The Business Cycle: Mapping Economic Performance Over Time

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The Business Cycle: Mapping Economic Performance Over Time

Business Essentials · Chapter 2: Economic Systems and IndicatorsSection 2.4 · lesson 12 of 10515 min · free with a free account

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In this lesson

Reading where the economy is, when no one can say for sure.

  • Describe the four phases of the cycle
  • Distinguish the four types of unemployment
  • Classify leading, coincident, and lagging indicators
  • Match business decisions to each phase

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Economic Systems and Indicators

The Business Cycle: Mapping Economic Performance Over Time

Every economy breathes in and out. Activity expands, slows, contracts, and recovers. For a business, knowing where you are in that pattern shapes almost every big decision. The trouble is that no one can see the pattern clearly while it's happening. In this section we'll describe the four phases of the business cycle, and what officially counts as a recession. We'll look at how unemployment is measured, and why it comes in four different types. We'll sort economic indicators into leading, coincident, and lagging, and see why none of them is perfect. And we'll see how businesses respond in each phase, with the hardest calls coming right at the turns.

Business Cycle

A Pattern Without a Timetable

The business cycle is the recurring pattern of expansion and contraction in economic activity. Output, employment, and incomes rise for a while. Then they fall. Then they rise again. Market economies have shown this alternation for a very long time. But the word cycle carries a qualification that matters. It suggests regularity, like a pendulum swinging on a fixed beat. Actual cycles are irregular, in both length and depth. Expansions have lasted anywhere from a year or two to a decade. Contractions have ranged from brief and mild, to long and severe. So the pattern recurs, but there's no reliable timetable. A business that plans as though the next turn is due on a schedule will plan badly.

Figure 2.4.1

Four Phases, Two Turning Points

Economists describe the cycle in four phases. During an expansion, output rises, employment grows, incomes increase, and businesses and households grow more confident. Firms invest, hire, and borrow, and consumers spend. Each of those reinforces the others. The peak is the turning point where expansion ends, and activity begins to fall. A contraction follows. Output and employment fall, incomes come under pressure, and confidence is weak. Firms cut spending, delay hiring, and reduce their inventories. The trough is the turning point where contraction ends, and activity begins to rise. A new expansion starts from there. The whole cycle is measured from peak to peak, or from trough to trough. Notice where the danger lies. Within a phase, output, employment, and confidence move together. But at the two turning points, the phase isn't yet known. The evidence is mixed, and acting on the wrong reading is costly. That's why the hardest business decisions come at the peak, and at the trough.

Recession

Identified Only After the Fact

A recession is a significant decline in economic activity that's spread across the economy, and lasts more than a few months. You'll often hear that a recession means two consecutive quarters of falling real GDP. That's a popular rule of thumb, and a convenience. It is not an official definition. In the United States, peaks and troughs are dated by a committee of professional economists, at a private research body. The committee looks at a range of measures, including employment, income, and production. And it announces its decisions only some months after the event. So a recession is identified after the fact. That has a hard consequence for business. The people who must act are acting on incomplete information, in real time. By the time a downturn is officially recognized, a good part of it may already have happened. A depression is an especially severe and prolonged contraction. But the term has no fixed definition. It's used as a category, not as a measurement.

Unemployment

Who Counts as Unemployed

Employment moves with the cycle, and its most visible measure is the unemployment rate. In the United States, a person counts as unemployed if they have no job, are available for work, and have actively looked in the past four weeks. Someone waiting to be recalled from a layoff also counts. The labor force is everyone employed, plus everyone unemployed. The unemployment rate is the unemployed as a percentage of that labor force. Here's the catch. The rate alone can mislead. A person who has stopped looking for work is no longer counted as unemployed. They've left the labor force altogether. So the unemployment rate can fall because people gave up, not because they found jobs. That's why the labor force participation rate matters. It's the labor force as a percentage of the civilian population aged sixteen and over, outside institutions. The Bureau of Labor Statistics also publishes broader measures that include people who want work, but have stopped searching. Reading the rate together with participation gives a fuller picture than either one alone.

