You may be asking how a measly-looking sine wave actually applies to real life. Well, the answer to that question is embedded within the business cycle! Each business cycle wave begins with a period of expansion known as the “Boom” which is most often created by the Federal Reserve or the US Government via monetary and fiscal policy to stimulate the economy. During this stage of the business cycle, the Gross Domestic Product (GDP) is increasing at a steady rate. Concurrently, businesses are flourishing and unemployment rates are low due to high demand, but inflation is also steadily increasing. This usually means that although people make more in this portion of the business cycle, their overall spending power remains the same. Soon, however, the inflation increases to where any expansion is stalled and instead the economy starts to decline. At this point, the economy has reached a maturing point and can no longer grow without going into hyperinflation. As a result, the Federal Reserve and US Government implement actions to reduce the supply of money to the economy, also known as contractionary fiscal (if done by the government) or monetary policy (federal reserve). This leads to the second section of this sine wave, the “Peak.”
The navigation of an economy over the sharp “peak” in the business cycle is referred to as a recession. During this point in the cycle, unemployment is at all-time highs due to low demand, and many businesses are struggling to stay open, but contrary to popular belief, inflation decreases. It is a common misconception that recessions have high inflation as people are often depicted as hungry or malnourished during these times; however, it happens to be that the unemployment is so high that people have no money to spend even as the economy deflates. Once economies reach this point in their business cycles, their monetary and fiscal policies take them through one of two scenarios. They either undergo a depression or an expansion.
But, how can two contrary economic possibilities arise from one portion of the business cycle? Well, to summarize, the answer is monetary policy. To elaborate, as the Federal Reserve sees high levels of inflation, it enacts a contractionary policy on the Interest On Reserves (IOR). This action is very effective at addressing rampant inflation; however, the effects of this policy are only felt after 6-8 months have passed. As a result, the Federal Reserve is playing a guessing game to perfectly stabilize the economy and can never really be sure of a “soft landing.” If the “soft landing” is achieved, the economy can successfully rebound without too large of an impact. However, in the past 60 years, the Federal Reserve has only achieved one “soft landing”. As aforementioned, if there isn’t a “soft landing”, then the economy will begin to collapse as supply and demand are low.
Furthermore, this digression aids in your understanding of what factor leads to the next portion of the business cycle, the Trough. This is essentially the breaking point of the economy and is also referred to as a depression. Some examples of this are the Great Depression and the market crash of 2008. During this segment, many businesses will close, and quality of life will decrease, but the economy will actually deflate, lowering the prices of consumer goods. Thus, this sets up the perfect environment for the economy to expand once more as people are now able to purchase more with the money they have.
Finally, to further bolster your understanding of the business cycle, I have an analogy to help: the day and night cycle. Just like how the sun rises, reaches its peak, and then sets, the economy goes through phases where it grows, reaches its peak, and then contracts. What makes the business cycle even more fascinating is not that it is just numbers on a graph, rather it is a reflection of the decisions made by people, businesses, and the government.
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