Economic Expansion

An upward trend in the business cycle marked by a growth in production and employment

Author: Himanshu Singh
Himanshu Singh
Himanshu Singh
Investment Banking | Private Equity

Prior to joining UBS as an Investment Banker, Himanshu worked as an Investment Associate for Exin Capital Partners Limited, participating in all aspects of the investment process, including identifying new investment opportunities, detailed due diligence, financial modeling & LBO valuation and presenting investment recommendations internally.

Himanshu holds an MBA in Finance from the Indian Institute of Management and a Bachelor of Engineering from Netaji Subhas Institute of Technology.

Reviewed By: Hassan Saab
Hassan Saab
Hassan Saab
Investment Banking | Corporate Finance

Prior to becoming a Founder for Curiocity, Hassan worked for Houlihan Lokey as an Investment Banking Analyst focusing on sellside and buyside M&A, restructurings, financings and strategic advisory engagements across industry groups.

Hassan holds a BS from the University of Pennsylvania in Economics.

Last Updated:January 17, 2024

What is Economic Expansion?

Economic expansion is an upward trend in the business cycle marked by growth in production and employment. It leads to an increase in income and spending of consumers and businesses.

Although not all people and businesses see income improvements as a result of expansion, their increased confidence in the future encourages them to make larger purchases and investments.

When real gross domestic product rises from a trough to a peak over two or more quarters, it is said to be expanding. 

When the economy is stimulated, there is an increase in employment, followed by consumer confidence and discretionary expenditure. Economic recovery is another name for this phase.

Increases in output during an economic expansion result from increased consumer and industry purchases of durable goods, machinery, and equipment. The demand for goods and services is fueled by consumer and business confidence. 

Businesses add to their inventories as demand develops to uphold new purchase orders. Beyond the rise in actual sales, the choice to expand inventory often has an extra impact on production volume.

Economic expansion usually comes with the following:

  • Expansion is a stage of the business cycle during which the economy is stimulated, prosperous, and flourishing, resulting in a graphical upward trend.

  • Expansions might last anywhere from four to five years on average.

  • Interest rates, business profits, and capital expenditures are a few indicators to consider when determining whether the economy is entering a recession or boom.

Key Takeaways

  • Economic expansion is a growth phase in the business cycle marked by increased production, employment, and spending.
  • It's part of a four-phase cycle: expansion, peak, contraction, and trough, bringing prosperity, low-interest rates, and reduced unemployment.
  • Typically lasting four to five years, indicators include rising business profits, capital expenditures, and interest rates.
  • Economic expansion involves growth and confidence, while recovery follows a recession with improved GDP, reduced unemployment, and increased income.

Understanding Economic Expansion

Economic expansion is part of a four-phase process known as the business cycle, which includes expansion, peak, contraction, and trough.

The economy is said to be thriving during an expansion. Low-interest rates, which make borrowing money cheap, high economic activity, and substantial discretionary expenditure are all characteristics of a thriving economy. 

Due to a huge number of work opportunities, GDP increases, disposable income per capita increases, and unemployment rates decrease.

When expansion achieves its culmination, it reaches a peak. When there is a high amount of demand for things, inflation rises, and prices begin to rise. Consumers gradually reduce their purchases, and macroeconomic indices begin to decline.

Economic growth begins to slow and contract after reaching its peak. Companies are not obtaining as much income to sustain or grow operations due to a lack of cash flow across the economy as a result of higher costs of goods. 

To save costs and protect their balance sheets, they frequently halt the hiring process and start laying off employees. At this stage, the business cycle contracts.

The trough is the lowest point in the business cycle. The trough is the point where a contraction turns into a recession.

The stages of the business cycle are

  • Expansion: The economy is emerging from the slump. Borrowing money is cheap, firms start to restock, and consumers begin to spend again. In general, GDP rises, per capita income rises, unemployment falls, and stock markets perform well.

  • The expansion phase finally reaches its peak. As a result of the increased demand, the cost of commodities rises, and economic indicators begin to stagnate.

  • Contraction: The economy begins to slow down. Companies halt hiring as demand declines, and then start laying off employees to cut costs.

  • Trough: The economy moves from a period of decline to one of expansion. The economy reaches a nadir, opening the path for a comeback.

Economic Expansion vs. Economic Recovery

While economic performance is largely unpredictable, we have seen some dramatic shifts that frequently result in a boom, defined by rapid economic growth, or a recession, defined by stagnant economic growth.

A complete business cycle consists of a single boom and a single contraction in sequence.

1. Economic expansion

At this stage, the economy grows for two or more quarters in a row and there are transitions from a trough to a peak. Consumer confidence in the economy, increase in employment, and stable equity markets characterize this time.

Expansions can span from a few months to more than ten years, but they usually last four to five years on average. 

Policymakers, investors, and economists are all interested in business cycles. Potential investment possibilities and future trends can be identified using historical economic patterns.

Unemployment claims, hours worked by manufacturing employees, interest rates, and capital investment are indicators of economic expansion.

Several significant factors might help anticipate whether or not an expansion will take place soon. The factors are

  1. Raising business profits

  2. Capital expenditures for operations maintenance and growth

  3. Interest rates

  4. Manufacturers' average weekly hours worked

  5. Unemployment claims

  6. Building permits and other considerations

These indications can also be used to anticipate contractions.

2. Economic recovery

Following a recession, the business cycle is marked by improved or sustained business activity, such as large growth in the gross domestic product, a drop in unemployment, and an increase in income.

During an economic recovery, the economy adjusts to the central bank's and government's policies and rules, including the recession triggers.

It also entails re-purposing other productive resources in the economy that had been idle during the recession. This lays the groundwork for a new expansion.

