AQA Specification focus:
‘Students should be able to discuss causes of cyclical instability such as: excessive growth in credit and levels of debt, asset price bubbles, destabilising speculation and animal spirits or herding.’
Introduction
Cyclical instability reflects fluctuations within an economy’s growth path, often driven by financial excess, speculation, and irrational behaviour that amplifies booms and deepens recessions.
Understanding Cyclical Instability
Cyclical instability refers to unpredictable swings in the economic cycle, where rapid expansion is followed by contraction. Such instability undermines sustainable growth and can create long-term structural challenges for an economy.
Key drivers include:
Excessive credit growth
Asset price bubbles
Speculation and destabilising behaviour
Animal spirits and herding
Credit and Debt Growth
Credit expansion fuels economic growth by providing businesses and households with borrowing opportunities. However, when credit grows excessively, risks emerge.
Excessive Credit Growth: A situation where borrowing levels rise significantly faster than income or output, leading to unsustainable debt burdens.
Excessive credit and debt levels can cause:
Rapid increases in consumption and investment, boosting short-run growth.
Over-leveraging by households and firms, creating vulnerability during downturns.
Financial system fragility, as banks face higher risks of default.
A collapse in confidence may then trigger a credit crunch, amplifying recessionary pressures.
Asset Price Bubbles
A common form of instability arises from asset price bubbles, where prices of housing, shares, or other assets rise far above their fundamental value.
Asset Price Bubble: A rapid and unsustainable rise in the value of an asset, driven by speculation rather than fundamentals.
Key features of bubbles:
Driven by expectations of ever-rising prices.
Encourage speculative investment rather than productive investment.
Collapse sharply when confidence falls, often causing recessionary shocks.
Examples include housing market bubbles, where high borrowing levels fuel demand, and the eventual correction causes widespread negative equity and banking crises.
Speculation and Destabilising Behaviour
Speculation involves purchasing assets primarily to profit from short-term price changes rather than underlying value.
Speculation: The practice of engaging in risky financial transactions in the hope of profiting from short-term market fluctuations.
While speculation can increase liquidity in markets, destabilising speculation occurs when:
Prices become increasingly detached from economic fundamentals.
Short-term gains dominate decision-making.
Volatility rises, discouraging long-term productive investment.
This destabilisation is often linked to sudden capital flight, exchange rate crises, and financial instability.
Animal Spirits and Herding
Cyclical instability is also shaped by human psychology.
Animal Spirits: A concept introduced by John Maynard Keynes describing the influence of human emotions, confidence, and herd behaviour on economic decision-making.
Characteristics of herding behaviour:
Investors and consumers mimic each other’s decisions rather than relying on rational assessment.
Amplifies bubbles and crashes, as collective optimism or pessimism moves markets away from equilibrium.
Creates self-fulfilling cycles of boom and bust.
Such behaviour explains why markets can appear irrational, with optimism fuelling unsustainable expansions and panic driving deeper recessions.
Interaction Between Causes
Cyclical instability rarely stems from a single factor. Instead, the causes often interact:
Excessive credit growth can inflate asset price bubbles.
Speculation accelerates bubble growth and sharpens corrections.
Animal spirits amplify the cycle, with confidence driving booms and fear deepening busts.
For example:
A housing boom may be fuelled by cheap credit and speculative demand.
Rising prices generate herd behaviour as more buyers enter the market.
Once confidence falls, lending contracts, asset prices collapse, and recession follows.
Implications for Economic Performance
Cyclical instability has significant effects on both the short run and long run:
Short-run impacts
Rapid GDP fluctuations, undermining stability.
High volatility in employment and investment.
Inflationary pressures in booms, deflationary risks in busts.
Long-run impacts
Reduced business confidence, lowering long-term investment.
Structural unemployment from repeated downturns.
Financial crises damaging banking systems and government finances.
These patterns explain why policymakers monitor credit growth, asset markets, and speculative activity to prevent instability.
Policy Considerations
Governments and central banks attempt to reduce cyclical instability through:
Monetary policy: Controlling credit growth with interest rates and bank regulation.
Macroprudential regulation: Ensuring banks maintain capital buffers and restrict risky lending.
Fiscal policy: Counter-cyclical spending to stabilise demand.
Market surveillance: Monitoring bubbles and speculative trends to reduce systemic risk.
These measures highlight that while cyclical instability cannot be eliminated, it can be managed to reduce harm to individuals, the economy, and financial stability.
FAQ
Banks extend credit during booms when confidence is high, encouraging further borrowing and investment. This can overinflate asset prices and household debt levels.
When downturns begin, banks often restrict lending due to rising default risks, worsening the slowdown. This procyclical behaviour means banks can both fuel expansions and intensify recessions.
Normal fluctuations reflect changes in fundamentals such as earnings or productivity.
Asset bubbles, however, occur when prices rise far beyond their underlying value due to speculative buying.
Fundamentals: justified by economic performance.
Bubbles: driven by speculation and expectations of continuous price growth.
The key distinction is sustainability—bubbles inevitably collapse, while normal adjustments do not destabilise the wider economy to the same extent.
Speculative investment prioritises short-term profit from price movements rather than long-term value. This encourages volatility and misallocation of resources.
Speculation can create sudden inflows and outflows of capital, destabilising currencies or asset markets. In severe cases, it undermines investor confidence and triggers financial crises.
Herding is not confined to investors. Consumers may copy each other’s spending choices, especially in housing or durable goods.
This can intensify demand during booms, raising prices further. When confidence falls, widespread cutbacks in spending occur at the same time, deepening the downturn and reinforcing cyclical instability.
Policymakers often watch for:
Rapid credit expansion relative to income growth.
Asset prices rising faster than fundamentals.
Sharp increases in speculative trading volumes.
Unusual volatility or herd-driven surges in market sentiment.
By monitoring these signals, governments and central banks aim to intervene before instability turns into a full financial crisis.
Practice Questions
Define the term asset price bubble. (2 marks)
1 mark: Identifies that it involves a rapid or excessive rise in the value of an asset.
1 mark: States that this rise is unsustainable and not based on economic fundamentals, often followed by a sharp fall in prices.
Explain how excessive growth in credit and herding behaviour can contribute to cyclical instability in an economy. (6 marks)
1 mark: States that excessive credit allows households and firms to borrow more, fuelling consumption and investment.
1 mark: Notes that this can create over-leveraging and vulnerability when debt cannot be repaid.
1 mark: Explains that herding behaviour occurs when individuals imitate the actions of others rather than acting independently.
1 mark: Links herding to the creation and reinforcement of bubbles as optimism drives prices higher.
1 mark: Explains that both factors amplify the boom phase of the cycle.
1 mark: States that when confidence collapses, credit contracts and herd behaviour reverses, intensifying the downturn and cyclical instability.
