The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
Aspect
Explanation
Boom and Bust Cycle
– The Boom and Bust Cycle, also known as the economic or business cycle, refers to the recurring pattern of economic expansion (boom) and contraction (bust) that occurs in market economies. This cycle is characterized by periods of rapid economic growth followed by downturns or recessions.
Phases
– The cycle typically consists of four phases: expansion, peak, contraction, and trough. Expansion is marked by rising economic activity, while the peak is the highest point of growth. Contraction leads to a decline in activity, and the trough is the lowest point before recovery.
Causes
– Several factors contribute to the boom and bust cycle, including changes in consumer spending, business investment, monetary policy (interest rates), government fiscal policy, and external shocks like financial crises or natural disasters.
Boom Phase
– During the boom phase, the economy experiences robust growth. Businesses expand, employment rises, and consumer spending increases. Asset prices, such as real estate and stocks, often soar. This phase can lead to optimism and overconfidence.
Peak Phase
– The peak is the zenith of economic growth. It’s characterized by maximum employment, high levels of production, and strong consumer demand. However, it’s also when inflationary pressures may build, and bubbles in asset markets can develop.
Contraction Phase
– Contraction marks the transition from economic growth to decline. Economic indicators such as GDP, employment, and consumer spending start to decline. Businesses may cut back on investments, and consumer confidence wanes. This phase can lead to layoffs and financial stress.
Trough Phase
– The trough is the lowest point in the cycle. Economic activity reaches its nadir, and unemployment may peak. Asset prices can plummet, and businesses face financial challenges. It’s often a period of economic hardship, but it also sets the stage for recovery.
Recovery
– After the trough, the economy enters a recovery phase. Economic indicators begin to improve, and businesses cautiously invest. Employment gradually rises, and consumer confidence returns. The recovery phase eventually leads to a new expansion, restarting the cycle.
Impacts
– The boom and bust cycle can have significant impacts on individuals, businesses, and governments. For individuals, it affects employment and income stability. Businesses must adapt to changing market conditions. Governments often use policy tools to mitigate economic fluctuations.
Investment Strategy
– Investors often adjust their strategies based on where they believe the economy is in the cycle. During booms, they may seek growth assets, while in busts, they may opt for defensive assets. However, timing the market perfectly is challenging, and diversification is key.
Policy Response
– Governments and central banks may implement various policies to manage the boom and bust cycle. For instance, they can use monetary policy (changing interest rates) or fiscal policy (government spending) to stimulate or cool down the economy as needed.
Table of Contents
Understanding the boom and bust cycle
Boom and bust cycles affect most areas of an economy, including sales, profits, employment rates, the housing market, government spending, and financial market performance.
Since the Wall Street Crash of 1929, there have been 28 boom and bust cycles of varying intensity, frequency, and duration.
What causes boom and bust cycles?
Why do boom and bust cycles occur? In other words, why does economic growth not follow a long, steady, upwards trajectory?
The answer can be found in the monetary policy of central banks. During periods of prosperity, banks lend money to individuals and businesses at low-interest rates.
This money is then invested into technology, stocks, and real estate, among many other things, with investors earning higher returns as the economy grows.
When capital is easily available, individuals tend to overinvest. This practice is called malinvestment, where money is invested in a wasteful way.
The abundance of capital also stimulates more demand, which creates a virtuous cycle of prosperity.
If demand outpaces supply, the economy can overheat. Too much capital chasing too few goods causes inflation, which then causes investors and businesses alike to try and outperform the market.
Bad investments then pour into the market as investors ignore the obvious risks.
During the bust phase of the cycle, investor confidence plummets. Apprehensive of a stock market correction, they pour capital into assets such as gold, bonds, and the U.S. dollar.
In a recession, discretionary spending decreases as consumers lose their jobs. The bust phase ends when prices are low enough to once again stimulate investor demand.
Phases of the boom and bust cycle
The boom and bust cycle has four phases, with each affording a more concise look at the machinations of alternating periods of growth and decline.
The four phases are:
Boom (expansion)
During the boom phase, economic growth accompanies a bull market with rising house prices, wage growth, and low unemployment.
This phase can last for years if growth remains in a healthy range of 2-3%.
However, if growth is above 4% for two or more consecutive quarters, the boom phase may be coming to an end.
End of boom (peak)
The point where expansion reaches a maximum value.
The National Bureau of Economic Research defines this phase as the inflection point where an economy ceases to expand.
Bust (contraction)
As most can appreciate, the bust phase is brutal, short, and devastating.
If the contraction of the economy lasts more than 3 months, it is considered a recession. Any resultant stock market crash also causes a bear market which may last for years.
End of bust (trough)
the end of the bust phase is the point where the economy stops contracting and begins to expand.
The boom and bust cycle describes the alternating periods of economic growth and decline common to many capitalist economies. Since the Wall Street Crash of 1929, there have been 28 boom and bust cycles.
The boom and bust cycle is caused by the monetary policy of central banks, who lower interest rates and freely lend capital during periods of prosperity. Irrational and unsustainable investment behavior then causes the economy to overheat.
The boom and bust cycle has four phases: boom, end of boom, bust, and end of bust. The cycle is ultimately set in motion if economic growth exceeds 4% in two or more consecutive quarters.
Key Highlights
Definition: The boom and bust cycle refers to the alternating periods of economic growth and decline that occur in many capitalist economies. It involves periods of expansion (boom) and contraction (bust), with the economy going through phases of prosperity and recession.
Cycle Impact: The boom and bust cycle affects various aspects of the economy, including sales, profits, employment rates, the housing market, government spending, and financial market performance.
Causes:
Central Bank Monetary Policy: Central banks play a role in the cycle by lowering interest rates and lending capital during periods of prosperity. This leads to excessive investments and demand.
Malinvestment: Abundant capital availability leads to malinvestment, where money is invested wastefully.
Inflation and Overheating: Excessive demand leads to inflation and economic overheating, with investors ignoring risks and making poor investments.
Phases of the Cycle:
Boom (Expansion): Characterized by economic growth, rising house prices, wage growth, and low unemployment. Sustainable growth is around 2-3%, but growth above 4% for consecutive quarters may signal the end of the boom phase.
End of Boom (Peak): The point where expansion reaches its maximum value and economic growth starts to slow down.
Bust (Contraction): Short and devastating, marked by high unemployment and devaluing investments. If the contraction lasts over 3 months, it’s considered a recession, often accompanied by a bear market.
End of Bust (Trough): The point where the economy starts recovering from the contraction phase.
History of Financial Bubbles: Examples of financial bubbles in history include Tulip Mania, Mississippi Bubble, South Sea Bubble, Stock Market Crash of 1929, Japanese Lost Decade, Dot-com Bubble, and the 2007-8 Global Financial Crisis.
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.
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Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.
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An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage. Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.
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The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”
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The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth. The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.
Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846. Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.
The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organizationscale further.
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