Recovery indicators include a leading indicator (such as the stock market), and a lagging indicator (such as employment). Employers may be skeptical about the economic recovery timescale, thus unemployment remains high when the economy begins to recover.

The Impact of Interest Rates on Economic Expansion

The Federal Reserve will drop interest rates when the economy needs a boost, lowering borrowing costs. Businesses and people are more likely to spend their discretionary income as borrowing money becomes very inexpensive.

Saving extra money isn't a good idea under these conditions, therefore people and businesses boost their investment and expenditure.

The cheap cash flow will eventually raise the cost of spending or inflation, forcing central banks to raise interest rates and urging consumers to save. This has a detrimental influence on a company's bottom line, causing the economic cycle to tilt downhill.

The federal funds rate is mentioned frequently when interest rates rise or drop. This is the rate at which banks lend money to one another. 

It can fluctuate daily, and because its movement has an impact on all other loan rates, it is used as a gauge to determine whether interest rates are growing or lowering.

Both inflation and recessions can be affected by these developments. Inflation is the gradual increase in the price of goods and services. It is the outcome of a strong and thriving economy, nevertheless, unregulated inflation can result in a severe loss of purchasing power.

The Fed monitors inflation measures such as the Consumer Price Index (CPI) and the Producer Price Index (PPI) to assist in maintaining inflation under control. 

When these indicators begin to climb at a rate of more than 2% to 3% per year, the Federal Reserve will raise the federal funds rate to keep a check on increasing prices.

People will soon start spending less since higher interest rates indicate greater borrowing costs. As a result, demand for goods and services will fall, lowering inflation.

Between 1980 and 1981, a good illustration of this occurred. Inflation was at 14%, and the Federal Reserve boosted interest rates to 19%. This resulted in a devastating recession but put an end to the country's skyrocketing inflation.

Similarly, the Fed has been raising rates throughout the year to counteract rising inflation in 2022.

Falling interest rates, on the other hand, can bring a recession to a conclusion. Borrowing money becomes cheaper when the Fed reduces the federal funds rate, which encourages individuals to spend again.

In 2002, the Fed dropped the federal funds rate to 1.25 percent. This considerably aided the economy's revival in 2003. The Fed can avoid runaway inflation and minimize the severity of recessions by raising and decreasing the federal funds rate.

Economic Cycle, Credit Cycle, and CapEx Cycle

The following is an explanation of the economic cycle, the credit cycle, and the CapEx cycle:

1. Economic cycle

The term "economic cycle" refers to the economy's swings between expansion (growth) and contraction (recession).

Gross domestic product (GDP), interest rates, total employment, and consumer spending indicate where the economy is in its cycle. 

Because it has a direct impact on everything from stocks and bonds to profits and corporate earnings, understanding the economic cycle may assist investors and businesses understand when to make investments and when to pull their money out.

The circular movement of an economy from expansion to recession is known as an economic cycle, also known as a business cycle. Growth is the hallmark of economic expansion. 

A contraction, on the other hand, results in a recession, characterized by a drop in economic activity that lasts at least a few months.

2. Credit cycle

The stages of borrowers' credit access are described by a credit cycle.

Credit cycles begin with periods when funds are relatively easy to borrow. These periods are marked by lower interest rates, fewer lending criteria, and an increase in the amount of accessible credit, which drive an increase in overall economic activity. 

These times are followed by a decrease in the amount of money available. Interest rates rise and lending standards tighten during the credit cycle's contraction phase, implying that there is less credit available for business loans, home loans, and other personal loans. 

The contraction period lasts until the lending institutions' risks are lessened, the cycle troughs and the cycle begins again with increased credit.

When the economy needs a boost, officials attempt to cut borrowing costs, encouraging firms and consumers to spend more. Saving becomes unfavorable when the Federal Reserve lowers interest rates, and the expansion phase begins.

Money is freely flowing through the economy, businesses are taking out loans to expand, job prospects are improving, and consumer spending is skyrocketing.

Inflation will eventually grow as a result of the cheap money flow and the accompanying increase in expenditure, prompting central banks to raise interest rates. 

Suddenly, the focus is on persuading individuals to cut back on their spending and slow down the economy. Revenues are down, stock values are down, and the economy is contracting once more.

The risk and profitability of the lenders determine credit availability. Lenders are more inclined to extend loans if the risk is lower and the profit margin is higher

Risk lowers during periods of strong availability to credit in the credit cycle because investments in real estate and enterprises increase in value. As a result, corporate borrowers' repayment ability is robust. 

Individuals incline more to borrow money to consume or invest because money is cheaper and their salaries are stable or rising.

When the economic cycle's peak shifts, assets, and investments often lose value or don't produce much income, reducing the amount of cash flow available to repay loans. 

Banks tighten lending standards and boost interest rates because the chance of a borrower defaulting is larger.

As borrowers deleverage their balance sheets, this reduces the available credit pool and, at the same time, reduces demand for new loans, bringing the credit cycle back to the low access point. 

Some economists believe that the credit cycle is an important aspect of the economy's wider business cycles.

3. CapEx cycle

Several economists, like Irving Fisher, have observed that business cycles move in lockstep with companies' efforts to meet ever-changing customer demand.

When the economy is doing well, people are buying, and financing rates are low, management teams frequently want to take advantage of the situation by increasing production.

Initially, this results in increased sales and reasonable returns on invested capital. Later, the competition becomes more intense, and greed begins to take its toll. 

Supply eventually outstrips demand, prices fall, early debt binges become more difficult to service, and businesses are forced to lay off employees.

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Researched and authored by Ruxue Bai | LinkedIn

Reviewed and Edited by Parul Gupta | LinkedIn

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