Four Types

Different Causes, Different Remedies

Unemployment is divided into four types, because they have different causes, and call for different responses. Frictional unemployment is short-term. People are between jobs, or entering the labor market, and searching for a suitable position. It exists even in a healthy economy, because matching people to jobs takes time. Structural unemployment comes from a mismatch. Workers' skills or locations don't fit the jobs available, often because an industry declined or technology changed. Cyclical unemployment is caused by a shortfall of demand during a contraction. It rises and falls with the cycle. Seasonal unemployment follows predictable patterns in the calendar, as in agriculture, tourism, and construction. Why does the distinction matter? Because the remedies differ. Policies that raise demand may reduce cyclical unemployment. Structural unemployment is unlikely to respond to them. It requires retraining, or relocation. Treat a structural problem as a cyclical one, and the remedy misses its target.

Economic Indicators

Leading, Coincident, and Lagging

The cycle can't be observed directly. So analysts follow economic indicators, measurable series that give evidence about the state of the economy. They're classified by timing. Leading indicators tend to change before the economy does. They're watched for early warning of a turning point. Coincident indicators move with the economy. They describe where it is now. Lagging indicators change after the economy has turned. They confirm that a turn has taken place. Leading indicators come with a serious weakness. They give false signals. A fall might reflect a temporary disturbance, like bad weather or a strike, rather than a change in direction. And consider a series that turned before each of the last three downturns. It may also have turned without any downturn. So treat indicators as evidence that adjusts the odds. Not as forecasts.

Table 2.4.1

Six Federal Indicators

Here are six indicators from federal sources, two in each class. New building permits for housing, from the Census Bureau, are leading. They reflect builders' expectations, because permits come before construction. They're a useful early warning, but local rules and interest-rate conditions affect them. Initial claims for unemployment insurance, from the Department of Labor, are also leading. They show the pace of new layoffs. Layoffs tend to rise before employment falls broadly. The claims data are timely, but volatile from week to week, and holidays distort them. Nonfarm payroll employment and industrial production are coincident. Payrolls count the jobs that exist now, though the figures get revised after first release. Industrial production measures current output of factories, mines, and utilities. It covers only part of an economy that's mostly services. The unemployment rate is lagging. It tends to peak after a recession ends, so it's reliable as confirmation, and poor as a warning. Commercial and industrial loans outstanding, from the Federal Reserve, are lagging too. Business borrowing adjusts after activity has changed. Put the reliability column together, and a trade-off appears. Leading indicators are timely but unreliable. Lagging indicators are reliable but late. No single series both warns early and is right. That's why analysts read a group together, and why turning points still get missed.

Responding by Phase

The Hard Calls Sit at the Turns

The cycle shapes the conditions of nearly every business decision. Demand, credit, input prices, hiring, and the cost of capital all move with it. A business doesn't choose its phase. But it does choose how prepared it is for the next one. These responses are general considerations. Any real business needs its own analysis. In an expansion, the risk is over-commitment. Demand is strong, credit is cheap, and it's tempting to build a cost base that assumes good times will last. Prudence means growing in steps that can be reversed, and building reserves while they're affordable. At a suspected peak, the evidence is mixed. Some indicators are turning, while others still look strong. Act early, and you risk a missed opportunity. Wait, and you risk being caught with too much capacity and debt. In a contraction, the priority is liquidity, the ability to meet obligations as they fall due. That means controlling costs, managing inventory tightly, and watching how customers pay. Firms with cash may even find opportunities, as assets and skilled workers get cheaper. At a trough, the difficulty is the reverse of the peak. Recovery has begun, but it isn't yet visible. Wait for clear proof, and competitors who moved earlier will have secured the position.

Industries and Policy

Who Feels It, and Who Responds

Industries differ in how they respond to the cycle. A pro-cyclical industry moves in the same direction as the economy, and by more. Its sales rise further in expansions, and fall further in contractions. Producers of durable goods and builders of structures are typical, because customers can postpone those purchases. A counter-cyclical industry moves against the cycle, or is much less sensitive to it. Some repair services and discount retailers hold up, or even grow, when households economize. So the same downturn calls for different decisions from a builder of new homes, and from a repairer of old ones. Governments, meanwhile, try to moderate the cycle. Fiscal policy uses government spending and taxation, for example spending more or cutting taxes in a contraction. Some of it works automatically. Unemployment insurance payments rise and tax receipts fall as activity slows, cushioning the decline without any new decision. How much fiscal policy can do is contested. Defenders say public spending can replace private spending that's been withdrawn. Critics say it can raise debt, divert resources from the private sector, and arrive too late. The empirical question is how large the effects are, and how long they take. The normative question is how to weigh stability now against the burden left for later. The other main tool is monetary policy, the central bank's management of money and credit, which chapter twenty-three develops.

