It seems like the US economy crashes every decade or so, and there is some fact in this; the US economy and every other economy undergoes alternating periods of expansion and depression. This phenomenon is called the business cycle.

What is the business cycle?

Specifically, the business cycle refers to the fluctuation of the economy about the potential level of GDP. The potential level of GDP is the GDP when all resources are efficiently used and there is a normal rate of unemployment. The real level of GDP falls below potential GDP when resources are not used efficiently or when the unemployment rate rises above the natural rate. The real level of GDP rises above potential GDP when resources are overused – like destructive logging or disastrous pollution – or when some people who are economically unemployable are given jobs.

The business cycle consists of a period of expansion relative to the trend of long-term growth, after which the economy will reach a peak. Then, there is a period of contraction/recession relative to the trend of long-term growth, after which the economy reaches a trough. Then, the business cycle begins again. Cycles are not regular in length; sometimes depressions can occur within a couple of years, while other times decades may past without another severe depression. Government policy and regulation can have a huge impact on speeding up or delaying the cycle.

During the period of expansion, real GDP will rise, unemployment will fall, and inflation will increase; however, real income — income adjusted for inflation — will also rise, meaning consumers can buy more, and businesses produce more. Generally, everything which is part of a “booming economy.” This period is also called the inflationary period. In contrast, unemployment rises, and prices fall during the period of recession. Correspondingly, the real income will fall, slowing the economy.

What affects the business cycle?

The causes of the business cycle are not yet agreed upon, but it largely can be attributed to 2 things: supply and demand. When supply or demand is changed rapidly – shocked – the economy is pushed away from the equilibrium position; for example, when oil prices rapidly increase, like in 1973, the supply of goods is sharply reduced, slowing the economy and reducing output. When demand falls, the economy is likewise slowed because there is less consumer spending. An increase in either will have the opposite effect.

Common supply shocks are sudden changes in input prices, natural disasters, and technical discoveries. Natural disasters, like the Dust Bowl during the Great Depression, disrupt production, decreasing supply, while technical discoveries increase supply by facilitating production; the industrial revolution in the early 1900s led to the great imbalance between the supply of products and demand, resulting in crashes caused by too many goods and not enough consumers.

Demand shocks are caused by changes in consumer and business expectations; and financial crashes. If consumers and businesses expect financial hardships ahead, they will cut their spending, causing a decrease in demand. If they expect good economic developments, they will increase their investment and spending. Financial crises destroy the wealth stored in financial instruments; this causes consumers to spend less as they have less money. Additionally, financial crashes destroy consumer and business confidence, also decreasing spending.

Government and Federal Reserve Policies

After the Great Depression, the US Government has taken up mitigating the expansion and contraction, attempting to keep real output as close as possible to potential output. Its effort can be categorized as fiscal policy and monetary policy.

Fiscal policy is composed of changing government spending and raising or lowering taxes. These measures are decided on by the President and Congress. They are targeted toward increasing demand in depression and decreasing demand in an expansion, as demand is composed of – among other things – government spending and consumer spending, which depends on taxes.

Monetary policy is manipulating the supply of money in the economy. This is done solely by the Federal Reserve, the U.S. central bank. Increasing the money supply, or the amount of money in the economy will decrease the real interest rate, which increases investing from businesses and spending from consumers. Businesses invest more because money “costs” less to borrow and invest as the interest rate is the payment made on loans. Inversely, consumers will want to save less because they earn less on the money. Decreasing the money supply has the opposite effect of decreasing investment and consumer spending. It is important to note that I am talking about economic investment, which refers only to spending made to facilitate the future production of goods. As consumer spending and investment spending are a part of aggregate demand, controlling the money supply controls demand indirectly.

Where are we in the business cycle?

Recently, in the news, you might have seen news about President Trump disagreeing with current Chairman of the Federal Reserve, Jerome Powell. Their spat is fundamentally about the business cycle: the extremely low unemployment rate and robust growth in the stock market have convinced Chairman Powell that the US economy is approaching the peak of the business cycle, and so he has started to raise interest rates, which is contractionary monetary policy. Of course, this means slowing the economy to bring it closer to the long term trend line and to prevent or ameliorate the predicted-impeding contraction. President Trump, however, wishes to sustain growth, doubting a recession is imminent and that the expansion is coming to a close.

Is a recession approaching?

After the stock market took two serious hits in early 2019, the Fed has eased off raising interest rates, as it could scare investors into a financial crash. Additionally, unemployment (3.8%) still remains below the natural rate (4-6%). These indicators show that the economy is in a fragile position above the long-term trend line. The last three contractions in America were 2008, 2001, and 1991, about once every decade. The longest period of expansion was after the 1991 recession, lasting about 120 months. Our current period of expansion has already reached 117 months, meaning the US economy is due for another downturn soon. As such, correct monetary and fiscal policy should be implemented to soften the fall.

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