whole economy
  • Can lead to serious economic crises
  • Due to far-reaching changes in demand (e.g. coal crisis, steel crisis)

Structural fluctuations

Structural fluctuations are long-term fluctuations. They usually last between 40 and 60 years . The reason for structural fluctuations are technical and social renewals and further developments (innovations). These usually increase the production potential with less work. This usually frees up high work capacities that can be used elsewhere.

The policy can not intervene in structural economic fluctuations. However, it tries to favor positive structural economic fluctuations within the framework of innovation policy.

Characteristics of structural fluctuations:

  • Due to far-reaching changes in demand (e.g. coal crisis, steel crisis)
  • Long lasting
  • Only affects a few branches of the economy
  • Requires lengthy adjustment processes
  • Lead to severe structural crises

Which indicators have an impact on the business cycle?

Business indicators are measured values that can be used to make statements about the business cycle of an economy. A distinction is made according to time and changes in price or quantity .

In some cases, the forecast of economic development is very subjective . But in general, various data on economic development can serve as economic indicators.

Since economic activity is extremely complex, measurement parameters are required to assess economic developments. These economic indicators are calculated and published by the Federal Statistical Office and various economic research institutes. These economic indicators are not only used by analysts, companies or the media. Central banks, business associations and governments also use them.

A major advantage of the indicators is that they can be used to get a quick overview of economic developments.

To be recognized as an indicator, it must have the following properties:

  • Theoretically plausible
  • Statistically appropriate in the calculation
  • Representative
  • High expressiveness

Since the economic indicators must also be up-to-date, the necessary economic data should be available quarterly or monthly. They must also have been collected over a long period of time. This is the only way to make a long-term comparison of economic developments over time. In this context, seasonal effects must always be deducted from the economic data, as otherwise a distorted picture of the economic development will arise.

The Federal Statistical Office in particular provides the data required for the economic indicators. Since 1950, the aim has been to show an overall picture of the economic structure and its course.

The most important economic indicators are those that either have a significant influence on the development of economies or on which such an influence is suspected by market participants.

One can quickly see whether an economic indicator is particularly important , among other things, by whether the publication of a key figure has an immediate  impact on the national and international stock and bond markets .

The main types of short-term indicators include:

  • Quantity indicators : They are based on the quantity development of a selected property. Quantity indicators are, for example, the number of unemployed or industrial production.
  • Price indicators: You can read off the price level or the price development from them. The price indicators include, among other things, share prices, property prices, the inflation rate, food and raw material prices or currency rates.
  • Leading indicators: These indicators are also called leading or leading indicators. They give pointers to the future development of the economic situation. Examples of leading indicators are the share index, the purchasing managers index, the consumer climate index, profit expectations or the commodities index.
  • Presence  indicators : Also called concurrent indicators, present indicators or actual indicators, provide information about the current economic development of an economy. They are collected using current values ​​such as consumption figures, a month’s gross domestic product, prices, stocks, industrial production or the current savings rate .
  • Lagging indicators: They are also known by the synonyms trailing or lagging indicators. Lagging indicators show the development of the economy in the past. Trailing indicators are the unemployment rate, the gross domestic product for a year, the inflation rate, bankruptcies and the state’s tax revenues.

Business cycle according to Kondratieff – theory of long waves

The Russian economist Nikolai Kondratieff developed the theory of long waves. This theory of cyclical economic development describes cycles that are triggered by basic innovations . Massive investments are made in the new technology (basic innovation), which leads to a general upturn.

Kondratieff assumes that such a long wave in average 52 years would take, with variations possible were. That in turn describes a duration of around  45 – 60 years .

Classification in the theories of business cycles

Basically, every market economy is affected by more or less regular fluctuations . The different types of fluctuations can be distinguished by the length of their cycles .

Seasonal fluctuations are having a duration of approximately 3 months . These are often due to the weather conditions. Economic fluctuations are due to an imbalance between supply and demand. The duration of these cycles is around 4 years.

Nikolai Kondratieff described structural fluctuations . These are accompanied by profound changes in production , the organization of work and also in society as a whole and have an extremely long duration (45 – 60 years).

The course of a business cycle according to Kondratieff

Kondratieff pointed out in his theory that the short and medium fluctuations are superimposed by long-term fluctuations.

At the beginning of a long wave, Kondratieff sees a basic innovation . Massive investments are being made in this new technology, which leads to a general upturn .

As soon as the new technology has established itself, investments decrease and the phase of downturn begins. In this phase, however, the innovation for the coming cycle is already being worked on.

As soon as the new innovation begins its advance , the business cycle has bottomed out according to Kondratieff and a new upswing begins .

The Kondratieff Cycles of the Past

When Nikolai Kondratieff published his theory in 1926 , he was able to refer to 2.5 cycles that could be determined up to this point in time.

The first cycle was triggered by the invention of  the steam engine and lasted approximately from 1780 to 1849 .

