The Business Cycle

An economy
undergoes periods of expansions followed by periods of contractions. These ups
and downs in economic growth are natural as the economy is basically a
reflection of human behaviour. The business cycle is divided into four phases:
expansion, peak, recession, and trough.

During an
expansion the economy is growing, businesses are investing, and households are
spending. Demand generally outstrips supply and inflation is gradually
increasing as businesses increase prices due to higher demand and workers
demand higher wages to keep up with inflation. At the beginning of an expansion
monetary and fiscal policies are generally expansionary and gradually become
contractionary as inflation starts to exceed the central bank target.

At some
point the economy reaches a peak as contractionary policies feed through and
demand naturally slows down. An economy doesn’t automatically enter a recession
as long as the policymakers don’t make mistakes like tightening too much or
there isn’t any demand shock like a crisis or exogenous factors like a global
slowdown.

When the
economy enters a recession households spending is weak, businesses lay off
workers and cut investment, and the growth rate is negative. During this phase
policymakers enact expansionary policies with the central bank cutting interest
rates or even starting a QE programme and the government lowering taxes and
increasing spending.

At some
point the economy reaches a trough as businesses start to see brighter times
ahead and thanks to easy policies start to invest and hiring workers.
Households start to increase their spending and borrowing, and the economy
starts to grow.

Generally,
periods of expansion are longer than periods of recession but nothing is
guaranteed, so always try to be aware which phase the economy is in and what
can keep it going or turn it around.

This article
was written by Giuseppe Dellamotta.