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IB DP Economics Study Notes

3.1.4 Business Cycles

Business cycles characterise the periodic but irregular up-and-down movements in economic activity. The cyclical movements involve shifts over time between periods of relatively rapid growth of output (recoveries and booms) and periods of relative stagnation or decline (contractions or recessions). Here's a deeper dive into the phases, causes, and economic indicators associated with business cycles.

A graph of business cycle

A graph illustrating a typical business cycle.

Image courtesy of businessinsider


The business cycle is typically divided into four primary phases:

1. Expansion

  • Definition: The expansion phase, often referred to as a boom or upswing, denotes a period during which an economy witnesses a sustained increase in the levels of GDP, employment, and output.
  • Characteristics:
    • Increased Production: Businesses typically increase production in response to expected rises in consumer demand.
    • Employment Growth: Firms tend to hire more to accommodate and further drive the increased production.
    • Rising Stock Markets: Bullish stock market trends often reflect the optimism of investors.
    • Consumer Optimism: As jobs become more abundant and wages increase, consumers are more willing to borrow and spend, further fuelling the expansion.

2. Peak

  • Definition: The peak represents the zenith of an expansion phase, marking the moment the economy transitions from the end of growth to the beginning of contraction.
  • Characteristics:
    • Maximum Output: Production and employment rates are at their highest.
    • Inflationary Pressures: Due to the heightened demand, prices often rise, leading to potential inflation.
    • Potential Overconfidence: Overenthusiastic investments might be made, not always backed by real demand or value.

3. Contraction

  • Definition: Following the peak, the economy begins to shrink. This downturn or decrease in the rate of economic growth is called contraction.
  • Characteristics:
    • Reduced Consumer Spending: Households might cut back on expenses, leading to a decrease in aggregate demand.
    • Job Losses: As demand falls, firms may need to lay off workers, leading to rising unemployment.
    • Falling Stock Markets: Pessimism in markets can lead to declining stock prices.
    • Credit Crunch: Banks and financial institutions might tighten lending standards, further reducing spending and investment. Understanding the limitations of fiscal policy is crucial during these phases.

4. Trough

  • Definition: The trough phase is the nadir of the contraction phase, indicating when an economy transitions from shrinking to growing.
  • Characteristics:
    • Stabilising Employment and Production: The rate of layoffs and production cuts may begin to slow.
    • Lowest GDP Levels: The economy's output is at its minimum in the cycle.
    • Potential for Renewed Confidence: As conditions no longer worsen, businesses and consumers may grow hopeful about future prospects. The phase of renewed confidence is a good moment to revisit the types of monetary policy that can aid recovery.
A graph illustrating business cycle of the UK

Image courtesy of economicshelp


Various factors influence business cycles:

1. External Shocks

  • Examples: Wars, oil price shocks, natural disasters, or global pandemics.
  • These unexpected events can jolt an economy, either boosting it (e.g., reconstruction post-disaster) or contracting it (e.g., trade disruption due to war). The impact of these shocks often highlights the limitations of monetary policy in managing the economy.

2. Financial Factors

  • Banking panics: Widespread panic regarding a bank's ability to meet its obligations can lead to a cascade of bank runs.
  • Credit cycles: Relaxed lending might lead to booms, while tighter lending can lead to recessions.

3. Government Policies

  • Monetary Policy: Central banks control interest rates and money supply, potentially stimulating or slowing economic growth.
  • Fiscal Policy: Increases in government spending or decreases in taxes can provide short-term economic stimulation.

4. Technology and Innovation

  • New Technologies: The introduction of new technologies can spur economic growth.
  • Obsolescence: Conversely, sectors relying on outdated technologies might face contractions.

5. Consumer and Business Confidence

  • Confidence Shifts: Perception about future economic conditions can be self-fulfilling. Optimism can lead to economic booms, while pessimism can contribute to downturns. This is where understanding the government and market failures can be particularly insightful.

Economic Indicators

These metrics provide insights into where an economy stands within the cycle:

1. Leading Indicators

  • Definition: Predict upcoming economic activities.
  • Examples:
    • Business Orders: An increase in orders might indicate businesses expect increased activity.
    • Building Permits: A surge might signal a near-future boom in the construction sector.
    • Inventory Levels: Declining inventories can suggest businesses anticipate higher demand. It's essential to also consider the effects of externalities and welfare loss on the economy.

2. Coincident Indicators

  • Definition: Reflect the current state of the economy.
  • Examples:
    • GDP: Real-time changes in GDP can show an economy's current health.
    • Personal Income: Increases or decreases can signify the direction of economic activity.

