Like human nature, the economy has its ups and downs. At times the economy can grow robustly, with household income rising, consumers happily spending, and companies hiring and expanding their business. However, there also are periods when the economy looks tired, with growth barely perceptible. There's less consumer shopping and little, if any, new business investment under way. In the most extreme case, the economy actually shrinks, which is what happens in a recession. Over time, however, recessions give way to a fresh round of economic activity. These swings, from good times to awful times and then eventually back to good times again, are roughly what we mean by a business cycle.
Why does the economy have such cycles? Why not have steady, continuous, non-stop growth? After all, that should make everyone happy.
The reason the economy is condemned to undergo business cycles is because it's only natural. An open economy is essentially a reflection of human behavior with millions of people making decisions every day. What should they buy? How much can they spend? Is it time to invest in stocks? Corporate leaders face different issues. Is it time to hire workers? Rebuild inventories? Buy another company?
Occasionally consumers and businesses make mistakes that can have broader economic consequences. Households might have borrowed so much that they're having difficulty servicing their debt. Banks could see their profits slip as loan defaults rise. Retailers might miscalculate by loading up their stockrooms with new goods just when consumers are cutting back on spending. If the mistakes are grave enough and widespread, they can lead to an economic downturn with people being laid off. Fortunately, the government has several tools at its disposal to revive growth again, such as lower interest rates, tax cuts, and greater federal spending.
The business cycle itself has five phases. The first phase refers the highest point of output the economy achieves just before it gets into trouble and turns down. After the peak comes phase two, which is the recession itself, a painful process whereby the economy actually shrinks. It saps the wealth and confidence of households and causes all sorts of financial distress for business. Such economic contractions can last six months or as long as several years. The third phase is reached when the economy finally hits bottom, a point known as the recession trough. The fourth occurs after the economy stops shrinking and resumes it growth path, or recovery. Finally, when the level of economic activity (or output) pushes past the previous high point, the business cycle marks the fifth and last phase, often referred to as the expansion.
Because a recession is an integral part of the business cycle, it's important to define just what we mean by that term. Many economists and journalists declare a recession when there are two back-to-back quarters of negative GDP growth. Those quarters equal six consecutive months where the economy is shrinking. However, that is a rough, finger-in-the-wind assessment. The real task of determining when a recession begins and ends is left to a select group of academic economists working under the National Bureau of Economic Research (NBER), a non-governmental and nonpartisan think tank based in Massachusetts. They make the call on whether the economy has turned down or up by evaluating several key economic indicators, such as job growth, personal income, industrial production, as well as the quarterly GDP figures.
According to the NBER, there have been 32 business cycles in the U.S. since 1854, with the average recession lasting 17 months. Since World War II, there have been 10 business cycles with recessions averaging only 10 months longwhich means the economy is now achieving longer periods of growth before getting into trouble. Just why the economy has been experiencing fewer recessions lately is a topic of debate among economists, though most attribute it to improved economic policymaking in Washington combined with a more versatile business sector.