Business cycle (Recession, Depression, Recovery), Economic stabilization

Recession

Where prosperity ends recession begins. Recession refers to a turning stage rather than a phase. It lasts relatively for a short period of time. During a recession, the banking system and the people, in general, try to attain greater liquidity. Therefore, credit supplies contracts. There is a tendency to reduce the scale of operation, which leads to an increase in unemployment and decline in the level of income. The decline in income leads to a decrease in aggregate expenditure i.e. effective demand. The decline in effective demand causes a decline in prices and profits. This process becomes cumulative.

The recession is characterized by

a. The increase in liquidity
b. Contraction of credit supply
c. A decrease in output, employment, and income
d. Decrease stage in effective demand, price level, and profit

All these changes occur at a low rate. To cite Prof. Lee, “A recession, once started tends to build upon itself much as a forest fire, once under way, tends to create its own draft and given internal impetus to its destructive ability.”

Depression

Depression is that phase in which real income consumed, real income produced and the rate of employment fall due to idle resources and capacity. In other words, there is a substantial decline in the production of goods and services and in the volume of employment. The general decline in the economic activity leads to a fall in bank deposits. These forces are cumulative and self – reinforcing and the economy is at the trough. In other words, the falling trend of all macroeconomic variables at high rate result economic darkness in the economy.

A depression is characterized by

a. Shrinkage in the volume of output, trade, and transactions
b. Rise in the level of unemployment
c. Price deflation
d. Fall in the aggregate income of the community
e. Fall in the structure of interest rates
f. Reduction in the level of effective demand
g. A collapse of M.E.C. and decline in the level of investment
h. Contraction of bank credit

When the economy bottoms out, a trough occurs. A trough is defined as the lowest point of depression or lower turning point of aggregate economic activities. It may be short-lived or it may continue for a considerable time. But sooner or later limiting forces are set in motion, which ultimately tend to bring the contraction phase to end.

The main causes responsible for ending depression are as follows:

1. During a depression, businessmen postpone the replacement of their plant and machinery and consumers postpone the purchase of durable goods. Hence, the need for replacement and the purchase of durable goods gradually accumulate. This, after some time, causes a moderate increase in the purchase of durable goods by the consumers and machinery by the producers.
2. Business firms formulate new business strategies or innovations (i.e. cost reducing innovations or demand raising innovations).

This calls for an increase in production, which in turn leads to increase in employment, income and aggregate effective demand. Pessimism gives place to optimism and the economic activity gathers momentum. The stage of recovery sets in.

Recovery

Revival or recovery refers to the lower turning stage. The recovery begins with the improvement in demand for capital goods. In order to meet this increased demand, the investment and employment increase in capital goods industries, which in turn, lead to a rise in incomes. The increased income push up the level of effective demand, which in turn leads to a rise in prices, profits, further investment, employment output and income rises slowly and steadily.

During recovery, stock markets become sensitive. A rise in the prices of stocks favors the expansion and strengthens revival. The process of recovery is cumulative. The wave of recovery once initiated soon begins to feed upon itself.

Recovery is characterized by

1. Increase in investment in capital industries
2. Increase in price level, profit and MEC
3. Improvement in financial market
4. Increase in effective demand
5. An increase in employment, output, and income in a whole economy.

All these changes occur at low rate

Economic Stabilization

Economic stabilization is one of the main remedies to control or eliminate the trade cycles in a capitalist economy. An economic stabilization policy is an action taken by the government to impact aggregate demand to moderate the expansion and contraction phases of the business cycle.

Stabilization policy aims at

1. Controlling cyclical fluctuations
2. Achieving and maintaining full employment with economic growth
3. Maintaining the value of money through price stabilization

The main instruments of stabilization policy are:

Monetary Policy

The fundamental problem of monetary policy with relation to trade cycles is to control and regulate the volume of credit in such a way as to achieve economic stability. During a depression, credit must be expanded and during an inflationary boom, its flow must be checked. The instruments of monetary policy adopted by the central bank are quantitative and qualitative. The quantitative credit control includes bank rate policy, open market operations and changes in reserve ratio. The selective controls aim at controlling particular types of credit. They include changing market requirements, regulation of consumer credit, rationing of credit, direct action, publicity, etc.

Fiscal policy

Fiscal policy is a powerful instrument of stabilization. Fiscal policy can be defined as the government actions affecting its receipts and expenditures. The budget is the principal instrument of fiscal policy. Deficit budget is an important method of overcoming depression. Fiscal policy through variations in government expenditure and taxation affects national income, output, employment, and prices. Basically, three methods are used in this context: 1) Built-in flexibility or automatic stabilizers 2) discretionary actions and 3) compensatory fiscal policy. When there are inflationary tendencies in the economy, the government should increase its expenditures through deficit budgeting and minimization in taxes. On the other hand, when there is an inflationary tendency, the government should reduce its expenditure by having a surplus budget and raising taxes in order to stabilize economy at the full employment level.

Direct controls

The aim of direct control is to ensure proper allocation of scarce resources for the purpose of price stabilization. They affect particular consumers and producers. Such controls are in the form of licensing, rationing, price and wage controls, export duties, exchange controls, quotas, anti-hoarding controls, etc. Their success depends on the existence of an efficient and honest administration. Otherwise, they lead to black marketing, corruption, long queues, etc.

Reference

Bernake and Abel, Macroeconomics, Singapore, Pearson Education latest edition