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BUSINESS CYCLES AND STABILIZATION

Business cycles are the rhythmic fluctuations in the aggregate level of economic activity of a nation.
A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term
natural growth rate. It explains the expansion and contraction in economic activity that an economy
experiences over time.

A business cycle is completed when it goes through a single boom and a single contraction in sequence.
The time period to complete this sequence is called the length of the business cycle. A boom is
characterized by a period of rapid economic growth whereas a period of relatively stagnated economic
growth is a recession. These are measured in terms of the growth of the real GDP, which is inflation-
adjusted. Business cycles occur because of reasons such as good or bad climatic conditions, under
consumption or over consumption, strikes, war, floods, d

roughts, etc

Stages of the Business Cycle

In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves
about the line. Below is a more detailed description of each stage in the business cycle:

1. Expansion
The first stage in the business cycle is expansion. In this stage, there is an increase in positive economic
indicators such as employment, income, output, wages, profits, demand, and supply of goods and
services. Debtors are generally paying their debts on time, the velocity of the money supply is high, and
investment is high. This process continues as long as economic conditions are favorable for expansion.

2. Peak
The economy then reaches a saturation point, or peak, which is the second stage of the business cycle.
The maximum limit of growth is attained. The economic indicators do not grow further and are at their
highest. Prices are at their peak. This stage marks the reversal point in the trend of economic growth.
Consumers tend to restructure their budgets at this point.

3. Recession
The recession is the stage that follows the peak phase. The demand for goods and services starts declining
rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on
producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive
economic indicators such as income, output, wages, etc., consequently start to fall.
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4. Depression
There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as
this falls below the steady growth line, the stage is called a depression.

5. Trough
In the depression stage, the economy’s growth rate becomes negative. There is further decline until the
prices of factors, as well as the demand and supply of goods and services, contract to reach their lowest
point. The economy eventually reaches the trough. It is the negative saturation point for an economy.
There is extensive depletion of national income and expenditure.

6. Recovery
After the trough, the economy moves to the stage of recovery. In this phase, there is a turnaround in the
economy, and it begins to recover from the negative growth rate. Demand starts to pick up due to low
prices and, consequently, supply begins to increase. The population develops a positive attitude towards
investment and employment and production starts increasing. Employment begins to rise and, due to
accumulated cash balances with the bankers, lending also shows positive signals. In this phase,
depreciated capital is replaced, leading to new investments in the production process. Recovery continues
until the economy returns to steady growth levels.

This completes one full business cycle of boom and contraction. The extreme points are the peak and the
trough.

Theories of Business Cycles

Schumpeter’s Theory of Innovation
According to Schumpeter, an innovation is defined as the development of a new product or introduction
of a new product or a process of production, development of new market or a change in the market.

Over − Investment Theory

Professor Hayek says, “primary cause of business cycles is monetary overestimate”. He says business
cycles are caused by over investment and consequently by over production. When a bank charges rate of
interest below the equilibrium rate, the business has to borrow more funds which leads to business
fluctuations.

Monetary Theory
According to Professor Hawtrey, all the changes in the business cycles take place due to monetary
policies. According to him the flow in the monetary demand leads to prosperity or depression in the
economy. Cyclical fluctuations are caused by expansion and contraction of bank credit. These conditions
increase or decrease the flow of money in the economy.

Keynesian Explanations
John Keynes explains the occurrence of business cycles is a result of fluctuations in aggregate demand,
which bring the economy to short-term equilibriums that are different from a full-employment
equilibrium.

Keynesian models do not necessarily indicate periodic business cycles but imply cyclical responses to
shocks via multipliers. The extent of these fluctuations depends on the levels of investment, for that
determines the level of aggregate output.

Technology Explanation
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In contrast, economists like Finn E. Kydland and Edward C. Prescott, who are associated with the
Chicago School of Economics, challenge the Keynesian theories. They consider the fluctuations in the
growth of an economy not to be a result of monetary shocks, but a result of technology shocks, such as
innovation.

Stabilization Policies
A stabilization policy seeks to limit erratic swings in the economy's total output, as measured by the
nation's gross domestic product (GDP), as well as controlling surges in inflation or deflation.
Stabilization of these factors generally leads to healthy levels of employment.

