In these videos, we walk through 5 AUD practice questions in each to teach about business cycles. These questions are from AUD content area 2 on the AICPA CPA exam blueprints: Assessing Risk and Developing a Planned Response.
The best way to use each video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Understanding Business Cycles
Business cycles are the natural rise and fall of economic activity over time, typically measured by changes in Gross Domestic Product (GDP). These cycles affect employment, consumer confidence, business investment, and inflation, influencing both individuals and businesses. A full business cycle consists of four main phases: expansion, peak, contraction, and trough. Understanding these phases helps explain why economies grow, slow down, and recover.
Expansion: The Growth Phase
During expansion, the economy is growing, and business activity is increasing. GDP rises steadily as consumer spending strengthens, businesses invest in growth, and unemployment declines. Wages typically increase as companies compete for workers, and consumer confidence fuels further spending. The stock market often performs well in this phase, reflecting positive economic sentiment.
For example, in the mid-2010s, after recovering from the Great Recession, the U.S. economy experienced a long period of expansion. Unemployment fell to historic lows, companies reported strong earnings, and housing prices climbed. However, expansion also brings the risk of inflation, as rising demand can push prices higher, leading policymakers to consider interest rate increases to prevent the economy from overheating.
Peak: The Turning Point
The peak marks the highest point of economic activity before a downturn begins. GDP growth slows or stalls, businesses find it harder to expand, and inflation may reach concerning levels. Unemployment is typically at its lowest, but wage growth and hiring may slow as companies anticipate potential economic cooling. Stock markets may become volatile as investors question whether growth can continue.
A notable example of a peak occurred in late 2007 before the financial crisis. The housing market had soared, consumer spending was high, and unemployment was low. However, rising interest rates and an overheated housing market signaled that the economy was at its peak, and soon, conditions began to reverse.
Contraction: Decline and Recession
A contraction is the phase where economic activity declines. GDP shrinks, unemployment rises, and consumer and business spending slows. If a contraction lasts for at least two consecutive quarters (six months) of negative GDP growth, it is classified as a recession. During this time, companies cut costs, job layoffs increase, and the stock market may decline as investors anticipate weaker corporate earnings.
For example, the COVID-19 pandemic triggered a sharp contraction in early 2020, with GDP plummeting and millions of workers losing their jobs. Businesses shut down, consumer demand fell, and financial markets faced extreme volatility. Governments responded with stimulus measures to stabilize the economy and support recovery.
In more severe cases, a prolonged contraction can lead to a depression. Unlike a recession, which is typically shorter-term, a depression involves long-lasting economic hardship, high unemployment, and deflation. The Great Depression of the 1930s is a key example, where GDP fell sharply, unemployment exceeded 20%, and the economy took years to recover.
Trough: The Low Point Before Recovery
The trough is the lowest point of the business cycle, marking the end of a contraction and the beginning of recovery. Economic decline has bottomed out, and while conditions remain weak, some indicators show stabilization. Businesses begin hiring again, consumer confidence slowly improves, and GDP starts to rise.
An example of a trough occurred in 2009 following the financial crisis. Unemployment was high, but economic stimulus programs, lower interest rates, and improved credit markets helped turn the economy toward recovery. Slowly, businesses resumed growth, and the expansion phase began again.
The Business Cycle in Action
Business cycles are a natural part of any economy. While the length and severity of each phase can vary, the cycle itself remains consistent—expansion leads to a peak, followed by contraction and a trough, before expansion begins again. Various factors influence these cycles, including government policies, global events, consumer and business confidence, and financial market conditions. Understanding these patterns helps businesses and individuals make informed financial decisions, prepare for economic shifts, and recognize opportunities for growth.