Worked Application

Reading Six Signals at Once

Let's read a set of signals. An analyst at a regional lender reviews six readings at the end of a quarter. Building permits have fallen for three straight months, and initial unemployment claims have risen for six weeks. Those two leading indicators point toward a slowdown. Payrolls rose modestly, and industrial production is flat. The coincident indicators say activity is still positive, but no longer accelerating. The unemployment rate is low, and commercial loans are at a record. So the lagging indicators look strong. But they'd look strong just before a downturn too, because they change late. Their strength offers no reassurance. The correct reading isn't that a recession has begun, or that one is certain. It's that the balance of evidence has shifted. One leading indicator can turn without a downturn. Two moving together raise the odds. So the analyst can responsibly say three things. The risk of contraction has risen. The timing is unknown. And the lender should test its plans against a slowdown, as well as against continued growth. That's the honest position on forecasting. Professional forecasters have repeatedly failed to anticipate downturns. So plan for a range of outcomes, keep costs and commitments flexible, and treat any forecast as one input rather than a fact.

Case Vignette

Expanding at the Top

Our closing case is a composite, built for instruction, with illustrative figures. Marcus is the operations manager of a regional cabinetry manufacturer. After three strong years, his order book is full and lead times have stretched. The owner asks him to approve a new production line, financed by a loan. The signals conflict. Regional building permits have been flat for two quarters, and initial unemployment claims have started to rise. But employment is still growing, and his customers report no slowdown. Marcus knows the leading series give false signals. He also knows the lagging series would confirm a downturn only after the line was built. And his business is pro-cyclical. It has the most to lose from committing at a peak, and the most to gain from new capacity if the expansion continues. So he separates what is known from what is guessed. He proposes leasing equipment in two stages, with the second stage conditional on orders holding for another two quarters. The trade-off is a higher price for flexibility, and possibly some lost orders while the second stage waits. No available indicator can tell him whether this is a peak. So he chooses the option that can be reversed. Next, we turn to the other dimension of economic conditions every business must read, prices and inflation.

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FAQ

Questions students ask us

About The Business Cycle: Mapping Economic Performance Over Time

What are the four phases of the business cycle?
The four phases of the business cycle are expansion, peak, contraction, and trough. In an expansion, output, employment, and incomes rise; the peak is the turning point where expansion ends; in a contraction, they fall; and the trough is the turning point where recovery begins. Cycles are irregular in length and depth, and the hardest decisions come at the turning points, when the phase is not yet known.
Is a recession officially two quarters of negative GDP growth?
No, two consecutive quarters of falling real GDP is a popular rule of thumb, not the official U.S. definition. A recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months. The Business Cycle Dating Committee of the National Bureau of Economic Research dates peaks and troughs using employment, income, production, and other measures, announcing them months after the fact.
What are the four types of unemployment?
The four types of unemployment are frictional, structural, cyclical, and seasonal. Frictional is short-term job searching, structural comes from a mismatch between workers' skills or locations and available jobs, cyclical comes from weak demand during a contraction, and seasonal follows the calendar, as in agriculture or tourism. Policies that raise demand can reduce cyclical unemployment but rarely fix structural unemployment, which calls for retraining or relocation.
What is the difference between leading, coincident, and lagging indicators?
Leading indicators tend to change before the economy turns, coincident indicators move with it, and lagging indicators change afterward. Building permits and initial unemployment insurance claims are leading, nonfarm payrolls and industrial production are coincident, and the unemployment rate and commercial and industrial loans outstanding are lagging. Leading indicators warn early but give false signals, while lagging ones are reliable but late, so analysts read several together.

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