Business Cycle and Stabilization Policies Business Cycle and Stabilization Policies

Business Cycle

Business Cycle refers to a wave like fluctuation in the overall level of economic activity particularly in national output , income , employment and prices that occur in a more or less regular time of sequence.

It is the rhythmic fluctuations in the aggregate level of economic activity of a nation.

Depression , Contraction or Downswing

Recovery or RevivalProsperity or Full EmploymentBoom or Over Full Employment or

InflationRecession – A Turn From Prosperity

To Depression

Good or bad climatic conditions.Business confidence , psychological

factors.Over optimism or over pessimism.Under consumption or over

consumption.Non-monetary factors such as war ,

earthquakes , strikes , drought , flood etc.

Theories of Business Cycle

1.Schumpeter’s innovations theory Acc. To Schumpeter, innovations are

source of business fluctuations .An innovation is defined as the development of a new product , or the introduction of a new method of production, a new process of production ,development of a new market , development of a new source of raw material ,a change in the organisation of business and so on…

2.Over-investment theory of Von Hayek

Acc. to professor Hayek business cycles are caused by overinvestment and consequent over production. According to him, the primarily cause of the business cycle is monetary over estimate which is brought about by discrepancies between the rate of interest charged by the bankers and the natural rate of interest. If the banks begin to charge a rate of interest which is below the equilibrium rate, the business borrows more funds. If there is any disparity between the two rates will lead business fluctuations.

3.Hawtrey’s pure monetary theory According to Prof. R.G. Hawtrey, “The trade cycle is

a purely monetary phenomenon.”  It is changes in the flow of monetary demand on the part of businessmen that lead to prosperity and depression in the economy.  He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. may at best cause a partial depression, but not a general depression.  In actually, cyclical fluctuations are caused by expansion and contraction of bank credit which, in turn, lead to variations in the flow of monetary demand on the part of producers and traders.  Bank credit is the principle means of payment in the present times.  Credit is expanded or reduced by the banking system by lowering or raising the rate of interest or by purchasing or selling securities to merchants.  This increases or decreases the flow of money in the economy and thus brings about prosperity or depression

Measures to control business cyclesMonetary measures 1. monetary policy and the expansionary

phase 2.monetary policy and the phase of

depressionFiscal policyPhysical controlsMiscellaneous measures

Stabilisation Stabilisation PoliciesPolicies

Introduction to Stabilisation PoliciesEconomic policies undertaken by governments to

counteract business-cycle fluctuations and prevent high rates of unemployment and inflation.

The two most common stabilization policies are Fiscal and Monetary.

Stabilization policies are also termed countercyclical policies, meaning that they attempt to "counter" the natural ups and downs of business "cycles."

Expansionary policies are appropriate to reduce unemployment during a contraction and Contractionary policies are aimed at reducing inflation during an expansion

(Contd)

Stabilization policies are government actions, especially fiscal policy and monetary policy, designed to fix the unemployment and inflation problems created by business-cycle instability.

During periods of high or rising unemployment associated with a business-cycle contraction, the appropriate action is to stimulate the economy through expansionary policies.

During periods of high or rising inflation associated with a business-cycle expansion, the appropriate action is to dampen the economy through contractionary policies.

This graph illustrates the goal of stabilization policies. The red line is the "natural" business cycle. Rising and falling around the blue long-run trend line. But it rises and falls too much, causing inflation and unemployment. Stabilization policies can achieve this result by countering business cycle ups and downs.

When unemployment rises with a business-cycle contraction, Expansionary policies are appropriate. When inflation worsens with a business-cycle expansion, Contractionary policies are appropriate.Stabilization policies are a countercyclical. Contractionary policies counter an expansion and expansionary policies counter a contraction.

What are the different Instruments of Economic Stability ?

1. Monetary Policy

2. Fiscal Policy

3. Physical policy or Direct Controls

Monetary Policy What is a monetary policy ? It is a part over all Economic Policy of a country. It

is employed by the government as an effective tool to promote economic stability and achieve certain predetermined objectives.

