Business Cycles, Economic Policy and Indicators

An adviser does not need to forecast the economy, but clients will ask what a recession, a rate hike or a jump in inflation means for their money, and the Series 65 expects you to answer. This chapter builds the toolkit. You will start with supply, demand and the way economists measure output, then follow the business cycle through its phases, see how the Federal Reserve and Congress try to smooth it, learn how inflation is measured and who it hurts, and finish with the indicators that signal where the cycle is heading. Exam questions here are mostly cause and effect: "If the Fed sells Treasury securities, what happens to bond prices?" or "Which indicator would an analyst use to forecast a turn?" Chapter 2 picks up interest rates, yield curves, credit spreads and international factors.

1.1Supply, Demand and Measuring the Economy

Every economic headline you will read in this chapter traces back to two forces: how much people want to buy and how much producers want to sell. Before studying the business cycle, you need that idea and a way to measure the economy's total output.

Supply and demand

Demand is the quantity of a good or service buyers are willing and able to purchase at each price. As the price rises, buyers generally want less. Supply is the quantity sellers are willing to offer at each price, and as the price rises, sellers generally offer more. The price at which the quantity demanded equals the quantity supplied is the equilibrium price. When demand rises faster than supply, prices tend to rise. When supply outruns demand, prices tend to fall. The same logic applies to the whole economy. When total spending grows faster than the economy's ability to produce, the general price level rises, and that is inflation, which Lesson 1.6 covers. It also applies to money itself: the interest rate is the price of borrowing, and it rises when the demand for credit outruns the supply.

Gross domestic product

The broadest measure of the economy is gross domestic product, or GDP: the total market value of all final goods and services produced within a country's borders during a period. "Final" means goods sold to the end user, so the steel in a new car is not counted twice. The Bureau of Economic Analysis, part of the Department of Commerce, reports U.S. GDP every quarter. Its first or advance estimate comes out about a month after the quarter ends, and it is revised twice over the following two months. Quarterly growth is usually stated as an annual rate, so "GDP grew 2 percent" means the economy grew at a pace that would equal 2 percent over a full year.

GDP is usually broken into four kinds of spending. GDP equals consumption plus investment plus government spending plus net exports.

• Consumption is spending by households on goods and services. It is by far the largest piece, roughly two-thirds of U.S. GDP, which is why consumer confidence gets so much attention.
• Investment here means business spending on equipment and buildings, new home construction, and changes in business inventories. It does not mean buying stocks and bonds.
• Government spending is purchases of goods and services by federal, state and local governments. Transfer payments such as Social Security benefits are not counted, because nothing is produced in exchange.
• Net exports equal exports minus imports. The United States imports more than it exports, so this piece is negative. Chapter 2 covers the trade deficit and the balance of payments.

Nominal and real GDP

Nominal GDP measures output at current prices. If prices rise 3 percent and the economy produces exactly the same goods as last year, nominal GDP still rises 3 percent, even though no one is better off. Real GDP removes the effect of price changes, so it measures the actual volume of goods and services. Economists and the exam almost always mean real GDP when they talk about growth or recession.

The price index used to convert nominal GDP to real GDP is the GDP deflator. Real GDP equals nominal GDP divided by the deflator, with the deflator expressed as a decimal. A handy approximation is that real growth equals nominal growth minus inflation.

1.2The Business Cycle

The economy does not grow in a straight line. It speeds up, slows down and sometimes shrinks before growing again. That rhythm drives corporate profits, interest rates and security prices, so it is the backdrop for almost every recommendation an adviser makes.

The four phases

The business cycle is the recurring pattern of expansion and contraction in real economic activity. It is usually described in four phases.

1. Expansion is a period of rising real GDP. Businesses hire and invest, unemployment falls, consumers spend more, and corporate profits grow. Early in an expansion, firms have spare capacity and inflation stays low. Later, as factories and workers become fully used, demand outruns supply, so inflation and interest rates tend to rise.
2. The peak is the high point. Output is at its maximum, unemployment is low, and inflation pressure is usually strongest. Sales begin to slow before businesses notice, so unsold inventories pile up. The Federal Reserve, the nation's central bank, is often tightening around the peak, meaning it is pushing interest rates up to cool the economy.
3. Contraction is a period of falling real GDP. Layoffs rise, spending drops, and corporate profits shrink, often sharply, because many costs are fixed. Businesses cut production to work off excess inventories. The demand for credit weakens, and interest rates tend to fall, helped along by Fed easing, meaning rate cuts.
4. The trough is the low point, where the decline ends and the next expansion begins. Inventories are lean, interest rates are low, and unemployment is high and may keep rising for a while even after output starts to grow.

