In the brief lag between the boost in spending and the higher inflation, output might be temporarily boosted, but the economy cannot function for long above full capacity. Monetary policy plays the primary role in economic stabilization today and has several practical advantages over fiscal policy. First, economic conditions change rapidly, and monetary policy is much more nimble than fiscal policy. The Fed meets every six weeks to consider changes in interest rates, and can call an unscheduled meeting any time in between.
Changes to fiscal policy are likely to occur once a year at most. For example, there were three large tax cuts from the recession through ; 13 in the same period, interest rates were changed 29 times. Once a decision to alter fiscal policy has been made, the proposal must travel through a long and arduous legislative process lasting months before it can become law, while monetary policy changes are made instantly.
Second, political constraints frequently lead to fiscal policy being employed in only one direction. Over the course of the business cycle, aggregate spending can be expected to be too high as often as it is too low.
This means that stabilization policy must be tightened as often as it is loosened, yet increasing the budget deficit is much easier politically than implementing the spending cuts or tax increases necessary to reduce it. As a result, the budget has been in deficit in 44 of the past 49 years. By contrast, the Fed is highly insulated from political pressures, 15 and experience shows that it is as willing to raise interest rates as it is to lower them.
Persistent budget deficits lead to the third problem. Third, the long run consequences of fiscal and monetary policy differ. Expansionary fiscal policy creates federal debt that must be serviced by future generations. Some of this debt will be "owed to ourselves," but some presently, about half will be owed to foreigners. When expansionary fiscal policy "crowds out" private investment, it leaves future generations poorer than they otherwise would have been.
Furthermore, the government faces a budget constraint that limits the scope of expansionary fiscal policy—it can only issue debt as long as investors believe that the debt will be honored—even if economic conditions require larger deficits to restore equilibrium.
Fourth, an economy, such as the United States, that is open to highly mobile capital flows changes the relative effectiveness of fiscal and monetary policy. If expansionary fiscal policy leads to higher interest rates, it will attract foreign capital looking for a higher rate of return. Foreign capital can only enter the United States on net through a trade deficit. Thus, higher foreign capital inflows lead to higher imports, which reduce spending on domestically-produced substitutes, and lower spending on exports.
The increase in the trade deficit would cancel out the expansionary effects of the increase in the budget deficit to some extent in theory, entirely. This theory is borne out by experience in the past few years—as the budget deficit increased, so did the trade deficit.
Foreign capital outflows would reduce the trade deficit through an increase in spending on exports and domestically produced import substitutes.
Thus, foreign capital flows would magnify the expansionary effects of monetary policy. In cases where economic activity is extremely depressed, monetary policy may lose some of its effectiveness. When interest rates become extremely low, interest-sensitive spending may no longer be very responsive to further rate cuts.
Furthermore, interest rates cannot be lowered below zero. In this scenario, fiscal policy may be more effective. But the United States has not found itself in this scenario since the Great Depression, although Japan did in the s. Of course, using monetary and fiscal policy to stabilize the economy are not mutually exclusive policy options. But because of the Fed's independence from Congress and the Administration, there is no way to coordinate the two policy options.
If compatible fiscal and monetary policies are chosen by Congress and the Fed, respectively, then the economic effects would be more powerful than if either policy were implemented in isolation. For example, if stimulative monetary and fiscal policies were implemented, the resulting economic stimulus would be larger than if one policy were stimulative and the other were neutral.
But if incompatible policies are selected, they could partially negate each other. For example, a stimulative fiscal policy and contractionary monetary policy may end up having little effect on the economy one way or the other.
Thus, when fiscal and monetary policymakers disagree in the current system, they can potentially choose policies with the intent of cancelling out each other's actions. If one actor chooses inappropriate policies, then the lack of coordination usefully allows the other actor to try to negate its effects. But if both actors choose appropriate policies, the policies could be slightly less effective than if they had been coordinated. If recessions are usually caused by declines in aggregate spending, and the government can alter aggregate spending through changes in monetary and fiscal policy, then why is it that the government cannot use policy to prevent recessions from occurring in the first place?
