What is the business cycle?

The business cycle is a theoretical model that tries to show how national economies expand and contract in a cyclical pattern. 🔃 While it’s a widely cited term, it should be remembered that the model is just a theory, and there’s no guarantee that each stage of the business cycle will follow the order that’s laid out in the model.

 

What is economic expansion?

Economic expansion happens when productivity and spending are increasing – people buy more goods and services, which means that companies make more products, putting more demand on output from supply chains. 🏗️

All of this usually results in rising employment, meaning that even more people have even more money to spend in the economy – which compounds the expansion. At the most basic level, economic expansion boils down to everyone wanting ‘more’.

 

What is economic contraction?

Economic contraction happens when productivity, manufacturing and spending are all slowing down. 🐌 This could happen for a number of reasons – for example, if interest rates are high, people have more incentive to put their spare cash into a savings account rather than spend it on themselves.

Economic contraction can be summed up by people wanting ‘less’ – often because unemployment is rising and times are tough. This can lead to stagnation (an extended period of little or no economic growth).

 

Stages of the business cycle

Although we’re talking about economic expansion and contraction, there are actually four distinct stages to the business cycle: expansion, peak, contraction and trough. Here’s what each of them means.

 

  • Expansion is when the economy is behaving as it should – production is increasing, employment is rising and the standard of living generally increases. There’s more money in the economy, so consumers have more cash to spend on themselves, which increases the demand on goods and services.
  • Peaks come when consumers are starting to ease back on their spending. Maybe they’ve bought everything they wanted to for the time being, and now they’re saving up for a bigger purchase.
  • Contraction starts after the peak has reached its maximum – people stop buying things and economic conditions change from ‘more more more’ to ‘not as much’. Production slows as demand falls, and unemployment might rise as companies make cuts to their workforce. It’s in this stage that recessions can sometimes set in. 
  • Troughs usually represent successful measures to halt contraction, because things slowed down so much that intervention was needed. Maybe the government cut payroll taxes for corporations to encourage them to hire more workers. And, perhaps companies have cut their prices to encourage consumers to purchase their products. After the trough, things will cycle back to expansion as people start to buy more and the process repeats itself.

 

 

How does the business cycle affect investments?

The business cycle affects your investments because the stock market rises and falls in value, depending on the stage of the business cycle we’re currently in. Periods of expansion will result in economic booms in the stock market – leading to rising stock prices across the board and fuelling an increase in the value of key stock market indices.

But, periods of contraction or troughs in the business cycle could mean that your investments fall in value as recessions set in. That’s because periods of contraction mean that people have less money to spend on shares, which will reduce demand and bring prices down. 📉 If you’ve invested in a tracker fund that follows a key index, it’s not uncommon to experience a decline in the value of your investments when economies are contracting.

Learn more about our fund range

When you invest with us, you’ll need to decide on a product as well as the funds you want to invest in. For tax-efficient exposure to the stock market, we’ve got a Stocks & Shares ISA – which lets you invest up to £20,000 a year without paying any tax on any of your gains. 

If you’ve hit your £20,000 annual ISA allowance, we’ve also got a General Investment Account (GIA). But, you won’t receive the same tax breaks on a GIA that you get with a Stocks & Shares ISA.

 

All investing should be long term (min. 5 years). The value of your investments can go up and down, and you may get back less than you invest. Tax treatment depends on individual circumstances and is subject to change.