FEATURES OF THE BUSINESS CYCLE

What exactly do we mean by “business cycles”?

The short-term fluctuations in output, employment, financial conditions, and prices that we call
the business cycle.
Or all market economies show patterns of expansion and contraction known as business cycles.

Economists typically divide business cycles into two main phases: recession and expansion.
Peaks and troughs mark the turning points of the cycle. Figure 22-1 shows the successive phases
of the business cycle. The downturn of a business cycle is called a recession. A recession is a
recurring period of decline in total output, income, and employment, usually lasting from 6 to 12
months and marked by contractions in many sectors of the economy. A recession that is large in
both scale and duration is called a depression. An alternative definition sometimes used is that a
recession occurs when real GDP has declined for two consecutive calendar quarters.
Although we call these short-term fluctuations “cycles,” the actual pattern is irregular. No two
business cycles are quite the same. No exact formula, such as might apply to the revolutions of
the planets or the swings of a pendulum, can be used to predict the duration and timing of
business cycles. Rather, business cycles more closely resemble the irregular fluctuations of the
weather.
While individual business cycles are not identical, they often share a family similarity. If a
reliable economic forecaster announces that a recession is about to arrive, what are the typical
phenomena that you should expect? The following are a few of the customary characteristics of
a recession:
● Investment usually falls sharply in recessions. Housing has generally been the first to decline,
either because of a financial crisis. Consumer purchases often decline sharply as well. As
businesses slow production lines, real GDP falls.
● Employment usually falls sharply in the early stages of a recession. It sometimes is slow to
recover in what are often called “jobless recoveries.” As output falls and the demand for crude
materials declines, and material prices tumble. Wages and the prices of services are unlikely to
face a similar decline, but they tend to rise less rapidly in economic downturns.
The case of an economic expansion is just the opposite. Suppose that a war leads to a sharp
increase in government spending. As a result, the AD curve would shift to the right, output and
employment would increase, and prices and inflation would rise.

Business-cycle fluctuations in output, employment, and prices are

often caused by shifts in aggregate demand. These occur as
consumers, businesses, or governments change total spending
relative to the economy’s productive capacity. When these shifts in
aggregate demand lead to sharp business downturns, the economy
suffers recessions or even depressions. A sharp upturn in economic
activity can lead to inflation.
Government Can Remedy the Shortcomings of the Market
 FISCAL POLICY

“Deliberate manipulation of the national budget to achieve desired social and economic goals is
called fiscal policy”. Or “Fiscal policy is the use of government spending and tax policy to alter
the economy”.

Aims and Effects of Fiscal Policy:

a. Maintain stability:

Government expenditures come in two distinct forms. First there are government purchases.
These comprise spending on goods and services—purchases of tanks, construction of roads,
salaries for judges, and so forth. In addition, there are government transfer payments, which
increase the incomes of targeted groups such as the elderly or the unemployed. Government
spending determines the relative size of the public and private sectors, that is, how much of our
GDP is consumed collectively rather than privately. From a macroeconomic perspective,
government expenditures also affect the overall level of spending in the economy and thereby
influence the level of GDP.
The other part of fiscal policy, taxation, affects the overall economy in two ways. To begin with,
taxes affect people’s incomes. By leaving households with more or less disposable or spendable
income, taxes affect the amount people spend on goods and services as well as the amount of
private saving. Private consumption and saving have important effects on investment and output
in the short and long run. In addition, taxes affect the prices of goods and factors of production
and thereby affect incentives and behavior.