Monetary Policy deals with the total money supply and its management in an economy.

It is essentially a programme of action undertaken by the monetary authorities generally the Central Bank to control and regulate the supply of money with the public and the flow of credit with a view to achieving economic stability.

General Objectives of Monetary Policy: 1. Neutral money policy 2. Price stability 3. Exchange rate stability 4. Control of trade cycles 5. Full employment 6. Equilibrium in the balance of payments 7. Rapid economic growth

Objectives of monetary policy in developing countries:

1. Development role 2. Effective central banking 3. Inducement to savings 4. Investment of savings 5. Developing banking habits 6. Magnetization of the economy 7. Monetary equilibrium 8. Maintaining equilibrium 9. Creation and expansion of financial institutions10. Integration of financial Institutions11. Integrated interest rate structure12. Debt management13. Long term loan for industrial development14. Reforming rural credit system15. To create a broad and continuous market for

Govt. securities

Instruments of Monetary Policy

1. Quantitative techniques of credit control

2. Qualitative techniques of credit controls

MONETARY POLICY to Control INFLATION

The best remedy for fighting Inflation is to reduce the aggregate spending. Monetary Policy can help in reducing the pressure on demand.

During Inflation the Central Bank can raise the cost of borrowing and reduce credit creation capacity of the commercial banks. This makes banks more cautious in their lending policies.

The rise in the bank rate, raising the interest rates, not only makes borrowing costly but also will have an adverse effect psychological effect on business confidence.

A rise in the raise may also encourage saving and discourage spending.

Limitations to Monetary Policy

An increase in the bank rates may be ineffective if commercial banks do not follow the rise in the bank rate by rising their own interest rates.

Even if there is a rise in the interest rate, it may not be able to curb spending significantly.

For the open market operations to be effective there should be a well developed and closely knit money market.

A major difficulty arises because of the dichotomy in the money market. In India the Reserve Bank can control only the organised sector, which contitues only a small portion of the money market.

Indigenous bankers and money lenders who do bulk of lending lie outside the control of the RBI.

MONETARY POLICY to check DEFLATIONDeflation is the opposite of Inflation.It is essentially

a matter of falling prices.It arise when the total expenditure of the

community is not equal to the value of the output at existing prices.

Consequently the value of money goes up and prices fall down

Deflation has an adverse effect on the level production, business activity and employment.

Deflation is considered worse than inflation The Monetary Authority can only encourage the

business enterprises and the lower interest rate may only improve the state of liquidity in the economy

Fiscal Policies – Inflation , Depression

Instruments of Fiscal Policy

Public Revenue

Tax Revenue Non- Tax Revenue

Direct Tax Indirect Tax 1) Personal and Corporate Income Tax 2) Property and Expenditure Tax

Customs Duties Excise Duties VAT etc

Administrative Revenues

Fees Liscence Fees Price of Public goods andservices Fines etc

Public ExpenditurePolicy

PlanExpenditure

Non - PlanExpenditure

Income generating projects Industries Generation of Electricity Development of transport and comm. Construction of Dams

Defence exp.Subsidies Interest payments Debt servicing changes

Public Debt

Borrowings Internal Borrow..External Borrow..

Deficit Financing

Printing of New and fresh currency

Automatic Stabilizer

Fiscal Tools Subsidies

Development Rebates Tax Reliefs

Tax Concessions Tax Exemptions

Transfer Payments etc

Objectives in Developing Countries • Help to break the viscious circle of Poverty • Help to formulate a rational consumption

policy • Help to raise the rate of savings • To Control the Operation of Business Cycle • Help to raise the volume of investment • Help to diversify the flow of resources • Help to raise living standard • Help to reduce economic inequalities • Help to control Inflation and Deflation • Help to create more job opportunities