The second cycle lasted from 1840-1890 and was dominated by railways and steamers .

The development of electrical engineering and heavy machinery given the cycle of 1890 – 1940 , the economy in which the timing of the publication was from Kondratiev’s theory.

The continuation of his theory describes the fourth cycle from 1940-1990 . This was characterized by cheap energy and affordable cars for large parts of the population.

In the period since 1980/90 , information and communication technologies and the globalization of information and services associated with it dominate.

Summary of the Kondratieff cycles and the following:

  • 1st cycle: Invention of the steam engineDuration: 1780-1849
  • 2nd cycle: Dominance of railways and steamshipsDuration: 1840-1890
  • 3rd cycle: Development of electrical engineering and heavy machineryDuration: 1890-1940
  • 4th cycle: affordable energy and cars for large parts of the populationDuration: 1940-1990
  • 5th cycle: Information and communication technology (digitization)Duration: since 1980/90

Even if the actual existence and regularity of the Kondratieff cycles is controversial among economists , there are a number of predictions for the next cycle. An innovation is assumed that represents a major advance in productivity and the development of society .

Bio- or nanotechnologies are usually mentioned as possible developments . The development of nuclear fusion energy as the energy of the future could also play a decisive role.

The Keynes Business Cycle

The British economist John Maynard Keynes (1883-1946) developed a  business cycle theory that deals with the question of how to end or alleviate deflationDeficit financing plays a key role here, because this is the idea that Keynes’ approach is mainly based on.

If investments decrease and fewer new loans are taken out, there is a severe collapse in demand for goods. One reason for the frugality is often too high real interest rates. Those who spend their money in such times lose. Those who keep it gain purchasing power.

If the population and the companies sit on their money instead of spending it, then logically less will be bought. This fact ensures full stocks – which in turn leads to falling production .

The result is layoffs and many new unemployed . The basic requirements for deflation are thus in place, and a recession is the possible consequence. Keynes’ way out of this vicious circle is deficit financing .

Often called “deficit spending”  this concept is used by countries not affected by deflation . The government plays a decisive role in this . In contrast to supply policy, in which companies have the majority of decisions, politics should take the reins in hand here.

The aim is to create money that the state spends. Usually, a country then takes on new debt and awards contracts to companies . This creates an artificial demand that theoretically does not exist, but is realized by the government.

New orders mean increasing production and new jobs . The consequence is supposed to stimulate the economy. These approaches can counteract the recession.

Again you now (hopefully) have more people workingincreasing  the average income. If more is earned, more can be spent. This in turn leads to increased production and more jobs. If this pattern works as planned, it can save a country from deflation and generate increased economic growth.

Criticism of Keynes’ concept is that the state only supports certain industries. Basically, the construction and defense industries in particular benefit from government funding.

In addition, high government spending can lead to over-indebtedness and inflation . That is why there are many critics who are of the opinion that Keynes’ concept can not prevent an economic crisis . When the economy is in good shape, a state usually seldom reduces its debts.

Should one adapt their investment strategy to the economic cycle?

Some investment professionals consider business cycle and investment strategy to be an inseparable pair; others do not.

In their perspective, the stock market and the  economy are difficult to separate from one another. The movements on the stock exchange and in the market influence each other.

However, conclusions cannot always be made clearly. How strong the mutual effects are on each other differs each time individually.

Even if the relationship between the economy and the financial market does not always move in the same way, a kind of “rule of thumb” has been established over the years. It says that the stock markets are 6-9 months ahead of the economy.

One of the founders of this connection is the US market analyst Martin J. Pring. With his theory, he wants to invest successfully in all economic phases. He wrote this down in his book “The All-Season Investor”.

The core of his model: He has expanded the original economic model – consisting of upswing, boom, downturn and low point – to six economic phases. There are three phases in its economic cycle in which it is going downhill.

And three phases in which the economy is expanding. He assigns the theoretically ideal buy and sell points for stocks, bonds and raw materials to these phases.

This should enable investors to make profits in any economic situation. Many investment advisors still use this model.

According to Martin J. Pring’s analysis, the stock market leads the business cycle. For example, technology stocks are typical precursors. These industries are already fighting their way if the economy is still a long way from recovering. It is the same with base materials and industrial values. The shares of companies in this sector develop positively when the economy is still at its lowest point.

The best time to purchase of shares in Pring’s view is Pring Phase 2. It describes the low point of the recession .

You should sell the shares in Pring phase 5 . In Pring’s model it represents the peak of the boom . For bonds, phase 1 (downturn) would be the most suitable time to buy and phase 4 (strong upswing) would be the best time to sell .

For raw materials , according to Pring should be three phase (slight increase) bought and Phase 6 (downturn) got off to.

Even if the model has proven itself over the years and many still use it, there is no guarantee that it will really apply to reality.

Every business cycle is very different, and so do share prices. In addition to the economy, there are other factors that affect the stock market. Such as wars or disasters.