A recession is a significant contraction. The common rule of thumb, and the definition most exam questions use, is two consecutive quarters of declining real GDP. Officially, U.S. recessions are dated by the Business Cycle Dating Committee of the National Bureau of Economic Research, a private research group. It looks for a significant decline in economic activity that is spread across the economy and lasts more than a few months, and it often announces a peak or trough many months after the fact. A depression is a severe and prolonged recession, and there is no official threshold for it. Since World War II, U.S. contractions have usually lasted about a year or less, while expansions have usually run for several years.

Explore the cycle: hover over each phase to see typical indicator readings, the Fed's usual posture, and which sectors tend to do well.

How the phases show up in markets

Stock prices tend to anticipate the cycle. Investors buy and sell on what they expect profits to be months from now, so stocks often fall before a recession begins and rally before it ends. That is why the stock market counts as a leading indicator in Lesson 1.7.

Interest rates tend to follow the cycle, and that matters for bonds. A bond is a loan to a government or company that pays a fixed rate of interest, called the coupon, and repays its face amount at maturity. Because the coupon is fixed, the market price of an existing bond moves opposite to interest rates: when new bonds pay more, older bonds paying less are worth less, and when rates fall, older bonds are worth more. Chapter 7 covers the math. In an expansion, businesses and consumers borrow more and inflation builds, so rates tend to rise and the prices of existing bonds tend to fall. In a contraction, the demand for credit drops and the Fed usually eases, so rates tend to fall and high-quality bond prices tend to rise. Chapter 2 explains how the yield curve and credit spreads react.

Industries also feel the cycle differently. Cyclical companies sell big-ticket or postponable goods and services, such as automobiles, homebuilding, heavy equipment, airlines and travel, so their earnings rise and fall with the economy. Defensive companies sell necessities, such as food, household products, utilities and health care, so their earnings hold up in a downturn. Cyclicals tend to lead early in an expansion and suffer most in a contraction. Defensives tend to hold up best in a contraction and lag in a strong expansion. Chapter 15 shows how a manager rotates among sectors as the cycle turns.

1.3Monetary Policy and the Federal Reserve

Governments have two broad ways to lean against the business cycle. Monetary policy is the management of the money supply and the cost and availability of credit, carried out by a central bank. Fiscal policy, covered in Lesson 1.5, is government taxing and spending. In the United States, monetary policy belongs to the Federal Reserve.

How the Fed is organized

The Federal Reserve System, or the Fed, is the central bank of the United States, created by the Federal Reserve Act of 1913. Its Board of Governors in Washington has seven members, each appointed by the President and confirmed by the Senate for a 14-year term. The long, staggered terms are meant to shield the Fed from short-term political pressure. Twelve regional Federal Reserve Banks carry out its operations around the country.

Policy decisions are made by the Federal Open Market Committee, or FOMC. It has 12 voting members: the seven governors, the president of the Federal Reserve Bank of New York, and four of the other eleven Reserve Bank presidents, who rotate. The FOMC holds eight scheduled meetings a year. The Fed is independent, meaning its decisions do not need approval from the President or Congress, although it reports to Congress regularly.

Congress has given the Fed its dual mandate: to promote maximum employment and stable prices. The statute also mentions moderate long-term interest rates. The FOMC defines price stability as inflation of 2 percent over the longer run, measured by the price index for personal consumption expenditures, which Lesson 1.6 explains. The Fed also supervises many banks and acts as the lender of last resort, lending to sound banks in a panic so that one failure does not spread through the system.

