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.
