What it is: The peak phase is the highest point of the business cycle. It was a turning point after an economic expansion had slowed but before moving towards contraction.
In the boom part, the economy is trying to reach its maximum limit, and inflationary pressure is high, leading to an overheated economy. This situation prompted government intervention to avoid hyperinflation. And when they are too aggressive, the policy does not moderate the inflation rate but directs the economy toward contraction.
At which stages: The business cycle consists of four main phases, namely the peak, contraction, trough, and expansion. The peaks and troughs are the turning points of the cycle. While the peak is the highest point, the trough is the lowest point of the cycle. Contraction refers to when real GDP decreases, while, conversely, during expansion, real GDP increases.
What’s going on during the peak phase
During its peak, the economy will exhibit the following characteristics:
- The actual real GDP will reach its maximum limit (potential output).
- The unemployment is at its natural rate, which is the lowest point (at full employment). Further falls will only cause inflation to spike.
- Inflationary pressures are high and can spike further if the economy operates above its potential output.
- Consumer and production spending have all reached maximum levels.
How does it work
During periods of expansion, economic activity increases. Real GDP grew strongly, and the inflation rate shot up. The unemployment rate is also low because the demand for labor is high.
As the expansion approaches its peak, the economy begins to test its highs. Real GDP grows at a slower rate than before. Likewise, the inflation rate has also risen at a slower pace.
In the labor market, unemployment is low, and the economy is close to full employment. A shortage of skilled labor emerges, pushing wages up. Companies are starting to find it challenging to find additional workers to increases production in meeting consumer demand.
When full employment is reached, a decrease in the unemployment rate will only produce upward inflation pressure (Philips Curve).
Scarcity in the labor market can lead to a price-wage spiral, leading to an uncontrolled inflation rate. Higher inflation forces labor to renegotiate higher nominal wages to compensate for the decline in purchasing power resulting from inflation. Companies have no other options because they find it challenging to find new workers due to shortages in the labor market.
The increase in wages increases the cost of production. To maintain profit, the company raises the selling price of the product. That makes inflation rise again. And, workers renegotiated higher wages. Wages, production costs rise, and selling prices rise further, pushing inflation up.
Such conditions continue and create a spiral in the economy. If left untreated, it can lead to hyperinflation, which can threaten the domestic economy’s stability.
To prevent hyperinflation, the government will intervene through contractionary economic policies. The policy options are:
- Contractionary fiscal policy by raising tax rates and reducing government spending.
- Contractionary monetary policy by raising the policy rate, purchasing government securities (open market operation), and raising the reserve requirement ratio.
Say, the central bank tries to moderate inflation by raising interest rates. The increase in interest rates accelerated the economy to its peak—higher interest rates slow down investment and consumer spending. If effective, it will moderate the rate of inflation and economic growth as aggregate demand weakens. And that doesn’t lead the economy towards a contraction.
But, if it is too aggressive, policies may bring the economy into contraction. Economic growth is negative, inflation falls dramatically, and the unemployment rate rises.