The federal funds rate

The Fed does its work through bank reserves, the funds banks hold as cash in their vaults or on deposit at a Federal Reserve Bank. Banks lend reserves to one another overnight at the federal funds rate. That rate is negotiated between banks, so the Fed does not set it directly. Instead, the FOMC announces a target range for the federal funds rate, such as a quarter-point band, and uses its tools to keep the market rate inside it. Changes in the fed funds rate ripple out to other short-term rates, loans and bond yields. Chapter 2 compares it with the prime rate, SOFR and Treasury yields.

The Fed's tools

Open market operations are the Fed's purchases and sales of U.S. government securities, mainly Treasury securities, the bills, notes and bonds the federal government sells to borrow money. They are directed by the FOMC and carried out by the trading desk at the New York Fed.

• When the Fed buys securities, it pays by crediting banks' reserve accounts. Reserves rise, credit becomes more plentiful, and interest rates fall. Buying is easing.
• When the Fed sells securities, buyers pay out of bank reserves. Reserves shrink, credit tightens, and interest rates rise. Selling is tightening.

The discount rate is the rate the Fed charges banks that borrow directly from a Federal Reserve Bank through the discount window. The Fed sets it directly. Lowering it makes emergency borrowing cheaper and signals easing; raising it signals tightening. Since March 2020, the Fed has set its main discount rate, the primary credit rate, at the top of the fed funds target range.

A reserve requirement is the percentage of certain deposits a bank must hold as reserves instead of lending. Lowering it frees money for lending, which is easing, and raising it is tightening. Because a small change hits every bank at once, it was always the bluntest and least-used tool. The Fed cut reserve requirements to zero in March 2020, where they remain, but the tool still exists in law, so the exam can still ask which direction eases or tightens.

Interest on reserve balances, or IORB, is the rate the Fed pays banks on reserves they keep at a Federal Reserve Bank. A bank will not lend reserves to another bank for less than it can earn risk-free at the Fed, so raising the IORB rate pulls short-term market rates up, and lowering it lets them fall. Because banks now hold ample reserves, IORB has become the Fed's main lever for keeping the fed funds rate in its target range, supported by an overnight reverse repurchase facility that sets a floor under other money market rates. Open market operations are still the tool the Fed uses most often: the New York Fed's trading desk conducts repurchase and reverse repurchase operations every business day, and since December 2025 it has also been buying Treasury bills to keep reserves ample. That is why exam questions still call open market operations the most frequently used and most flexible tool.

Try it: choose a policy direction and a tool, and follow the effects through the economy.

1.4Tightening, Easing and Their Effects

Knowing the tools is half the job. The other half, and the half the Series 65 tests most, is predicting what a policy change does to rates, money, bonds, stocks and the dollar, and what that means for a client.

Easy money

Easing, also called easy money or expansionary monetary policy, is what the Fed does to fight a recession or high unemployment. It lowers its target range for the fed funds rate, lowers IORB and the discount rate, or buys securities. The chain of effects runs like this.

• Bank reserves and the money supply, the total money available in the economy, grow. The Fed tracks the money supply with measures such as M1, which is currency, checking deposits and savings deposits, and M2, which adds small time deposits and retail money market funds.
• Short-term interest rates fall, and other rates usually follow.
• Prices of existing bonds rise, because bond prices move opposite to interest rates. A bond paying yesterday's higher coupon becomes more valuable when new bonds pay less.
• Stock prices tend to rise, because cheaper borrowing helps companies and lower bond yields make stocks relatively more attractive.
• The dollar tends to weaken, because lower U.S. rates make dollar investments less attractive to foreign investors.

The risk of easing too much or too long is inflation.

Tight money

Tightening, also called tight money or contractionary policy, is the Fed's response to inflation running above its goal. Every arrow reverses. Reserves and money growth shrink, interest rates rise, prices of existing bonds fall, stocks tend to come under pressure, and the dollar tends to strengthen as higher U.S. rates attract foreign money. The risk of tightening too much is a recession.