>Expansionary fiscal policy It increases the level of aggregate demand through either
increases government spending or reduction in taxes. Expansionary policy can do this by
increasing consumption, increasing investment and increasing government spending.
Government expenditure influences the relative size of collective spending and private
consumption. Taxation subtracts from incomes, reduces private spending, and affects private
saving. In addition, it affects investment and potential output. Fiscal policy is primarily used to
affect long-term economic growth through its impact on national saving and investment; it is also
used to stimulate spending in deep or sharp recessions.
(In Recession or Depression >>Deficit Budget)

>Contractionary fiscal policy It decreases the level of aggregate demand by decreasing

consumption, decreasing investments and decreasing government spending either through
cuts in government spending or increases in taxes.
(In Expansion or Inflation >>Surplus Budget)
b. Attain equitable income distribution:

The higher income group could be taxed at a progressive rate and the tax revenue could be used
to promote the welfare of the lower income group. E.g. provision of free education, subsidized
health care and low cost housing and social welfare payments.

c. Achieve balance of payments equilibrium:

To discourage imports, the government could impose tariffs or tax incentives (e.g. lower
corporate tax) could be given to export-oriented industries to encourage exports.

d. Achieve economic growth:

Government expenditure incurred in improving quality of its factors of production (e.g. training
scheme to upgrade skills of workers). Its infrastructure, healthcare facilities or in participating in
certain economic activities, could lead to increases in production capacity and national income.

Monetary Policy
The second major instrument of macroeconomic policy is monetary policy, Monetary policy,
conducted by the central bank, determines short-run interest rate through managing the nations
money, credit, and banking system. You may have read how our central bank, the SBP, affects
the economy by determining short term interest rates It does so primarily by setting short-run
interest-rate targets and through buying and selling government securities to attain those targets.
Through its operations, the SBP influences many financial and economic variables, such as
interest rates, stock prices, housing prices, and foreign exchange rates. These financial variables
affect spending on investment, particularly in housing, business investment, consumer durables,
and exports and imports. Historically, the SBP has raised interest rates when inflation threatened
to rise too high. This led to reduced investment and consumption, causing a decline in GDP and
lower inflation. In the most recent slowdown, which started in 2007, the SBP acted quickly to
lower interest rates, provide credit, and extend its lending facilities outside traditional banking
institutions.

Monetary policy aims to regulate the volume and direction of money

supply within the economy.

THE EVOLUTION OF MONEY

Money is anything but useless from a macroeconomic point of view. Monetary policy is today
one of the two important tools (along with fiscal policy) the government has to stabilize the
business cycle. The central bank uses its control over money, credit, and interest rates to
encourage growth when the economy slows and to slow growth when inflationary pressures rise.
When the financial system is well managed, output grows smoothly and prices are stable. But an
unstable financial system, as seen in many countries torn apart by war or revolution, can lead to
inflation or depression. Many of the world’s major macroeconomic traumas of the twentieth
century can be traced to mismanaged monetary systems.

What is money? Money is anything that serves as a commonly accepted medium of exchange.
Because money has a long and fascinating history, we will begin with a description of money’s
evolution.

Money’s functions:
1. The central function emphasized here is that money serves as a medium of exchange.
2. Money is also used as the unit of account, the unit by which we measure the value of things.
Just as we measure weight in kilograms, we measure value in money. The use of a common unit
of account simplifies economic life enormously.
3. Money is sometimes used as a store of value. In earlier days, people held currency as a safe
form of wealth. Today, wealth is held in nonmonetary assets, such as savings accounts, stocks,
bonds, and real estate.

The History of Money

Barter. Barter system, which consists of the exchange of goods for other goods.
As economies develop, people no longer barter one good for another. Instead, they sell goods for
money and then use money to buy other goods they wish to have. At first glance this seems to
complicate rather than simplify matters, as it replaces one transaction with two. If you have
apples and want nuts, would it not be simpler to trade one for the other rather than to sell the
apples for money and then use the money to buy nuts?
Actually, the reverse is true: two monetary transactions are simpler than one barter transaction.
For example, some people may want to buy apples, and some may want to sell nuts. But it would
be a most unusual circumstance to find a person whose desires exactly complement your own—
eager to sell nuts and buy apples. To use a classic economics phrase, instead of there being a
“double coincidence” of wants,” there is likely to be a “want of coincidence.” So, unless a
hungry tailor happens to find an unclothed farmer who has both food and a desire for a pair of
pants, under barter neither can make a direct trade.

