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Why does the level of economic activity fluctuate?

The fluctuations in economic activity were first noticed long time ago. It appeared that economy went from boom to recession after 3.5 years in 19th century. It was called trade cycle and was thought to be natural until the First World War broke the cycle and led the UK into a recession in 1930-s. Then a man called Keynes suggested that the government should intervene to correct this market failure. It did during the Second World War and there was virtually no unemployment. Intervention has been continued thereafter, but the cycle has remained, although it is not as ordered. The last major recession was in 1990-1992, the UK came out of it in 1995, but this year the growth appears to be stagnating again.

Recession is characterised by the fall in percentage of GDP and high unemployment, whereas in recovery unemployment is low and the national income might be growing up to 5% per annum.

The pattern in trade cycle implies that it is caused by endogenous factors - factors working inside the economy and cannot be influenced. It is thus argued that the policy aimed against trade cycle might even worsen the situation (mainly conservative view) as the policy works after a time lag, thus when it is used in recession by the time it starts working economy has already recovered and thus inflation is created.

In recovery the prices of raw materials are rising as the demand increases sharply. This will lead to an increase of the price of them, because suppliers face inelastic supply cure in short run. As the price of raw materials goes up so does the price. Then people start demanding higher wage, thus forcing firms to cut expansion that together with inflation leads to a new recession. Opposite (e.g. falling raw material prices and very low wages and inflation) is true for recession.

Also as price raises the export prices rise and import prices become cheaper, so country will face huge balance of payments' deficit that can lead to deficit in the budget and increase in the public sector borrowing requirement. The government then (to avoid inflation and high interest payments) have to cut back on investment, that again leads from growth to stagnation.

The economies nowadays are not isolated. Usually the recession in other countries will leave the UK to recession as well as its exports (that are 40% of GDP) will soar. On the other hand if UK is experiencing a rapid growth together with its main trading partners then their market might become saturated and thus demand for UK exports will decrease.

Unemployment fluctuations tend to reinforce trade cycle as well. If there is high unemployment (in recession) then wages and the power of trade unions will fall thus attracting new investment, that is very important in determining the growth of GDP through the accelerator. On the other hand, in the boom wages tend to be higher and firms will seek for overseas investment, reducing the growth of GDP.

The fluctuations in the exchange rate can cause trade cycle. A country in recession is forced to depreciate its currency. Its exports will become cheap and thus increase leading the country out of recession. As its currency becomes stronger again the export prices and thus the demand for it will contract. It extent of this is highly dependant on the relative elasticities of demand and supply. This was the case in the UK in 1992. When UK left the ERM its exports boomed leading the economy out of recession.

The marginal propensity to save has definitely got an effect on trade cycle. In times of high inflation people tend to save more, thus firms are faced with decreasing demand. But in recession people might be saving again for rainy days thus increasing the opportunity for firms to invest. Investment again operates through accelerator (small fall in GDP can bring investment to zero) and is thought to be the main determinant of business-cycle. UK recoveries have been mostly consumption led (e.g. increase in consumption causes increase in demand) and not so often export led. Also the multiplier will magnify any changes occurring.

The monetarists think fluctuations are due to fluctuations in the rate of growth of money supply and the level of interest rates. These are called political cycles and can also be due to stop-go policies for reducing unemployment.

The business expectations are also very important as is the optimism and pessimism among customers.

There are also exogenous factors determining the trade cycle such as major gold findings, the growth of population (e.g. baby-boom) that all have feedback after several years causing a pattern.

The reason economy cannot expand for ever when some conditions become in favour, or fall into an everlasting depression, is that floors and ceilings exist for possible GNP. When country reached full employment only other trend possible in downward which will be emphasized by inflation. Conversely if income and thus savings fall the floor is reached when savings reach to zero and thus no further decline is possible.

The inventory cycle is caused by firms buying inventory cyclically. As the stocks increase when demand falls, after a while, shops will severely cut down orders. Then again some time passes until the producer cuts back production. If the stock is fallen to acceptable level firms will order again, the demand rises suddenly and it takes some time to fulfil orders- full cycle. Recent just-in-time principle may modify the cycle.

Discuss the policies government might adapt to minimise these fluctuations.

Government has always had 2 main policies to fight against any economic failures: fiscal and monetary policy. Direct intervention was used as well, but it ruined the relationship between government and taxpayers.

Monetary policy is direction of the economy through supply & price of money.

Liquidity ratios (the amount that banks have to keep in liquid form like cash and money at call or short notice in LDMA) were used to determine the ability of banks to lend money. This helped, through the multiplier effect on credit creation, to control investment. In recession liquidity ratios were lowered and that increased investment and ended slump. Excess liquidity that exists makes this policy a bit weak. Open-market operations (sale of govn securities) are part of the liquidity programme. The general public must buy them to decrease liquidity because banks regard them as liquid assets.

It was believed until 1930-s that low interest rates stimulate economy. Thus in recession interest were lowered and in boom they were raised. Keynes noted that decreasing might not increase investment whereas raising locks up funds, because most investment decisions are non-marginal. Anyway interest rates have been very widely used by conservatives to cure a variety of failures.

In very special cases special directives and deposits can be used (if economy is really overheating). They are very effective, but damage the relationships between the Bank and commercial banks.

Monetarist's measures can also be used to decrease unemployment (e.g. training schemes to increase labour mobility) and thus help the economy out of the recession.

Monetary policies became especially important in 1970 because of the inflation that fiscal policy brings - the feature that monetary policies didn't have.

The second main policy - fiscal policy was suggested by Keynes in 1930-s as the market forces seemed not to overcome the depression of 1930-s. Keynes looked the economy from the aggregate side and as in theory the equilibrium should occur where there is full employment:

In reality the economy can reach to equilibrium with unemployment and thus causing recession:


Unemployment of WX occurs at wage E although economy is in equilibrium at Ye.

Keynesians thus believe that the speed the market forces work is too slow. If the demand is low, then the wages are not cut, but the quantity produced is decreased and some people are fired (because wages are "downward sticky" and there are usually trade unions). Furthermore, if wage is lowered it will result in a decrease in demand and even further unemployment. Thus government should direct the economy to increase the Y line through spending. Increase in spending shifts the curve up and causes more factors to be employed, directing the economy out of the recession, whereas in boom extra expenditure causes inflation. In boom government should decrease spending to hold back the economy. Government can also use taxation (direct taxes - income tax, corporation tax, taxes on capital, national insurance; indirect taxes - customs and excise duty, VAT) to expand and contract the economy at the same way. Government now spends 40% of GNP so fiscal policy has a particularly important meaning.

The deficit (or surplus) in the budget is balanced by public sector borrowing requirement(PSBR). Thus to come out of slump PSBR must be increased and vice-versa.

It concentrated to money supply at the beginning, leaving interest rates free. Nowadays vice-versa.

Direct intervention is the third weapon to fight trade cycle. It is not widely used nowadays although it was in 1960-s where every new government promised not to use them, but at the end due to increasing unemployment had to. Prices and incomes' policies are the main type of direct intervention. If in boom wages are rising too fast government might set a ceiling on how much they can rise. This policy will cause wage drifts (extra bonuses etc.) and will be for public sector disadvantage as it is harder to implement in private sector.

The main criticism for these policies is the time it takes for them to take effect. E.g. if the trade cycle (given below) is been cured by government policy then:

As seen the government has made things even worse.

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