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Set out the stages the business cycle passes through

CFA® Level I · Economics · Understanding Business Cycles · EC.2.a

The idea

The business cycle runs expansion, peak, contraction, trough, and back to expansion. In expansion, output and employment rise and inflationary pressure builds; the peak marks the turn. Contraction brings falling output and rising unemployment, and the trough is the low before recovery. Indicators are classified by timing: leading (new orders, building permits), coincident (industrial production) and lagging (unemployment duration). The cycle describes fluctuations around trend growth, not the trend itself.

A practice question

From the question bank, with the reason each wrong option is wrong.

The phases of the business cycle, in order, are:

  1. expansion, peak, contraction, trough — correct
  2. peak, expansion, trough, contractionWhy not: Puts each turning point before the movement that produces it. An expansion leads to a peak, not the other way round.
  3. trough, contraction, peak, expansionWhy not: Has the economy contracting out of a trough and expanding out of a peak, which reverses both directions.

Output rises to a peak, falls through the contraction to a trough, and recovers into the next expansion.

A harder one

Building permits are best classified as:

  1. a lagging indicatorWhy not: Lagging indicators turn after the economy does. A permit is filed before any building happens, so it turns early.
  2. a leading indicator — correct
  3. a coincident indicatorWhy not: Coincident series move with current output. A permit precedes the construction it authorises by months.

Permits are filed well before construction shows up in output, so they turn ahead of the cycle.

The hardest tier

New orders for consumer goods are rising while the average duration of unemployment is still lengthening. The economy is most likely:

  1. near a peak, beginning to contractWhy not: At a peak the leading indicators are the ones turning down first, while lagging measures still look strong. Here the pattern is inverted.
  2. in the middle of a sustained expansionWhy not: Mid-expansion the lagging indicators have caught up and are improving too. A lagging measure still deteriorating points to a turn only just under way.
  3. near a trough, beginning to recover — correct

Leading indicators turn up first while lagging ones are still deteriorating — precisely the pattern seen around a trough.

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