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 Revival
Prosperity or Full Employment
Boom or Over Full Employment or
Inflation
Recession – 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
cycles
Monetary measures
1. monetary policy and the expansionary
phase
2.monetary policy and the phase of
depression
Fiscal policy
Physical controls
Miscellaneous measures
Stabilisation
Policies
Introduction to Stabilisation
Policies
 Economic 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 institutions
 10. Integration of financial Institutions
 11. Integrated interest rate structure
 12. Debt management
 13. Long term loan for industrial development
 14. Reforming rural credit system
 15. 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
DEFLATION
 Deflation 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 Public Expenditure Public Debt Deficit Financing Automatic
Policy Stabilizer
Borrowings
Internal Borrow.. Printing of
Tax Non- Tax
Plan Non - Plan External Borrow.. New and
Revenue Revenue Expenditure fresh currency
Expenditure
Defence exp.
Income generating projects
Industries Subsidies
Administrative Interest payments
Direct Tax Indirect Tax Generation
Revenues of Electricity Debt servicing
1) Personal and
Corporate Income Tax Development of changes
Fees transport and comm.
2) Property and
Expenditure Tax Liscence Construction of Dams
Fees
Price of
Customs Public
Duties goods and Fiscal Tools
services
Excise Duties Subsidies
VAT etc Fines etc 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
C2

C1
ne

Demand
Demand or Cost

Li
n
tio
fla
In

Demand Line

w1 w2
Wages
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 Policy
 When 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 Policy
Direct 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
Controls
1) 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.
Disadvantages
1) 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