Contents
The trough phase, often shrouded in uncertainty, represents the bottom point of the business cycle. Here, economic activity hits its lowest ebb before the tide turns towards recovery and expansion. Understanding this crucial phase is valuable for students of economics, investors, and anyone curious about economic trends. By delving into the characteristics of the trough phase and its impact on various economic indicators, we gain valuable insights into how economies navigate periods of hardship and ultimately pave the way for future growth.
What is the trough phase?
The trough phase is the lowest point of the business cycle. It occurs when the recession reaches its deepest point before leading to economic recovery and expansion.
The business cycle is up and down phases of economic activity. Consecutively, it consists of the contraction, trough, expansion, and peak phases.
- Contraction – the period when economic activity decreases
- Trough – the lowest point of the cycle
- Expansion – economic activity increases
- Peak – the highest point of the cycle
Related terms:
- Recession – a period when contraction lasts for more than two consecutive quarters. A great recession refers to a more severe recession, such as the 2007-2009 crisis.
- Depression – a period of recession that is prolonged, even for years, and lasts more severely than a recession.
- Economic recovery – an initial period of expansion when the economy is out of the trough phase.
- Economic boom – the final part of expansion before the peak.
Why understanding the trough phase matters
Understanding the trough phase is crucial for several reasons:
Economic literacy: It enhances your overall grasp of the business cycle. By recognizing the trough as the low point before recovery, you gain a more complete picture of economic health and its natural fluctuations. This knowledge allows you to interpret economic news and data better.
Investment decisions: Investors can leverage their understanding of the trough phase to make informed choices. During the trough, asset prices may be depressed due to low economic activity.
By recognizing the trough as a temporary low point, investors can potentially identify opportunities to buy undervalued assets in anticipation of future economic recovery and potentially higher prices. Additionally, the trough phase can signal sectors likely to experience a rebound during the subsequent expansion. Investors can then adjust their investment strategies accordingly.
Business planning: Businesses can utilize their knowledge of the trough phase for strategic planning. By understanding the characteristics of the trough, businesses can anticipate potential challenges such as weak demand and high unemployment. This foresight allows them to implement strategies to weather the economic downturn, such as optimizing operations, controlling costs, and potentially exploring new markets.
Overall, understanding the trough phase empowers individuals to make informed decisions in various economic contexts, whether navigating personal finances, making investment choices, or planning business strategies.
How the business cycle works
The peak is the upper limit of economic activity. During the final period of expansion, the inflation rate spiked. Policymakers intervene to prevent the economy from overheating. If effective, economic growth and inflation will slow down.
Intervention can be through contractionary fiscal or monetary policies. The fiscal policy requires the government to reduce spending or increase tax rates. Meanwhile, for monetary policy, the central bank can raise policy rates, sell government securities (open market operations), or increase the reserve requirement ratio.
But, if it is too aggressive, the intervention can lead to a contraction in the economy. In the contraction phase, real GDP will decline. When it lasts two quarters in a row, the economy is headed for recession. Inflation fell and even led to a negative number (deflation), and the unemployment rate increased.
To prevent a prolonged recession, policymakers adopt expansionary policies (as opposed to contractionary policies), namely by:
- Increase government spending
- Lower tax rates
- Cut interest rates
- Lowered the reserve requirement ratio
- Open operation by buying government securities
Say, the central bank cuts interest rates to stimulate the economy. The cut will affect the interest rate on the financial market.
If the interest rate policy is effective, the economy will soon bottom out (trough) and move toward recovery. Lower interest rates ultimately make new loans cheaper and stimulate the household and business sectors to borrow. As borrowing costs are lower, household spending on durable goods and housing usually starts to increase. An increase in household consumption then raises aggregate demand.
Expectations play an important role. Hoping that demand growth continues, businesses are starting to use their capacity more intensively. Yet, during this period, they did not employ more workers. Instead, they will increase the use of overtime workers and temporary workers.
If aggregate demand gets stronger, businesses will start hiring a new workforce. And, the economy is moving from a period of recovery to expansion. During this period, economic growth was positive, and the inflation rate began to slowly increase.
Characteristics of the trough phase
The trough phase marks a critical turning point, characterized by several key features:
- Lowest point of economic activity: Real Gross Domestic Product (GDP) growth reaches its nadir during the trough. This signifies the weakest point of the economic downturn, with production and output at their lowest levels.
- High unemployment rate: When businesses experience weak demand, they often resort to layoffs or hiring freezes. This leads to a surge in the unemployment rate, which indicates that a significant portion of the workforce is unable to find jobs.
- Low inflation or deflation: The trough phase is typically marked by low or even negative inflation (deflation). This occurs because weak demand leads to an excess supply of goods and services. With an abundance of goods readily available, businesses may struggle to raise prices, potentially leading to price stagnation or even price declines.
- Stagnant investment: Uncertainty and economic weakness typically lead businesses to postpone investment in new equipment, facilities, or expansion projects. This stagnation in investment further restricts economic growth during the trough phase.
- Excess production capacity: As demand wanes, businesses may find themselves with excess production capacity. This means they have the ability to produce more goods and services than consumers are currently willing to buy.
- Consumer confidence (shaken but shows signs of improvement): Consumer confidence typically takes a significant hit during the trough phase due to economic hardship and job insecurity. However, as the trough signifies a potential turning point, there might be early signs of improvement in consumer confidence, indicating a cautious optimism about the future.
Important note: It’s challenging to pinpoint the exact timing of the trough phase. We can only definitively identify it in hindsight, once the economy begins to recover and economic indicators signal a transition towards expansion.
Government policies and solutions to exit from the trough phase
Governments don’t take a passive approach during the trough phase. They actively employ various policy tools, primarily focused on maintaining expansionary policies (previously explained) to stimulate economic growth and encourage recovery. Here are some key examples:
- Increased government spending: By injecting money into the economy through infrastructure projects, social programs, or direct stimulus payments, governments aim to boost demand for goods and services. This increased demand can incentivize businesses to hire more workers and ultimately stimulate economic activity.
- Lower taxes: Reducing tax burdens on individuals and businesses allows them to retain more of their income. This can lead to increased consumer spending and business investment, which can help propel the economy out of the trough.
- Maintaining low interest rates: Central banks can keep interest rates low, making it cheaper for businesses and consumers to borrow money. This encourages borrowing for investment and spending, which can help stimulate economic growth.
- Purchase of government bonds: Central banks can engage in quantitative easing, a process where they purchase government bonds from investors. This injects additional money into the financial system, lowers interest rates further, and encourages lending by banks.
- Lowering reserve requirement ratio: The reserve requirement ratio is the amount of money banks are required to hold in reserve rather than lend out. By lowering this ratio, the central bank allows banks to lend out more money, increasing the money supply in circulation and potentially stimulating economic activity.
These are just some of the common policy tools governments utilize during the trough phase. The specific mix of policies will depend on the unique circumstances of each economic downturn.