3. Lagging Indicators

  • Definition: Confirm the patterns or trends of an economy, giving evidence after the fact.
  • Examples:
    • Unemployment Rate: Typically, unemployment peaks after a recession has already begun.
    • Corporate Profits: Declining profits often follow an economic downturn.

The intricacies of business cycles are vast, but by understanding its dynamics, phases, and the indicators that guide interpretations, students can better appreciate the complexities of macroeconomic management.


Consumer and business confidence play pivotal roles in the business cycle. When confidence is high, consumers are more likely to spend and take on debt, while businesses might increase production, hire more workers, and invest in new projects. This can amplify the expansion phase. Conversely, if consumers fear future economic downturns or job losses, they might curtail spending, and businesses might cut back on production, investment, and hiring. Such behaviour can deepen a contraction or even trigger one if the drop in confidence is substantial and widespread. In essence, confidence acts as a forward-looking indicator, shaping economic behaviours and influencing the cycle's progression.

In the face of a prolonged contraction phase, governments often adopt expansionary fiscal and monetary policies. Fiscal policies might include increased government spending on public projects to stimulate demand, tax cuts to increase disposable income, or providing subsidies to key industries. Monetary policies could involve reducing interest rates to make borrowing cheaper, thereby encouraging spending and investment, or implementing quantitative easing to increase the money supply. Such interventions aim to boost economic activity, combat rising unemployment, and restore consumer and business confidence.

All economies are susceptible to business cycles, but the intensity, duration, and nature of these cycles can vary widely. Some economies, particularly those heavily reliant on a single resource or industry, might experience sharper and more frequent fluctuations, while diversified economies might have more muted cycles. Economies with strong institutional frameworks, effective macroeconomic policies, and robust financial systems might be better equipped to manage and mitigate the adverse effects of downturns. However, no economy is entirely immune to the forces that drive the cyclical nature of economic activity.

No, an economy cannot remain in the expansion phase indefinitely. While it is desirable for an economy to experience sustained growth, there are natural limitations. As the economy expands, resources can become scarce, leading to increased costs. Over-optimism can lead to speculative bubbles, and mounting debt can become problematic. Additionally, external shocks, technological changes, or macroeconomic policies can influence the economy's trajectory. Overheating, where growth is too rapid, can also lead to inflationary pressures. Eventually, these factors, among others, can lead to the economy peaking and then entering a contraction.

It's called a 'cycle' primarily due to the recurring nature of the phases: expansion, peak, contraction, and trough. Although real-world economies don't move through these phases in a regular or entirely predictable manner, over a longer duration, economies tend to exhibit patterns of growth followed by decline and then recovery. The term 'business cycle' encapsulates this observed cyclical behaviour, even if the exact timings, durations, and intensities of each phase vary due to a multitude of factors, both internal and external to the economy.

Practice Questions

Describe two phases of the business cycle and explain how external shocks can influence each phase.

The expansion phase of the business cycle represents a period of sustained economic growth, characterised by increased production, employment growth, bullish stock market trends, and consumer optimism. Conversely, the contraction phase sees the economy shrink, with reduced consumer spending, rising unemployment, declining stock markets, and tightened lending conditions. External shocks, like an oil price spike, could shorten the expansion phase by increasing production costs, reducing consumer purchasing power, and leading to lowered business confidence. In contrast, a global pandemic could exacerbate a contraction, intensifying job losses and dramatically decreasing consumer spending due to lockdowns or health concerns.

How can leading and lagging economic indicators assist policymakers in making informed decisions about the state of the economy?

Leading economic indicators, like business orders or building permits, predict upcoming economic activities, giving policymakers foresight into potential economic trends. An uptick in these indicators might suggest an imminent economic upswing, allowing for pro-active policy adjustments. On the other hand, lagging indicators, such as the unemployment rate or corporate profits, confirm economic trends after they've occurred. A rise in unemployment, typically peaking after a recession has begun, gives evidence of an economy's downturn. Policymakers can use this information to design responsive policies, such as stimulus packages, to counteract or stabilise negative impacts, ensuring the wellbeing of the economy.

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Written by: Dave
Cambridge University - BA Hons Economics

Dave is a Cambridge Economics graduate with over 8 years of tutoring expertise in Economics & Business Studies. He crafts resources for A-Level, IB, & GCSE and excels at enhancing students' understanding & confidence in these subjects.

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