Lesson 2 of 6 · 15 min
The four phases, recessions and market behaviour
Measured against potential output, the cycle runs through recovery, expansion, slowdown and contraction, and each phase has a typical pattern of spending, hiring, inflation and asset prices that analysts use to locate the economy.
In short
- Recovery: economy passes through the trough; the negative output gap starts to narrow. Activity below potential but rising; unemployment still high; inflation moderate.
- Expansion: growth above average; a positive output gap opens (late on, a boom). Firms switch from overtime to hiring; inflation picks up; shortages and overinvestment can appear.
- Slowdown: output is furthest above potential (largest positive gap) and the gap starts to narrow. Hiring slows, unemployment still falls but more slowly, inflation keeps rising.
- Contraction: output falls below potential; confidence drops; firms cut hours, then overtime and hiring, then jobs. Unemployment rises; inflation slows with a lag. A severe one is a recession or depression.
- Rule of thumb: a recession = two consecutive quarters of negative real GDP growth. Dating committees (e.g. the NBER) look at many series and decide with a long delay.
- Markets look ahead: equities typically bottom 3–6 months before the economy; safe assets (government bonds, utilities, staples) are prized in contractions.
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