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
- 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 out of the trough phase.
- Economic boom – the final part of expansion before the peak.
The economic cycle affects critical macroeconomic variables, such as:
- Gross domestic product (GDP)
- Capital investment
- Unemployment rate
Not only that. The government will usually take discretionary policies to avoid destructive economic cycles such as recessions and hyperinflation. So, you may see changes in:
- Government spending
- Tax policy
- Interest rate policy
- Open market operations
- Reserve requirement ratio
How the business cycle works
The peak is the upper limit of economic activity. During the final period of expansion, inflation rate spiked. Policymakers will intervene in the economy 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 towards recovery. Lower interest rates ultimately make new loans cheaper and stimulate the household and business sector 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.
So what happened during the trough phase
The trough is a reversal phase from recession to economic recovery. Hence, during this period, real GDP growth was at its lowest level. And, it may be accompanied by the following conditions:
- The unemployment rate reached its highest point
- The inflation rate is at its lowest point because the economy shows high excess supply
- Low-interest rates because the central bank still maintains expansionary policies to restore the economy.
- Capital investment is not there yet as revenue and business sales fall
- Excess production due to weak demand
It’s hard to know when trough will happen. Only after the economic recovery is headed for expansion will we know that the trough phase has passed.
Solutions to exit from the trough phase
During the trough phase, the government usually still maintains a loose economic policy (contractionary policy). It involves several alternatives, such as:
- Increasing government expenditures
- Lowering tax rates
- Cutting interest rates
- Purchase of government bonds
- Lowering reserve requirement ratio
When the policy is sufficient, the economy and immediately come out of a period of recession towards economic recovery. Usually, in the early period of economic recovery, the government will still keep a loose policy.