Economic Cycles: Inflation, Housing, and Oil Impact
Cyclical Inflation
When there’s high unemployment, stocks piling up in warehouses, and low production levels, the European Central Bank (ECB) might inject cash into the economy. The president of the ECB achieves this by buying government bonds from the capital market. This sale provides banks with high cash reserves. However, cash earns low interest compared to other assets, so banks prefer to lend it out.
Banks then offer businesses attractive loan deals, encouraging expansion. After expanding, the factory owner needs more employees, causing the unemployment rate to drop and wages to increase.
Increased incomes allow households to buy more goods, leading to a reduction of stocks and an increase in goods’ prices. Stores need more goods, restarting the cycle as factories increase production.
The finance minister benefits from increased tax revenue. Additionally, less money is spent on unemployment benefits. The government starts to run a surplus and can begin paying off public debt.
The government buys back previously issued bonds from investors and banks. As their cash reserves increase, interest rates decrease.
Low interest rates make borrowing cheaper, further stimulating the economy. This marks a full recovery from the recession.
The Housing Boom
Due to banks’ efforts in boosting the cash supply, the economy thrives. With nearly full employment, banks perceive lending as low-risk.
The finance minister allows banks to offer mortgages with fewer conditions, anticipating electoral benefits.
As people buy houses, real estate prices rise. Bankers continue offering attractive mortgages, creating a cycle where families sell and buy new houses, increasing government tax income.
However, the Central Bank observes rapidly increasing prices.
The Housing Collapse
The Central Bank brakes the economy by selling government bonds to the capital market, reducing the money supply. Banks receive cash in return, causing bond prices to fall.
Commercial banks now have less cash, and their remaining government bonds have decreased in value. This creates an imbalance between cash and less liquid assets. Banks need more cash to restore balance.
Banks increase interest rates, negatively impacting companies. Businesses reduce production and lay off workers. Newly unemployed individuals struggle to pay mortgages and lose their houses.
House prices fall. There’s also a reduction in consumption and less tax revenue for the government.
Banks and companies become cautious, neither lending nor borrowing. The economy stagnates in a deep recession, heading towards depression.
The Bank Bailout
The Central Bank (CB) tries to increase cash flow. Many unemployed people, companies, and banks are hesitant to lend or spend, preventing banks from collapsing completely.
The CB and the finance minister decide to intervene. The finance minister sells more government bonds to cover unemployment costs.
The finance minister also orders goods from factories, restarting production. However, unemployment costs remain, wages are low, and public debt increases. The finance minister issues bonds directly from the government (despite CB disapproval). The money from these bonds (helicopter money) is distributed to the population. Prices start to rise: inflation returns.
The Oil Effect
An economic boom increases energy demand. Oil prices rise. Factories face higher oil costs, increasing the price of their goods, which leads to higher shop prices.
However, workers’ wages don’t increase, reducing their purchasing power. Stocks pile up, and shops cancel orders. Factory workers are laid off, further reducing purchasing power. The Central Bank becomes concerned, and the cycle begins anew.