The business cycle is caused by the forces of supply and demand—the movement of the gross domestic product GDP—the availability of capital, and expectations about the future. This cycle is generally separated into four distinct segments, expansion, peak, contraction, and trough. You may hear this series referred to as the economic or trade cycle.
Here's what causes each of the four phases of the boom and bust cycle.
Business Cycle Expansion Phase
When consumers are confident, they buy now. They know there will be future income from better jobs, higher home values, and increasing stock prices. As demand increases, businesses hire new workers. The increase in consumer income further stimulates demand. A little healthy inflation can trigger demand by spurring shoppers to buy now before prices go up.
A healthy expansion can suddenly turn into a dangerous peak. It happens when there's too much money chasing too few goods. It can either cause price inflation or an asset bubble.
If demand outstrips supply, then the economy can overheat. Investors and businesses compete to outperform the market, taking on more risk to gain some extra return. This combination of excess demand and the creation of risky derivatives created the housing bubble in 2005.
You can always recognize a peak by two things: First, the media says that the expansion will never end. Second, it seems everyone and their brother are making tons of money from whatever the asset bubble is.
Business Cycle Contraction Phase
A contraction causes a recession. Three types of events trigger a contraction. They are a rapid increase in interest rates, a financial crisis, or runaway inflation. Fear and panic replace confidence. Investors sell stocks and buy bonds, gold, and the U.S. dollar. Consumers lose their jobs, sell their homes, and stop buying anything but necessities. Businesses lay off workers and hoard cash.
Consumers must regain confidence before the economy can enter a new expansion phase. That often requires intervention with monetary or fiscal policy. In an ideal world, they work together. That, unfortunately, doesn't occur often enough.
How Monetary Policy Changes the Business Cycle
Monetary policy is how the nation's central bank uses its tools to manage the economic cycle. It adjusts liquidity by changing interest rates and the money supply.
Expansion: Central banks try to keep the core inflation rate around 2 percent to create a healthy expectation of inflation. In the United States, the Federal Reserve will keep the fed funds rate right around 2%. If economic growth remains at a healthy growth rate, the Fed won't make any changes.
Peak: Central banks raise interest rates during expansion to avoid the irrational exuberance of a peak. That is called contractionary monetary policy. If needed, they will sell Treasury bonds and other assets during open market operations.
Contraction: At this point, a stock market correction may indicate that assets are overvalued. The Fed can switch to expansionary monetary policy if economic growth slows or even turns negative. It will lower interest rates and buy Treasurys in open market operations.
Trough: Central banks pull out all the tools to jump-start the economy out of a trough. In 2008, the Fed used a variety of innovative tools to keeps banks from collapsing. It also expanded its open market operations in a program called quantitative easing.
How Fiscal Policy Changes the Business Cycle
Fiscal policy is what elected officials use to change the business cycle. But they disagree on the best ways to implement it. As a result, they don't take advantage of the power of fiscal policy.
Expansion: When the economy is in the expansion phase, politicians are content because their constituents are happy. They will pursue other policies, such as foreign affairs, defense, or immigration.
Peak: During the irrational exuberance phase, politicians continue to ignore fiscal policy. They would be smart to pursue a contractionary fiscal policy to avoid the peak. But politicians don't get re-elected when they either raise taxes or cut spending.
Contraction: This is when expansionary fiscal policy is crucial. Elected officials are quick to cut taxes and increase spending to create jobs, demand, and confidence. The best unemployment solution in a contraction is government spending on public works and education jobs.
Trough: By this point, there is so much outcry among voters that the elected officials must do something to turn things around. That was successfully done in 2009 with the American Recovery and Reinvestment Act that ended the Great Recession.