Boom And Bust Cycles Definition Causes How It Works

Boom and Bust Cycles Definition

Key Takeaways

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.

Explanation

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.

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Causes and Impact of Boom and Bust Cycle

#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 banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more stimulate investment in CAPEXCAPEXCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more 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 Leading IndicatorsLeading Indicators are statistics which help in a Company’s macro-economic forecasts & predict the emerging stage of a business cycle. They act as a variable with economic linkage offering details about early signs of turning points in the business cycles, which precede the lagging & coincident indicators. read more 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 exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more 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 subsidySubsidyA subsidy in economics refers to direct or indirect financial assistance from the government to an individual, household, business, or institution to promote social and economic policies.read more 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 Foreign InvestmentForeign investment refers to domestic companies investing in foreign companies in order to gain a stake and actively participate in the day-to-day operations of the business, as well as for essential strategic expansion. For example, if an American company invests in an Indian company, it will be considered a foreign investment.read more, 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.

How to protect yourself from Boom and Bust Cycle?

Pre-empting boom and bust cycles is a very difficult task. Therefore, market timing Market TimingMarket timing is the plan of buying and selling the securities on the basis of decisions made by financial investors. They do security analysis to earn a profit on selling and it is the action plan to cope up with the fluctuations in the market prices.read more 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 investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more. Therefore, they may only analyze when they can observe a clear indication of the economy’s direction.

However, this does not mean that retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more 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 portfolioDiversification In The Investment PortfolioPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio.read more 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 economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more 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 derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more, 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.

Conclusion

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 Fiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more and monetary policy Monetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more 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.