Quantitative easing and tightening

When short-term rates are already near zero, the Fed cannot cut them further. After 2008 and again in 2020, it turned to quantitative easing: very large purchases of Treasury securities and agency mortgage-backed securities, which are bonds backed by pools of home mortgages and issued or guaranteed by government agencies and government-sponsored enterprises. These purchases pushed down long-term rates and flooded banks with reserves. The reverse, letting those holdings mature without replacing them so the Fed's balance sheet shrinks, is quantitative tightening. The Fed did this from 2017 to 2019 and again from June 2022 until December 1, 2025, when the FOMC ended the runoff. Quantitative easing is easing and quantitative tightening is tightening, with the same arrows as above.

Policy works with a lag

Monetary policy takes time to work. A rate change affects loan demand within months but may not show up fully in employment and inflation for a year or more. The Fed therefore has to act on forecasts, which is why it watches the leading indicators in Lesson 1.7. Markets also move on expectations: if investors are sure the Fed will raise rates next month, bond prices may fall well before the meeting.

1.5Fiscal Policy and Schools of Economic Thought

Fiscal policy is the government's decisions about taxing and spending, set by Congress and the President through legislation and the federal budget. Its tools are blunter and slower than the Fed's, but they put money directly into, or take it out of, the hands of households and businesses.

Expansionary and contractionary fiscal policy

Cutting taxes or increasing government spending is expansionary fiscal policy, because it raises total spending in the economy. Raising taxes or cutting spending is contractionary. A government trying to end a recession might send rebate checks or fund public works. A government trying to cool an overheating economy might raise taxes or trim spending, though that is politically harder.

Some fiscal policy works automatically. Automatic stabilizers are features of the tax and benefit system that expand in a downturn and shrink in a boom without any new law. When workers lose jobs, unemployment insurance payments rise and income tax collections fall, which cushions spending. When the economy booms, tax collections rise and benefit payments fall, which cools it.

Deficits, debt and crowding out

When the government spends more than it collects in a year, the shortfall is a budget deficit. When it collects more than it spends, it runs a surplus. The national debt is the total accumulated borrowing from all past deficits, net of surpluses. Think of the deficit as one year's overspending and the debt as the balance on the credit card. The Treasury finances deficits by selling Treasury bills, notes and bonds.

Heavy government borrowing can cause crowding out. The Treasury competes with businesses and households for a limited pool of savings, which pushes interest rates up and discourages private borrowing for factories, equipment and homes. In that case, some of the boost from government spending is offset by less private investment.

Schools of economic thought

Economists disagree about how much, and how, government should manage the cycle. The exam tests three views at a general level.

Keynesian economics, from the British economist John Maynard Keynes, holds that total spending in the economy, called aggregate demand, drives output and employment. Keynesians believe an economy can stay stuck in a slump, so government should step in with active fiscal policy: spend more and cut taxes in a recession, even if that means a deficit, and do the reverse in a boom.

Monetarism, most associated with the American economist Milton Friedman, holds that the money supply is the main driver of economic activity and, above all, of inflation. Monetarists argue that inflation results from money growing faster than the economy's output, so the central bank should keep money growing at a steady, predictable rate rather than trying to fine-tune the cycle.

Supply-side economics holds that lower tax rates and lighter regulation encourage people to work, save and invest, which expands the economy's capacity to produce. Supply-siders argue that cutting very high tax rates can raise growth enough to offset part of the lost revenue, an idea illustrated by the Laffer curve. The approach is associated with the U.S. tax cuts of the 1980s.

1.6Inflation and Deflation

Inflation quietly erodes what a client's savings will buy, and it drives interest rates, so advisers watch it closely. The Series 65 expects you to know how it is measured, what causes it, and who wins and who loses.

Measuring inflation

Inflation is a sustained rise in the general level of prices, which reduces purchasing power, meaning each dollar buys less. The most widely cited gauge is the Consumer Price Index, or CPI, published monthly by the Bureau of Labor Statistics. The CPI tracks the prices urban consumers pay for a fixed market basket of goods and services, including food, housing, transportation, medical care and energy. The inflation rate is the percentage change in the index: the new level minus the old level, divided by the old level.

The full index is called headline inflation. Core inflation leaves out food and energy, whose prices swing with weather, harvests and oil markets. Core is a better guide to the underlying trend, while headline is what consumers actually feel at the grocery store and gas pump.

Two other price indexes appear on the exam.

