Boom and Bust Cycles

The boom and bust cycles are the Gross Domestic Product (GDP) cycle of upward and downward movements and their long-term trend. It helps identify the level of production in the economy and the performance of the associated economic indicators such as employment, inflation, stock performance, and investor behavior.

The boom and bust cycle is a part of the economic framework and is unavoidable. Therefore, it is best to stay familiar with the changing economic scenario and take necessary actions as the circumstances demand to minimize the loss during busts and maximize the gains during the boom. Tracking the  fiscal policy and monetary policy can be a good start for staying aware and ahead of dire circumstances or pre-empting profitable situations and modifying savings, investment, and consumption strategies accordingly.

• The boom and bust cycles are the rising and downward movements and their long-term trend. It aids in determining the economy's output level and the related economic indicators, such as employment, inflation, stock performance, and investor behavior.
• The causes and impacts of the boom and bust cycle are money supply, investor confidence, and fiscal intervention.
• Diversification, savings, and hedging are the steps retail and institutional investors can take to avoid losing in the cyclical change.
• Tracking the fiscal and monetary policy can be a good start for identifying dire circumstances, acquiring profitable solutions, and modifying savings, investment, and consumption strategies accordingly.  

The boom and bust cycle refers to the concept which explains the rise and fall of the economic condition of a country, which is a repetitive process. It is a process that can be characterised by sudden and fast growth and then a contraction or a downturn. They are fluctuation in the economy that take place in the form of a cyclic pattern.

During the boom period, there is a robust expansion in the economy in the form of high levels of employment creation, rising in prices of stocks and real estate, which in turn increase the income of consumers due to which they have more money in their hands which they can afford to spend. This again increase demand and gives a boost to production in the domestic market and international trade. Overall, the economy experiences a huge growth and expansion.

During bust, the opposite happens. There is a downturn in the economic condition leading to recession, fall in employment opportunity, loss of income and wealth of consumers. Due to this they have less money to spend and there is low spending, low demand and fall in investment.  

It is to be noted that the above situations are normal phenomenon in any market economy and is the result of combined interaction of different factors that influence the market, which might be internal, which are within the organization or external, which are macroeconomic factors.

It is possible to control such situations so that the adverse effects do not influence the economy in a big way. But it is not possible to eliminate them. Policymakers follow them closely and ensure that the designed strategies to control them are implemented to the fullest.

Below is an image of the GDP cycle. The straight line is the potential GDP, upwards sloping, implying progress in overall production technology and scientific innovation. At the same time, the crests are the boom periods, and troughs are the bust periods.

Let us look at some of the causes of the concept in detail.

#1 - Money Supply

• It is the most important factor that leads to GDP's cyclical behavior. Lower policy rates and lower lending rates of commercial banks stimulate investment in CAPEX in the economy. As a result, as production expands, employment and working hours increase, wages increase, and consumption increases.
• Such measures are taken by the Central Bank when the economy is underperforming, and therefore it needs a boost. The continued expansion causes a boom in the economy until production exceeds the full employment level or the potential GDP level.

• This situation is called the overheating of the economy or a condition of excess supply. When there is insufficient demand, the revenue generation reduces, leading to non-repayment of borrowed money and an increase in NPA. That leads to the start of the bust cycle leading to the reverse trend.

#2 - Investor Confidence

• Investors pump in money before they expect a boom. The investment is cheaper and assessed that the future boom cycle can bring huge returns. So, one of the leading indicators of a boom cycle is investor confidence and investment inflow.

• However, when investors notice that the investment may not be fruitful and, therefore, lower returns than expected, they withdraw money and seek safer investments. Due to this, a bust cycle emerges.

• Investors use a stock exchange as a barometer for their assessment; if it rises continuously, their confidence is maintained. However, any decline resulting from misplaced economic policies undermines their faith, and the investors pull out money, pre-empting the future reduction in returns.

#3 - Fiscal Intervention

• Fiscal intervention is the government side of actions that lead to expansion or contraction in the economy.

• Taxation and subsidy are the two most important tools that the government has at its disposal. The reduction in taxation or providing a tax holiday for a given time can induce expansion. Providing utilities at subsidized rates can encourage producers to undertake a higher production level because production costs fall. The opposite measures are undertaken when the economy is overheating.

• There are many regulations that the government liberalizes to attract foreign investment, such as the FDI & FPI norms, exchange rate policies, repatriation laws, etc. However, auto-correction in the economy takes ample time, so fiscal or monetary intervention is required; otherwise, the economy may go into depression, leading to immense dissatisfaction and geopolitical instability.

Let us understand the concept with a suitable example as given below.

We assume that a country ABC is undergoing a recession or a bust situation where there is a lot of umemployemnt prevailing in the economy, lack of disposable income in the hands of consumers leading to less demand, lack of investment due to less money supply in the economy, which is turn is again leading the country ABC towards severe downturn.

In such a situation, the central bank of the country decides to intervene by implementing monetary policy measures. The policy makers decide to lower interest rates of banks and financial institutions. This will instigate consumers and corporates to borrow funds at less rates that can be used for spending, investment and increase in consumption, thus bringing the economy out of recessionary situation.  

A few months down the line, the economy recovers and slowly the boom situation can be seen, when there is a recovery towards employment generation, growth in trade, industry, demand, supply and international trade.

Pre-empting boom and bust cycles is a very difficult task. Therefore, market timing is important in the stock market trading domain. Unfortunately, most retail investors are not able to time properly as they are not aware of the actions of institutional investors. Therefore, they may only analyze when they can observe a clear indication of the economy's direction.

However, this does not mean that retail investors cannot achieve sufficient returns from the uptrends and save themselves from the downtrends. Retail and institutional investors alike can take the following steps to not lose capital in the cyclical change by undertaking the next steps:

#1 - Diversification

It is always good to have some level of diversification in the investment portfolio and income portfolio. For example, a good mix of equity, bonds, and commodities will protect the investor from high inflation or bust cycles and provide good returns during boom cycles. However, investors who are heavily dependent on any sector for their income should not take on financial investments only to diversify their risks to that sector.

#2 - Savings

Maintaining a healthy level of savings in a retirement fund and for the bust cycle periods is a good strategy because that can come in handy when the economy is not performing well. In addition, postponing consumption that is not needed immediately is a good strategy.

#3 - Hedging

It is always a safer strategy to forgo profits by investing in hedging instruments such as derivatives, which help the investors control their losses in unforeseen events. In the case of a Boom market, the tools expire out of the money, and therefore only the cost is a drag on the return.

Thus, the above are some of the methods by which individuals or corporations can protect their portfolios and effectively plan their budgets so that the fluctuations can minimize damage to their investments and their daily lifestyle. It is important to take calculated risks and gain as much idea and knowledge about various financial procedures as possible so that they can be effectively utilized to control any negative effect in unforeseen situations.

This article has been a guide to what are Boom And Bust Cycles. We explain the concept with an example, along with graph, causes & how to protect oneself. You can learn more about it from the following articles: -

• Expenditure Approach for GDP
• Calculate Debt to GDP Ratio
• Calculate Nominal GDP