While recessions should theoretically be avoidable, there are several real world problems that keep stabilization from working with perfect efficiency in practice. First, many of the economic shocks that cause recessions are unforeseeable.
Policymakers can only react to the shocks after they have already occurred; by then, it may be too late to avoid a recession. As their name suggests, economic shocks tend to be sudden and unexpected.
Second, there is a time lag between a change to monetary or fiscal policy and its effect on the economy because individual behavior adjusts to interest rate or tax changes slowly. For example, higher interest rates will reduce housing demand, but only gradually—the Fed has been raising interest rates since , but the housing market did not cool off until Because of lags, an optimal policy would need to be able to respond to a change in economic conditions before it occurred.
For example, if the economy were going to fall below full employment next year, policy would need to be eased this year to prevent it.
Third, for stabilization policy to be effective given lags, policymakers must have accurate economic forecasts. Yet even short-term economic forecasting—particularly in the case of turning points in the business cycle—is notoriously inaccurate. In January , for example, the Congressional Budget Office, the Office of Management and Budget, the Federal Reserve, and virtually all major private forecasts predicted growth between 2.
Given the important role of unpredictable shocks in the business cycle, perhaps this should not be a surprise. Fourth, because forecasts are not always accurate, understanding of the economy is limited, and because the economy does not always respond to policy changes as expected, policymakers sometimes make mistakes. For example, if the natural rate of unemployment NAIRU rises and policymakers do not realize it, they may think that expansionary policy is needed to reduce unemployment.
Economists believe that this is one reason inflation rose in the s. Fifth, in the case of monetary policy, changes in short-term interest rates do not lead to one-for-one changes in long-term interest rates.
Long-term interest rates are determined by supply and demand, and many factors enter that equation besides short-term interest rates. Yet many types of spending may be more sensitive to long-term rates, reducing monetary policy's effectiveness.
One reason the housing boom continued after was that mortgage rates increased far less than the federal funds rate. Sixth, because policy changes do not lead to large and rapid changes in economic activity for the reasons listed above, it may take extremely large policy changes to forestall a recession.
Yet policy changes of that magnitude could be destabilizing in their own right. For example, extremely large swings in interest rates could impede the smooth functioning of the financial system and lead to large swings in the value of the dollar. Large increases in the budget deficit could hamper the government's future budgetary flexibility.
More modest policy changes are more prudent in light of uncertainty. Finally, policy's influence on the economy is blunted by the open nature of the U. As discussed above, the expansionary effects of increases in the budget deficit have been largely offset by increases in the trade deficit in recent years.
Likewise, the contractionary effects of higher short-term interest rates have not led to significantly higher long-term rates because of the ready supply of foreign capital. Nevertheless, higher short-term interest rates have still had a contractionary effect on the economy through the larger trade deficit that accompanies foreign capital inflows.
But in a situation where some observers feared that the economy might be suffering from a housing bubble, higher interest rates might have been a more desirable way to curb economic activity than an increase in the already record-high trade deficit. An open economy is also one that is more influenced by developments abroad—as the economy's openness has increased over time, foreign economic shocks positive or negative have had a larger effect on the United States, and domestic events, including policy changes, have had a smaller effect.
If policymakers were concerned with only economic growth, policy decisions would be considerably easier. Above average growth would lead to contractionary policy, and below average growth would lead to expansionary policy. Given uncertainty about the true state of the economy, policymakers could err on the side of caution when tightening to avoid recessions.
Unfortunately, policymakers must weigh these considerations against the effects of a policy change on price stability inflation.
Typically, the same policy is needed to achieve both price stability and economic stability the Fed's mandated goals —a tightening of policy when economic growth is above its sustainable rate will also help to keep inflation from rising, and inflationary pressures are typically low during recessions. Of course, underlying policy decisions are uncertain estimates of the economy's sustainable rates of growth and unemployment, so policymakers must decide how optimistic their assumptions of both should be.
More optimistic assumptions increase the risk of rising inflation, while more pessimistic assumptions increase the risk of sub-par growth. Besides uncertainty, goals also become conflicted when inflation and economic activity do not move in the same direction. There are several possible reasons why inflation sometimes rises although economic activity is sluggish.