• The Producer Price Index, or PPI, also from the Bureau of Labor Statistics, measures the prices domestic producers receive for their output, closer to wholesale prices. Because rising costs for producers are often passed on to consumers later, the PPI can give an early read on consumer inflation.
• The personal consumption expenditures price index, or PCE price index, from the Bureau of Economic Analysis, covers a broader range of spending than the CPI and adjusts as consumers substitute cheaper goods for pricier ones. It usually runs a little below the CPI. It is the measure the Fed uses for its 2 percent goal, and the Fed pays special attention to core PCE.

Causes of inflation

Demand-pull inflation happens when total demand outruns the economy's ability to produce, described as "too much money chasing too few goods." It is typical late in an expansion, after strong government spending, or after a long period of easy money. Cost-push inflation happens when production costs rise, such as a jump in oil prices or wages, and businesses pass those costs on. The oil shocks of the 1970s are the classic cost-push example. Rising prices can also feed on themselves: workers demand higher wages to keep up, businesses raise prices to cover the wages, and a wage-price spiral develops.

Deflation, disinflation and stagflation

These three terms are favorite distractors, so keep them straight.

• Deflation is a sustained decline in the general price level. It usually comes with severe contractions, such as the Great Depression. It is dangerous because consumers delay purchases while waiting for lower prices, which deepens the slump, and because fixed debts become harder to repay in real terms.
• Disinflation is a slowdown in the rate of inflation. Prices are still rising, only more slowly, such as inflation falling from 6 percent to 3 percent.
• Stagflation is high inflation combined with high unemployment and slow or no growth. It puts the Fed in a bind, because easing to help jobs would worsen inflation, and tightening to fight inflation would worsen unemployment. The United States experienced it in the 1970s.

Who wins and who loses

Unexpected inflation transfers wealth from lenders to borrowers. A borrower with a fixed-rate mortgage repays with dollars that buy less, so the borrower gains. The lender, including anyone who owns fixed-rate bonds, loses purchasing power. Retirees living on fixed pensions or fixed annuity payments also lose, because the payments do not rise with prices. Rising inflation also pushes interest rates up, so the market prices of existing bonds fall, with long-term bonds hit hardest. Investors with cash in low-yielding accounts lose as well. A bond yielding 5 percent while inflation runs 3 percent earns a real return of only about 2 percent; Chapter 2 covers real interest rates.

Deflation reverses the transfer. Lenders and holders of high-quality bonds gain, because each dollar of interest and principal buys more, while borrowers lose, because their debts grow heavier in real terms. Many borrowers default in a deflationary slump, so holders of lower-quality bonds can still be hurt.

Assets whose value or income tends to rise with prices, such as common stocks over long periods, real estate and Treasury Inflation-Protected Securities, are the traditional hedges. Chapter 5 treats inflation as purchasing power risk, and Chapter 6 explains TIPS.

1.7Economic Indicators

An economic indicator is a statistic used to judge where the economy is and where it is heading. Analysts group indicators by their timing relative to the business cycle. The groupings below follow the composite indexes that The Conference Board, a private research organization, publishes each month.

Leading, coincident and lagging indicators

Leading indicators tend to change direction before the overall economy does, so they are used to forecast turning points. Standard examples include these.

• Building permits for new private housing, because a builder gets a permit before construction starts.
• Stock prices, because investors trade on what they expect profits to be.
• Manufacturers' new orders for consumer goods and for business equipment, because orders come before production.
• The average weekly hours worked by manufacturing employees, because employers trim or add hours before they lay off or hire.
• Initial claims for unemployment insurance, where a rise is an early warning of weakness.
• Consumer expectations for business conditions, and the spread between 10-year Treasury yields and the federal funds rate, which Chapter 2 explains.

Many textbooks also list money supply growth as a leading indicator.

Coincident indicators move at the same time as the economy, so they confirm where it is now. The standard four are the number of employees on nonfarm payrolls, personal income excluding government transfer payments, industrial production, and manufacturing and trade sales. GDP itself is generally treated as a coincident measure.

Lagging indicators change only after the economy has turned, so they confirm a trend already underway. Examples include the average duration of unemployment, the ratio of business inventories to sales, changes in labor cost per unit of output, the average prime rate banks charge, outstanding commercial and industrial loans, consumer credit relative to personal income, and the change in consumer prices for services.