Stabilization policies are also known as counter cycle policies. These policies try to counter the natural
ups and downs of business cycles. Expansionary stabilization policies are useful to reduce
unemployment during contraction and contractionary policies are used to reduce inflation during
expansion.

Instruments of Stabilization Policies

The package is usually initiated either by a government or central bank, or by either or both of these
institutions acting in concert with international institutions such as the International Monetary Fund (IMF)
or the World Bank. Depending on the goals to be achieved, it involves some combination of restrictive
fiscal measures (to reduce government borrowing) and monetary tightening (to support the currency).

Monetary Policy
Monetary policy is employed by the CBN as an effective tool to promote economic stability and achieve
certain predetermined objectives. It deals with the total money supply and its management in an
economy. Objectives of monetary policy include exchange rate stability, price stability, full employment,
rapid economic growth, etc.

In the armoury of the central bank, there are quantitative as well as qualitative weapons to control the
credit- creating activity of the banking system. They are bank rate, open market operations and reserve
ratios. These are interrelated to tools which operate on the reserves of member banks which influence the
ability and willingness of the banks to expand credit. Selective credit controls are applied to regulate the
extension of credit for particular purposes.

Fiscal Policy
The term ‘‘fiscal policy” embraces the tax and expenditure policies of the government. Thus, fiscal policy
operates through the control of government expenditures and tax receipts. It encompasses two separate
but related decisions: public expenditures and level and structure of taxes. The amount of public outlay,
the inducement and effects of taxation and the relation between expenditure and revenue exert a
significant impact upon the free enterprise economy.

Broadly speaking, the taxation policy of the government relates to the programme of curbing private
spending. The expenditure policy, on the other hand, deals with the channels by which government
spending on new goods and services directly add to aggregate demand and indirectly income through the
secondary spending which takes place on account of the multiplier effect.

Taxation, on the other hand, operates to reduce the level of private spending (on both consumption and
investment) by reducing the disposable income and the resulting savings in the community. Hence, under
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the budgetary phenomenon, public expenditure and revenue can be combined in various ways to achieve
the desired stimulating or deflationary effect on aggregate demand.
Fiscal policy helps to formulate rational consumption policy and helps to increase savings. It raises the
volume of investments and the standards of living. Fiscal policy creates more jobs, reduces economic
inequalities and controls, inflation and deflation. Fiscal policy as an instrument to fight depression and
create full employment conditions is much more effective as compared to monetary policy.

As a matter of fact, all government spending is an inducement to increase the aggregate demand (both
volume and components) and has an inflationary bias in the sense that it releases funds for the private
economy which are then available for use in trade and business.

Similarly, a reduction in government spending has a deflationary bias and it reduces the aggregate
demand (its volume and relative components in which the expenditure is curtailed). Thus, the
composition of public expenditures and public revenue not only help to mould the economic structure of
the country but also exert certain effects on the economy.

For maximum effectiveness, fiscal policy should be planned on both long-run and short-run basis. Long-
run fiscal policy obviously is concerned with the long- run trends in government income and spendings.
Within the framework of such a long-range plan of fiscal operations, the budget can be made to vary
cyclically in order to moderate the short-run economic fluctuations.

Physical Policy
When monetary policy and fiscal policy are inadequate to control prices, government adopts physical
policy. These policies can be introduced swiftly and thus the result is quite rapid. Broadly speaking,
direct controls are imposed by government which expressly forbid or restricts certain kinds of
investment or economic activity. Sometimes, direct government controls over prices and wages as a
measure against inflation have been advocated and implemented.

Price-wage controls were employed in conjunction with consumer rationing and materials allocation to
curb generalised total excess demand and to direct productive resources into channels desired by the
government. Monetary-fiscal controls may be used to curb excess demand in general but direct controls
can be more useful when they are applied to specific scarcity areas.

However, there are serious objections to direct economic controls:

1. Direct controls suppress individual initiative and enterprise.

2. They tend to inhibit innovations, such as new techniques of production, new products etc.
3. Direct controls may breed or induce speculation which may have destabilising effects.
4. Direct controls need a cumbersome, honest and efficient administrative organisation if they are to
work effectively.

In summary
The biggest problem of the business cycle is that a recession represents a large wastage of resources. The
uncertainty created by a volatile business cycle tends to cause lower investment, and this can lead to
lower long-term economic growth.