First, prices of individual goods may rise for reasons unrelated to the business cycle. If the price of a specific good rises relatively quickly and other prices do not fall, then overall inflation will rise.
Most goods account for too small a share of overall spending to boost inflation by more than a trivial amount. But a few goods, such as food, shelter, and especially energy, are very large as a share of overall spending.
Energy increased the growth rate of the consumer price index by 0. The Fed has argued that temporary individual price shocks that cause overall inflation to rise can be ignored as long as they do not feed through to other prices. Second, inflation shows persistence over time—current inflation is influenced by past inflation, even when economic conditions have changed.
Thus, an economic slowdown may not instantly lead to lower inflation. Third, expectations play an important role in determining inflation.
Expectations change slowly, which partially explains inflation persistence, but economists generally believe that they eventually adjust to accurately reflect circumstances. In other words, persistently expansionary monetary policy will eventually lose its effectiveness, causing inflation to rise even if economic growth is sluggish, as occurred in the s. Because of the role of expectations, any short-term tradeoff between inflation and growth will not persist in the long run.
In the long run, the economy will adjust to any attempts to keep unemployment below its natural rate, and that adjustment will come about through a rising inflation rate. In other words, monetary policy's effect on output is temporary, but its effect on inflation is permanent. Therefore, some economists argue that growth stability should be de-emphasized as a policy goal and price stability should be given primacy, perhaps through a formal change to the Fed's statutory mandate.
But as long as policymakers are mindful of the limits of economic stabilization, there is no reason that monetary policy cannot be prudently used to reduce cyclical fluctuations without undermining price stability.
After all, economic stability and price stability often go hand-in-hand. Another major debate is how vigorously stabilization policy should be pursued.
This may seem surprising—why would policymakers not take every action they could to keep the economy at full employment? But given our limited understanding of economic fluctuations, skeptics argue that less policy intervention—what they refer to as "fine tuning"—can often achieve better long-term results. As discussed in the introduction, the rate of economic growth changes because of both changes in the business cycle and random fluctuations.
It is not obvious how to differentiate between the two until after the fact. Without enough working capital to keep the doors open, some are forced to close down. Representatives from supply companies are stopping by the office hoping to get an order for even the smallest quantity of materials.
The new truck and tools that the owner purchased during the boom now sit idle and represent additional debt and costs. The owner increases his advertising budget, hoping to capture any business that might be had. Though each stage has its stressors, he has learned to plan for them. One thing he knows is that the economy will eventually begin to expand again and run through the cycle all over again. Answer the question s below to see how well you understand the topics covered in this section.
This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times. Use this quiz to check your understanding and decide whether to 1 study the previous section further or 2 move on to the next section.
Skip to main content. Module: Economic Environment. Search for:. Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product.
What Is a Business Cycle? In a business cycle, the economy goes through phases like expansion, peak economic growth, reversal, recession and depression, finally leading to a new cycle.
The business cycle, also known as the economic cycle or trade cycle, are the fluctuations of gross domestic product GDP around its long-term growth trend. Business cycles are usually measured by considering the growth rate of real gross domestic product. A business cycle will affect all the sectors of an economy.
Similarly, it will also affect all sectors of a firm as well. Right from demand to supply to the cost of production every aspect will depend on the phase of the business cycle. So the firm must be able to correctly identify its current phase. The business cycle refers to the vast economic fluctuations in trade, production, and general economic activities. The features of the business cycle have different phases. Business cycles are identified into four distinct phases: Expansion, Peak, Contraction, and Trough.
The business cycle since the year is a classic example. The expansion of activity happened between and was followed by the great recession from to It started with the easy access to bank loans and mortgages. For investors, therefore, it is vital to be on the lookout for not only business cycle recessions, but also the economic slowdowns designated as GRC downturns.
Those interested in learning more about business cycles, stock prices, and other financial concepts may want to consider enrolling in one of the best investing courses currently available. Arthur F. National Bureau of Economic Research, National Bureau of Economic Research. The National Bureau of Economic Research. Economic Cycle Research Institute.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Introduction to Economic Depression. History of Economic Depression. Government Actions. Economy Economics. Table of Contents Expand. What Is a Business Cycle?
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