Business Cycle and Suitable Fiscal policy

Discuss the phases of business cycle. Suggest Suitable Fiscal policy and monetary policy to overcome the recession in economy. Business Cycle - A business cycle is also known as trade cycle. It implies wave like fluctuations in the level of economic activity, particularly in national income a, employment and output. It is a short term picture of the behaviour of real output in a private enterprise economy. Business cycle refers to upturn and downturn in the level of economic activity that extends over a period of time.

The business fluctuations occur in aggregate variable such as national income, employment and price level. The variables nearly move at the same time and in the same direction. However they vary in duration and intensity. Cyclic fluctuations have the following features:

•Wave line movements –
ocyclical fluctuations are wave like movements and are recurrent in nature ocharacterized by alternation of expansions( prosperity) and contraction ( depression) in economic activity oare repetitive and rhythmic

ocontains oscillating movements in the form of waves from peak to trough and trough to peak •Synchronic –
oEntire business of an economy acts like an organism
oAny happening on economic front affects the entire economy oAnd through the mechanism of international trade affects entire world oexample -The Great depression 1929
•Cumulative –
oProcess of expansion and contraction is of cumulative and self-reinforcing in nature oMoves in same direction until external forces reverses its direction •Self-generating forces –
oIt can terminate the period of prosperity and start depression oCannot have definite period of prosperity or depression
•Non identical –
oPeriod of trade cycle are not identical although they recur with great regularity •Not symmetrical
oPeak and trough are not symmetrical
oMovement from upward to downward is more sudden and violent than that from downward to upward oDownturn is sharp and steep

oIt is relatively narrow at its peak and flatter at its trough

Phases of business cycle:
A business cycle can be divided into four phases.

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They are shown in the fig 1.1 The phases are:
1.Expansion or prosperity or the upswing
2.Recession or upper-turning point
3.Contraction or depression or downswing
4.Revival or recovery or lower turning point

These phases are recurrent and uniform in case of different cycles. But no phase has definite periodicity or time intervals. A business cycle starts from trough or low point, passes trough a recovery and prosperity phase, rises to peak, declines through a recession and depression phases and again reaches a trough.

1)Expansion or prosperity or the upswing or peak or Boom -
The top of a business cycle is called Peak or Boom or prosperity phase. In the boom period, the overall business activity is rising at a more rapid rate. There is a rise in real output and incomes of the people. There is a rise in production, prices, employment, wages, interest rates, profits and in the volume of bank credit. The general mood of the businessmen is that of optimism and commercial. The industrial activity both speculative and non-speculative shows remarkable expansion. Construction activity gets a big boost. Share markets give good gains to the investors.

Financial institutions tend to expand credit. In the words of Haberler. ‘‘Prosperity is ‘a state of affairs in which the real income consumed, real income produced and the level of employment are high or rising and there are no idle resources or unemployed workers or very few of either”. During prosperity period, there is a high level of demand for capital goods and consumer goods and services. Risky investments are undertaken by the entrepreneurs.

Inefficient firms enter into the market and manage to survive. The high level of demand for the various inputs creates shortage of some of them. Inflation goes up. The economy becomes supply constrained. The state of prosperity proves to be short lived and the downturn of its period starts. 2) Recession or upper-turning point -

The end of prosperity comes and enters into recession. Recession is a slowdown of business activity. In recession employment and output both decline. The forces which bring the contractionary phase of business fluctuations (recession) are as follows: a) As prices of the commodities rise the wages of the workers tend to lag behind. The reduction in the purchasing powers of the workers brings down the demand for consumer goods b) Due to shortage of some inputs the expansion in production of goods is hampered. c) The non-availability of credit beyond a particular limit of expansion acts as a serious brake on prosperity. The financial institutions begin to recover the loans.

The firms which are unable to pay back the loans begin to liquidate their stocks. When more firms sell their output at the same time the price level starts falling. If a few firms get involved in losses a wave of pessimism runs through the share markets. The firms begin to curtail production. Workers are laid off. The outstanding orders for raw materials are cancelled. The new projects are shelved. The wave of pessimism passes on to other sectors of the economy and the businessmen become panicky and the whole economic system runs into crisis. Then the next stage of business cycle called depression starts. 3)Depression or Trough or downswing –

Depression is the most fearful stage of a trade cycle. The phase of depression (also called slump) is characterized by low economic activities, rapid decline in general output and employment. The decline in economic activity is not uniform. There is much more decline in output in manufacturing mining construction transport industries. However there is comparatively less contraction in output in retail trade and agriculture. In slump, there is a marked fall in the average prices of the commodities. The costs are relatively higher the profits of the entrepreneurs decline.

The purchasing power of the money is high but due to low income there is too much contraction in effective demand for consumer goods. The expenditure on capital goods or its replacement greatly falls Most of the firms reduce their output or close down. The income of the shareholders goes down. Depression or slump leads to redistribution of national income Profits and wages fall faster relatively to rent and other fixed incomes.

