During the boom the economy grows, jobs are plentiful and the market brings high returns to investors. In the subsequent bust the economy shrinks, people lose their jobs and investors lose money. Boom-bust cycles last for varying lengths of time; they also vary in severity.
Since the mid-1940s, the United States has experienced several boom and bust cycles. Why do we have a boom and bust cycle instead of a long, steady economic growth period? The answer can be found in the way central banks handle the money supply.
During a boom, a central bank makes it easier to obtain credit by lending money at low interest rates. Individuals and businesses can then borrow money easily and cheaply and invest it in, say, technology stocks or houses. Many people earn high returns on their investments, and the economy grows. The problem is that when credit is too easy to obtain and interest rates are too low, people will over-invest.
This excess investment is called malinvestment. There won’t be enough demand for, say, all the homes that have been built, and the bust cycle will set in. Things that have been over-invested in will decline in value. Investors lose money, consumers cut spending and companies cut jobs. Credit becomes more difficult to obtain as boom-time borrowers become unable to make their loan payments. The bust periods are referred to as recessions; if the recession is particularly severe, it is called a depression.
Additional Factors in Boom and Bust Cycles
Plummeting confidence also contributes to the bust cycle. Investors and consumers get nervous when the stock market corrects or even a crashes. Investors sell their positions, and buy safe-haven investments that traditionally don’t lose value, such as bonds, gold, and the U.S. dollar. As companies lay off workers, consumers lose their jobs and stop buying anything but necessities. That exacerbates the a downward economic spiral.
The bust cycle eventually stops on its own. That happens when prices are so low that those investors that still have cash start buying again. This can take a long time, and even lead to a depression. Confidence can be restored more quickly by central bank monetary policy and government fiscal policy.
What Causes the Boom and Bust Cycle?
Government subsidies that make it less expensive to invest may also contribute to the boom-bust cycle by encouraging companies and individuals to over-invest in the subsidized item. For example, the mortgage interest tax deduction subsidizes a home purchase by making the mortgage interest less expensive. The subsidy encourages more people to buy homes.
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