Causes of the Business Cycle

Three Ways Monetary and Fiscal Policy Change It

Confidence is one of the causes of changes in the business cycle. Photo: Christopher Furlong/Getty Images

The business cycle is caused by the forces of supply and demand, the availability of capital, and expectations about the future. Here's what causes each of the four phases of the boom and bust cycle.

Expansion: When consumers are confident, they buy now because they know there will be future income from better jobs, higher home values and increasing stock prices.  As demand increases, businesses hire new workers, which increases income, further stimulating more demand.

Even a little healthy inflation can trigger demand by spurring shoppers to buy now before prices go up. 

Too much capital will turn a healthy expansion into a peak. That's because there's too much money chasing too few goods. This causes inflation

Peak: If demand outstrips supply, then the economy can overheat. In addition, 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 asset bubble in 2005.

You can always recognize a peak by two things: First, the media is saying that the expansion will never end. Second, it seems everyone and his brother is making tons of money from whatever the asset bubble is.

Contraction: A contraction is usually triggered by an event, such as 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. For more, see Causes of Recession.

Trough: Confidence must be restored 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. Unfortunately, that 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. That's called liquidity and is itself dependent upon interest rates and the money supply.

Expansion: Central banks try to keep the core inflation rate at around 2 percent to create a healthy expectation of inflation. In the United States, that means the Federal Reserve will keep the Fed funds rate right around 2%. If economic growth remains at the healthy 2-3 percent growth rate, the Fed won't make any changes.

Peak: Central banks use contractionary monetary policy during an expansion to avoid the irrational exuberance of a peak. That means they raise interest rates. If needed, they will sell Treasuries 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. That means it will lower interest rates and buy Treasuries in open market operations.

Trough: Central banks pull out all the tools to jumpstart the economy out of a trough. In 2008, the Fed used a variety of innovative tools to keeps banks from collapsing. It also significantly expanded its open market operations in a program called Quantitative Easing.

How Fiscal Policy Changes the Business Cycle

Fiscal policy is used by elected officials to change the business cycle. Although it can be more powerful than monetary policy, it is rarely used as effectively. That's because elected officials have different opinions on the best ways to use fiscal policy.

Expansion: When the economy is in the expansion phase, politicians are happy because their constituents are happy. They will pursue other goals, such as foreign policy, defense, or immigration. The United States is currently in this the bsiness cycle.

Peak: During the irrational exuberance phase, politicians will also ignore fiscal policy. However, this is they should pursue contractionary fiscal policy to avoid the peak. That means raising taxes and cutting spending. However, since the budget cycle is usually 18 months in the making, by the time the economy reaches the peak, it's probably too late. In addition, politicians don't get re-elected by doing either of those things.

Contraction: This is when expansionary fiscal policy is desperately needed. That means cutting taxes and increasing 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 will do something to turn things around. That was successfully done in 2009 with the Economic Stimulus Act, which ended the Great Recession