The bankers follow the policy of credit contraction. Due to dull business conditions producers are also reluctant to borrow funds Summing up in a period of slump there is negative net investment by firms falling demand of consumer as well as capital goods high unemployment and low level of imports. In the words of Haberler, Depression is a state of affairs in which real income consumed or volume of production per head and the rate of employment are falling.

There are idle resources and unused capacity especially unused labour.’’ In the economic life of the world such acute crises have occurred in the years 1710 1827 1873 1907 and 1929. 4) Revival or Recovery -

The economic conditions which we have described in depression phase do not remain as such forever. After sometime revival or recovery sets in under the influence of a variety of factors. The revival phase develops when the accumulated stock of commodities with the businessmen are exhausted. The costs under the impact of prolonged depression begin to fall. The prices which have reached its lowest level stop falling further. There is then complete harmony between costs and price relationship.

When profits begin to reappear, the businessmen are induced to invest their hoarded money in some enterprises: In order to steal a march over other industrialists, they start repairs, renewal and replacements of their capital equipments and stocks. The capital goods industries resume activities. There is gradual of labor.

The money incomes begin to increase and the effective demand is revived. The government also tries to break the spell of depression by starting construction or expanding some public works with a view to give more employment. The commercial, banks which have accumulated large reserve offer credit on favorable terms. The marginal efficiency of capital begins to rise and investment opportunities brighten up.

The consumers start buying commodities to avoid the rise. Due to increase in demand for commodities, investment in various industries is stimulated and thus the revival takes place. The recovery phase of business cycle thus is characterized by rising production, increasing prices of both consumption and capital goods, rising of wages, rates, enlarged opportunities of employment, and greater amount of spending on consumption and investment goods. Prior to 1940’s, there were frequent booms and depressions in the capitalistic world.

However, after the World War-Il, the strong cyclical upswings and downswings have been considerably tamed by the timely applications of fiscal and monetary measures. The fluctuations in economic activity are now moderate. Consequently, the term economic expansion and economic contraction are used now for the terms boom and recession.

Both expansionary monetary policy and expansionary fiscal policy are being used to counter the recession. Expansionary monetary policy is basically just lending more money to people; people borrow that money and spend it creating demand in the process. The United States has been using expansionary monetary policy for about 20 years straight now which has directly lead to massive increases in the levels of debt in the economy.

Debt levels are so high now that no one can actually borrow any more so monetary policy has stopped working. Monetary policy is at the most expansionary setting possible right now and it is having effectively no expansionary impact on the economy as a consequence of excessive debt levels.

Fiscal policy thus is the only option left available to actually rectify the situation; basically all you are doing is spending money through the government thus creating demand in the economy. Measures being taken include tax cuts, other measures being taken include infrastructure spending and extending the length of unemployment benefits.

This is basically a Keynesian approach. Keynesian economics revolves around the concept of 'aggregate demand' the government can increase the amount of aggregate demand through government spending. A Keynesian approach is fundamentally the right way to go under the circumstances that exist as this crisis is basically a crisis of demand. The classical approach is to do nothing and to rely on the natural robustness of the macro economy to solve the problem. Most macroeconomists agree that this is ineffective if not stupid, but it was first thought to be the solution to the 1929 market crash.

The Keynesian approach takes several forms but all of them are supposed to result in the so called "multiplier effect" causing the economy to grow once it has been stimulated by making more money available at some place in the social system. Unfortunately it doesn't work due to this money having to be borrowed or taken from some other part of the system. Keynesian economics is only a partial model and is unable to really show how it might grow.

The current Keynesian methods in use are to borrow money from the public and increase the national debt. Also to print more money and use it to reduce this debt, but this means inflation and it is no more effective than that of the greater loans. Inflation is also dishonest because it makes the debt owed by the government of smaller value in terms of what its money can buy. Money is only a representative of wealth, not wealth itself. If the system were one of barter and in the present crisis then more money does not mean more wealth, except for the printers of course.

To reduce the rate of interest on the national debt does help to reduce the budget deficit for the next year, but it is not very effective and will not solve the problem at anything like the speed needed. So that with present methods there is no way to get out of the recession. Fiscal Policy

When it comes to how fiscal policy affects the economy during a recession, the government has some automatic stabilizers in effect. These items work to automatically stabilize the economy when a recession takes place. With fiscal policies, the government influences the economy by changing how it (the government) spends and collects money. For example, the income tax system acts an automatic stabilizer. When people make less money, they also pay less money in income taxes. Unemployment benefits are another example of an automatic stabilizer. This helps families continue to receive income so that they can keep spending and keeps the economy going.

The most common fiscal policy actions in a recession are:

•Tax cuts for businesses or for individuals - When the economy is struggling during a recession, the government can attempt to help the situation by charging less in taxes. In many cases, the executive and legislative branches work together to cut taxes for Americans. By doing this, it gives people more discretionary income so that they can spend and stimulate the economy. i.e people and corporations have more money, which may make them more likely to buy things, which increases demand.Once the economy stabilizes, the government can gradually reintroduce the taxes and help keep the economy and the government going.