Employment indicators

The Bureau of Labor Statistics publishes the monthly Employment Situation report, usually on the first Friday of the month. It draws on two surveys.

• A survey of households produces the unemployment rate: the number of unemployed people divided by the labor force. The labor force is everyone 16 or older, outside the military and institutions such as prisons, who either has a job or is unemployed. To count as unemployed, a person must have no job, be available for work and have actively looked for work in the past four weeks; workers on temporary layoff who expect to be recalled also count. A person without a job who has not looked in the past four weeks is otherwise not counted as unemployed. Workers who have given up looking, called discouraged workers, drop out of the labor force entirely, which can make the unemployment rate fall even when the job market is weak.
• A survey of employers produces nonfarm payrolls, the monthly change in the number of jobs outside farming. It is the most closely watched coincident indicator of the labor market.

The labor force participation rate equals the labor force divided by the civilian population age 16 and older outside institutions such as prisons. It shows how much of the adult population is working or looking for work, and it falls as the population ages and more people retire.

Initial jobless claims, reported weekly by the Department of Labor, count people filing for unemployment insurance for the first time. Because they arrive every week, they are the timeliest sign that layoffs are rising.

Unemployment is a lagging indicator in its own right. Employers wait until they are confident a recovery is real before hiring, so the unemployment rate often keeps rising for a few months after the trough. Economists also distinguish frictional unemployment, people between jobs; structural unemployment, a mismatch between workers' skills and available jobs; and cyclical unemployment, job losses caused by a contraction. Even a healthy economy has some frictional and structural unemployment.

Reading indicators together

No single statistic settles where the economy is. An analyst who sees building permits, new orders and stock prices falling while initial claims climb would expect a slowdown, even if payrolls and industrial production, the coincident measures, still look healthy. If the prime rate and inventory-to-sales ratio then keep rising after output has already fallen, that confirms a turn that happened earlier. Advisers use this reading not to time the market but to explain risks to clients and to check that a portfolio can withstand the next phase of the cycle. Chapter 2 adds two more international indicators, the trade deficit and the balance of payments.

Chapter Summary

• Prices rise when demand outruns supply and fall when supply outruns demand. GDP, the value of final goods and services produced within a country, equals consumption plus investment plus government spending plus net exports, and consumption is about two-thirds of the U.S. total.
• Nominal GDP is measured at current prices, while real GDP removes inflation. Real growth is roughly nominal growth minus inflation.
• The business cycle moves through expansion, peak, contraction and trough. Inventories build near the peak and are worked off in the contraction, profits and employment follow output, and rates tend to rise in expansions and fall in contractions. A recession is commonly defined as two consecutive quarters of falling real GDP, though the NBER officially dates U.S. cycles.
• The Fed's dual mandate is maximum employment and stable prices, with a 2 percent PCE inflation goal. The FOMC sets a target range for the federal funds rate. The Fed sets the discount rate and interest on reserve balances directly, and reserve requirements have been zero since March 2020.
• Easing means buying securities or cutting the Fed's rates. It expands the money supply, lowers rates, raises bond prices, tends to lift stocks and tends to weaken the dollar. Tightening does the reverse.
• Fiscal policy is taxing and spending by Congress and the President. Deficits add to the national debt, and heavy government borrowing can crowd out private investment. Keynesians favor active fiscal policy, monetarists favor steady money growth, and supply-siders favor lower tax rates.
• The CPI measures consumer prices, core inflation excludes food and energy, the PPI measures producer prices, and the PCE price index is the Fed's preferred gauge. Disinflation is slower inflation, deflation is falling prices, and stagflation is inflation with high unemployment.
• Inflation helps fixed-rate borrowers and hurts lenders, bondholders and people on fixed incomes. Deflation does the opposite.
• Leading indicators such as building permits, stock prices, new orders and initial jobless claims forecast turns. Coincident indicators such as nonfarm payrolls and industrial production confirm the present. Lagging indicators such as the duration of unemployment, the prime rate and the inventory-to-sales ratio confirm the past.

Key Numbers