Commodity Money. Money as a medium of exchange first came into human history in the form
of commodities. A great variety of items have served as money at one time or another: cattle,
olive oil, copper, iron, gold, silver, rings, diamonds, and cigarettes. Each of the above has
advantages and disadvantages. Cattle are not divisible into small change. Olive oil provides a
nice liquid currency that is as minutely divisible as one wishes, but it is rather messy to handle.
And so forth.
By the eighteenth century, commodity money was almost exclusively limited to metals like
silver and gold. These forms of money had intrinsic value, meaning that they had use value in
themselves. Because money had intrinsic value, there was no need for the government to
guarantee its value, and the quantity of money was regulated by the market through the supply
and demand for gold or silver. But metallic money has shortcomings because scarce resources
are required to dig it out of the ground; moreover, it might become abundant simply because of
accidental discoveries of more deposits. The advent of monetary control by central banks has led
to a much more stable currency system. The intrinsic value of money is now its least important
feature.

Modern Money. The age of commodity money gave way to the age of paper money. Money is
wanted not for its own sake but for the things it will buy.
The use of paper currency has become widespread because it is a convenient medium of
exchange. Paper currency is easily carried and stored. The value of money can be protected from
counterfeiting by careful engraving. The fact that private individuals cannot legally create money
keeps it scarce. Given this limitation on supply, currency has value. It can buy things. As long as
people can pay their bills with currency, as long as it is accepted as a means of payment, it serves
the function of money.
A few years ago, many people predicted that we would soon move to a cashless society. They
foresaw that cash and checking accounts would be replaced by electronic money, such as the
stored-value cards found in many stores today. But, in fact, consumers have been reluctant to
adopt electronic money in substantial amounts. They trust and prefer government money and
checks.

FUNCTIONS AND OBJECTIVES OF CENTRAL BANK

Central bank is set up by the government to achieve the following objectives:

 Secure stability in the internal and external value of the currency

 Promote economic growth
 Achieve full employment
 Safeguard gold reserves of the country
 Issue notes and coins
 Acts as the government bank
 Performs as a lender of last resort
 Implement monetary policy
 Monetary Policy Instrument
The instruments of monetary policy affect the level of aggregate demand through the supply of
money and availability of credit. It includes bank rate variations, open market operations and
changing reserve requirements. They are meant to regulate the overall level of credit in the
economy through commercial banks.

BANK RATE POLICY:

The bank rate is the minimum lending rate of the central bank at which it rediscounts first class
bills of exchange and government securities held by the commercial banks. When the central
bank finds that inflationary pressures have started emerging within the economy, it raises the
bank rate. Borrowing from the central bank becomes costly and commercial banks borrow less
from it.
The commercial banks, in turn, raise their lending rates to the business community and
borrowers borrow less from the commercial banks. There is contraction of credit and prices are
checked from rising further. On the contrary, when prices are depressed, the central bank lowers
the bank rate.
It is cheap to borrow from the central bank on the part of commercial banks. The latter also
lower their lending rates. Businessmen are encouraged to borrow more. Investment is
encouraged. Output, employment, income and demand start rising and the downward movement
of prices is checked.

OPEN MARKET OPERATION:

Open market operations refer to sale and purchase of securities in the money market by the
central bank. When prices are rising and there is need to control them, the central bank sells
securities. The reserves of commercial banks are reduced and they are not in a position to lend
more to the business community.
Further investment is discouraged and the rise in prices is checked. Contrariwise, when
recessionary forces start in the economy, the central bank buys securities. The reserves of
commercial banks are raised. They lend more. Investment, output, employment, income and
demand rise and fall in price is checked.

CHANGES IN RESERVE RATIO:

Every bank is required by law to keep a certain percentage of its total deposits in the form of a
reserve fund in its vaults and also a certain percentage with the central bank.
When prices are rising, the central bank raises the reserve ratio. Banks are required to keep more
with the central bank. Their reserves are reduced and they lend less. The volume of investment,
output and employment are adversely affected. In the opposite case, when the reserve ratio is
lowered, the reserves of commercial banks are raised. They lend more and the economic activity
is favourably affected.