An economy experiences periods of expansion followed by periods of contraction. These ups and downs in economic growth are natural, because the economy is essentially a reflection of human behavior. The economic 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 usually exceeds supply and inflation gradually rises as companies raise prices due to higher demand and workers demand higher wages to keep up with inflation. At the start of an expansion, monetary and fiscal policies are generally expansionary and gradually become restrictive as inflation begins to exceed the central bank’s target.
At some point, the economy peaks as contractionary policies materialize and demand naturally slows. An economy does not automatically go into recession until policymakers make mistakes like over-tightening or there is a demand shock like a crisis or exogenous factors like a global slowdown.
When the economy enters a recession, household spending is low, companies lay off workers and reduce investment, and the growth rate is negative. During this phase, policymakers adopt expansionary policies, with the central bank cutting interest rates or even launching a program of quantitative easing and the government lowering taxes and increasing spending.
At some point, the economy bottoms out as businesses begin to see better days and, with easy policies, begin to invest and hire workers. Households begin to increase spending and borrowing, and the economy begins to grow.
Generally, periods of expansion are longer than periods of recession, but nothing is guaranteed, so always try to find out what phase the economy is in and what can maintain it or reverse it.
This article was written by Giuseppe Dellamotta.