•Increase Government Purchases Another way that the government can use fiscal policy to stabilize the economy during a recession is to increase government purchases. The government can use more money to buy goods and services from domestic providers. This increase in sales helps stimulate the businesses. This increases demand for labour, which can lower the unemployment rate.These businesses can then use this increase in income to buy more supplies and expand even further. Once this begins to happen, it can have a positive effect on the entire economy and stabilize the recession by providing more jobs and opportunities for unemployed entrepreneurs.

•Expansionary vs.Contractionary - One of the arguments among economics on how to use fiscal policy centers around expansionary and contractionary strategies. An expansionary fiscal policy involves increasing government expenditures or lowering taxes so that the deficit increases. By comparison, a contractionary fiscal policy cuts back on government expenditures or increases taxes so that the government can have a financial surplus. Using an expansionary policy can improve the economy in the short-term, but eventually it could hurt the economy as the government's debt becomes too large.

Monetary Policy
During an economic recession, unemployment rises while incomes, business investment and consumer spending fall. Monetary policy aims to shorten recessions by encouraging consumer spending and investment. Monetary policy actions can help shorten recessions or reduce their impacts, but economic conditions may limit their impact. In addition, it takes time for policy decisions to be felt throughout the economy at large. Government usually responds to an economic recession through stimulative fiscal policy, expansionary monetary policy or a combination of the two.

Stimulative fiscal policy involves higher government spending in an attempt to stimulate the economy. Expansionary monetary policy consists of actions by central banks, such as the U.S. Federal Reserve, RBI to expand the money supply to encourage more consumer spending and business lending. Expansionary monetary policy actions to battle a recession include the purchase of government bonds by central banks, reducing banks' reserve requirements, and lowering short-term interest rates.

Effects Of monetary policy-
The purchase of government bonds by central banks injects more money into the economy. Lower reserve requirements give banks more money to lend because they are required to hold fewer reserves against deposits. Increased lending by banks stimulates business investment and expansion. A reduction in short-term interest rates also encourages more investment by reducing the cost of borrowing. Lowering short-term interest rates also reduces the rates on home mortgages, lowering mortgage payments for homeowners, giving them additional disposable income.

Although expansionary monetary policy has the ability to reduce the length and severity of an economic recession, there is no guarantee it can do so. Lower interest rates, for example, may not stimulate consumer spending if consumers have little confidence in the economy. They are unlikely to increase their spending if they believe their jobs are at risk because of a sluggish economy. Businesses may be reluctant to invest in new facilities and equipment for expanded operations if the economy is in a recession. Finally, banks may be unwilling to increase their lending during a recession. Time Frame

•Another concern about the ability of monetary policy to impact a recession is that the effects of policy decisions, such as a cut in interest rates, will not be immediately felt. It can take more than a year for the effects of lower interest rates to be felt. •During the 1991 and 2001 recessions, Federal Reserve policymakers repeatedly cut short-term interest rates to stimulate investment and consumer spending. It took time, however, for the effects to be felt. In 2001, for example, a series of Fed cuts reduced short-term interest rates to near zero.

However, consumer uncertainty about the future, resulting from the 9/11 terrorist attacks, coupled with a distrust of corporate accounting practices resulting from the collapse of Enron, blunted the effects of Fed efforts to expand the money supply.

•In the end, the course of a nation's recession is controlled by the actions of everybody living in the country. Anything influenced by so many people is beyond the control of any one person or group -- it seems to have a mind of its own. But in the United States, time has proven that attitudes and economic factors shift, and every recession is a temporary recession. Eventually, things turn around and an upward spiral is reestablished.

In the face of an economic collapse, the role of the government is invaluable. Governments have the power to avert an impending economic and financial disaster. 1. Encourage exports. The government should focus on the export business segment because it would infuse necessary foreign currencies into the country which would be used to pay debts, import goods and other necessities. 2. Provide Accessible Credit for Business. Local businesses should be encouraged by the government to compensate for unemployment thru extending credit to them.

More businesses mean more jobs for the people. Or at least, source of income for the family. 3. Improve Tax Collection. Implement speedy and effective tax collection measures. Taxes can finance government expenditures such as provision of credit to businesses or budgets for social welfare. 4. Set Aside Large Amount Amount for Social Welfare.

This will quell panic and riots and restore confidence in the people. Positive outlook will be developed in the process. This will also enable people to get back of their feet and start anew. 5. Control Expenditures in Other Fields. Slash budgets on unnecessary expenditures in other areas - military, legislative, executive, other branches.

6. Improve Tourism. Lure more tourists to the country. More tourists mean more money injected to the economy. Businesses will naturally sprout even small businesses in order to cater to the needs of these tourists. The main problem is the lack of funds as businesses closed and investors pull out their investments. The solution is to encourage the injection of money back to the country. Focus on the solution.