Use of Macroeconomic Policies to Manage Cyclical Fluctuations in Economy - Essay Example

Introduction Cyclical fluctuations are common in all the economies of the world and it is the responsibility of governments to strive to keep the economy in a stable condition so as to avoid extreme waves of booms and recessions. This paper advises the government concerning the use of several macroeconomic policies for the purpose of managing cyclical fluctuations in the economy. It emphasises on the role of certain macroeconomic policies like fiscal policy and, in particular, the monetary policy in controlling the cyclical pressures in the economy. Use of Macroeconomic Policies to Manage Cyclical Fluctuations in Economy The business or economic cycle is simply a pattern displayed by a particular economy over a period of time. An economic cycle comprises several phases viz. recession, recovery and boom. In the recovery phase, individuals and businesses borrow and invest more causing the aggregate demand to rise up which leads to boom or expansionary pressures in the economy. This boom brings with it problems like inflation and high imports etc. In such a situation, the government needs to take some action through various macroeconomic policies for the purpose of stabilisation of economy. Thus, the recessionary pressures enter the economy characterised by weak investment and business slow down (Smith, 2003). The economy displays several peaks and troughs over a cyclical phase (see Fig 1). Fig 1: The UK’s GDP in Expansion and Contraction: 1990-2000 Source: Smith (2003, p67) The responsibility of government to stabilise the economy leads it to make use of various macroeconomic policies in order to manage the cyclical economic fluctuations. As an advisor to the government, I would like to recommend the use of monetary and fiscal policies for the purpose of curtailing cyclical fluctuations. Macroeconomic policies like monetary and fiscal policies can be utilised by government to control economic fluctuations. Macroeconomic factors like taxation and government spending fall within the realm of fiscal policy whereas inflation, interest rates, exchange rates and other monetary factors are relevant to the monetary policy. Government can control economy by fluctuating interest rates, exchange rates, and the growth of money and credit in the economy (Smith, 2003). Most particularly, changing interest rates on the part of the government affects inflation, supply of money and credit, exchange rates, foreign and domestic investment and business expansions etc. All these factors put a great impact on the cyclical pressures in the economy. Monetary policy can be utilised in two dimensions under cyclical fluctuations in business. In the case of expansionary pressures or boom in the economy, the government can undertake a “monetary tightening” policy which calls for increasing the interest rates and exchange rates followed by a decreasing level of money and credit flow in the economy and consequently the economy will slow down. On the contrary, when economy suffers from recessions, the government could go for a “monetary loosening” policy which entails a reduction in interest rates followed by an increase in the supply of money and credit in the economy causing the economy to expand (Smith, 2003). Government needs to maintain the economy in a stable condition because of the effects of both expansion and contraction in the economy. The use of monetary policy through central bank ensures that the economy can resist the pressures of high boom as well as easily rise up from recessions. The government’s attempt to affect the supply of money and credit in the economy through interest rates results in several dimensions. In the case of recessions, governments can reduce the interest rates which would consequently enhance the money and credit available for businesses and individuals to invest in the economy (see Fig 2). This would lead to an increase in investment and employment opportunities leading to output maximisation and thus economic growth. In this situation “… money supply is the key variable in the economy. The faster the growth in the money supply, the faster the growth of GDP in monetary terms.” (Smith, 2003, p42) This is so because increase or decrease in money supply directly affects the investment sector of the economy. Furthermore, decreasing the rate of interest implies reduction of foreign investment because of a consequent decline in the value of currency. This would lead to maximisation of export and increase the level of foreign reserves in the economy. Fig 2: Interest Rates and Demand for Money Source: Smith (2003, p42) Under cyclical economic pressures, the government should adopt policies that would lead to price stabilisation i.e. maintain a certain level of inflation. Bach propounds that “price stabilisation, if actually maintained, could and would guarantee that expansive or contractive tendencies would not result in the great cumulative waves of expansion and contraction we know as booms and depressions.” (1947, p232) If government succeeds to keep prices at a stable level, the cyclical expansion and contraction in the economy would not lead to extreme boom and recession. The government should utilise monetary and fiscal policies to keep the prices at a stable level for instance, by using interest rate fluctuations to control inflation. An increase in interest rates would lead to a decline in inflation whereas a fall in interest rates would evoke a rise in inflationary pressures in the economy. Inflation control on the part of government is important in managing cyclical fluctuations because of the fact it helps to control the level of output produced in the economy, as Gasper and Smets illuminate that “stabilising inflation will also keep output close to potential.” (2002, p197) Increase in level of output leads to a growth in GDP and vice versa. An increase (decrease) in GDP, consequently, would accelerate (decelerate) the growth in economy. Conclusion This paper discusses the importance of macroeconomic policies in helping the government to keep the economy under control in the event of strong cyclical fluctuations such as booms and recessions. Government should utilise fiscal and monetary policy in order to manage various macroeconomic factors like inflation and money supply etc. The monetary policy is of particular use to the government in controlling all the crucial economic variables. References Bach, G.L. (1947), Monetary-Fiscal Policy, Debt Policy, and the Price Level, The American Economic Review, 37(2), May, pp. 228-242 Gasper, V. and Smets, F. (2002), Monetary Policy, Price Stability, and Output Gap Stabilisation, International Finance, 5(2), pp. 193-211 Smith, D. (2003), UK Current Economic Policy, 3rd edition, Harcourt Heinemann Read More