Role of Fiscal policy in economic Development • To act as a optimum allocator of resources • To act as a saver • To act as an Investor • To act as price stabilizer • To act as an economic stabilizer • To act as an economic generator • To act as balancer • To act as growth promoter • To act as an income redistributor • To act as stimulator of living standards of

people

Inflation Depression

De

ma

nd

or

Co

st

Wages

Infla

tion

Line

De

ma

nd

Demand Line

w1 w2

C1

C2

Fiscal Policy to Control Inflation Taxation as an anti-inflationary measure

should be used carefully Inessential and unproductive expenses of

the government should be cut down Public Borrowing from Non Banking lenders Other factors as the role in the economic

development

Fiscal Policy to control Depression Reduction in Personal Income tax and

corporate tax Increase in Public Expenditure Encouraging Investment in public work

programmes, social and economic overheads

Social Security Schemes , unemployment insurance , pension, subsidies should be provided

Fiscal Policy as an instrument to fight depression and create full employment conditions is much more effective than the monetary policy , since it affects the level of effective demand directly , while monetary policy attempts to do it only indirectly

Physical Policies and Direct Control Physical Policies and Direct Control

Physical PolicyWhen monetary and fiscal measures are inadequate

to control prices govt. resorts to direct control.During wars etc. when inflationary force are strong

price control involve, imposing ceilings in respect of certai prices and prices are to be stopped from rising too high.

Price control is done by control of distribution of commodities trhough rationing.

In U.S. price control takes the form of price support programme in which prices are prevented from falling below certain levels considered fair.

Under certain circumstances govt may even resort to dual pricing.

Instruments of Physical PolicyDirect controls are imposed by govt. to ensure

proper allocation of scarce resources like food, raw materials, consumer goods, capital goods etc.

Govt. can strictly forbid or restrict certain kinds of investments or economic activity.

During the period of inflation govt. can directly exercise control over prices and wages. Monetary and fiscal controls will have a general impact on the economy while physical controls can be employed to affect specific scarcity areas.

Types of Direct controls 1) Control over consumption and distribution

through price control and rationing.2) Control over investment and production

through licensing and fixing of quotas etc.3) Control over foreign trade through import

control, import quotas, export control etc.

During war period there will be a terrific increase in the demand for certain commodities causing a steep rise in prices of commodities, this is intensified by war financing, allowing surplus purchasing power in the economy.

Price control attempts to check the inflationary rise in prices, enable all citizens to get a minimum of certain basic necessaries of life and serves as an effective instrument of resource mobilization.

Govt. may fix ceiling prices for various commodities.

If the govt. doesn’t revise such policies from time to time, it may lead to hoarding and black-marketing.

It requires govt. to exercise some control over supply and demand.

Direct link between commodity market and factor market during emergency conditions govt. can resort to control of profit, interest, rent and wages.

Dual Pricing – Wherein two prices prevail in the market at the same time foer the same product out of which one is a controlled price for the lower income group and the other is a free market price determined by the conditions of demand and supply.

Administered Prices – Fixed by the govt. for a few goods like steel, aluminium, fertilizers, cement etc. which serve as raw materials for other industries.

Control over investment and production is equally essential.

To overcome short – term scarcity generally essential goods are imported to meet the excess demand.

Advantages of Direct Controls1) They can be introduced quickly and

easily, hence the effects of these can be rapid.

2) Direct controls can be more discriminatory than monetary.

3) There can be variation in the intensity of the operation of controls from time to time in different sectors.

Disadvantages1) Direct controls suppress individual initiative

and enterprise.2) They tend to inhibit innovations, such as new

techniques or production, new products etc.3) Direct controls may include speculation which

may have destabilizing effect. It thus encourages the creation of artificial scarcity through large scale hoardings.

4) Direct controls need a cumbersome, honest and efficient administrative organization if they are to work effectively.

5) Gross disturbances may appear when the controls are removed.

Thank you Thank you