Topic 6

Business Cycle Fluctuations and Stabilization Policy – Introduction

Dr. JB Nnyanzi
26th June, 2022
• What are business cycles
• Phases of a business cycle
• Main features/characteristics of business cycles

• Causes of business cycles

• Direction and Timing of Variables and the Business Cycle: Stylized Facts

• Control of Business Cycle: Stabilization Policy

• Business cycles in Uganda
• Impact on Business Operations – Practical illustration
• Review questions

A. What is a Business Cycle?

 Market economies have regular fluctuations in the level of economic activity which we
call the business cycle.
 The term “business cycle” (or economic cycle or trade cycle or boom-bust cycle) refers to
economy-wide fluctuations in production, trade, and general economic activity over
several months or years.
 A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around
its long-term natural growth rate. It explains the expansion and contraction in economic
activity that an economy experiences over time.
 From a conceptual perspective, the business cycle is the upward and downward
movements of levels of GDP (gross domestic product) and refers to the period of
expansions and contractions in the level of economic activities (business fluctuations)
(Short‐run variations) around a long-term growth trend.
 The recurrent but irregular and nonrepeating ups and downs in economic activity
observed in market economies. Despite being termed cycles, most of these fluctuations in
economic activity do not follow a mechanical or predictable periodic pattern.
 The length of a business cycle is the period of time containing a single boom and
contraction in sequence.
 The time period to complete this sequence is called the length of the business cycle. A
boom is characterized by a period of rapid economic growth whereas a period of

1
 relatively stagnated economic growth is a recession. These are measured in terms of the
growth of the real GDP, which is inflation-adjusted.
 The time horizon when business cycles take place is approximately 0‐4 years. Beyond
about 5 years is domain of long run.
 Why is the business cycle a central concern in macroeconomics?
 The business cycle is a central concern in macroeconomics, because business cycle
fluctuations are felt throughout the economy.
B. Phases/Stages of a Business Cycle
The diagrams below demonstrate a business cycle. In the first diagram, the straight line in the
middle is the steady growth line. The business cycle moves about the line. Here the business
cycle appears to have more than four stages, though in essence it is just expanding on figure
that follows.

• In the diagram below, this trend over time is represented by the straight line. The
phases appear only four. Both diagrams are the same, only that one is an extension of
the other.

2
 • The stages or phases of the business cycle are sometimes given as six (or sometimes
three or four for convenience), but all definitions include the boom and contraction of
an economy. 1) Expansion
• The first stage in the business cycle is expansion. In this stage, there is an increase in
positive economic indicators such as employment, income, output, wages, profits,
demand, and supply of goods and services. Debtors are generally paying their debts
on time, the velocity of the money supply is high, and investment is high. This
process continues as long as economic conditions are favorable for expansion. In the
first phase, the economy is growing along its long term trends in employment, output,
and income. 2) Peak
• The economy then reaches a saturation point, or peak, which is the second stage of
the business cycle. The maximum limit of growth is attained. The economic
indicators do not grow further and are at their highest. Prices are at their peak. This
stage marks the reversal point in the trend of economic growth. Consumers tend to
restructure their budgets at this point. Thus, at some point the economy will overheat,
and suffer rising prices and interest rates, until it reaches a turning point -- a peak.
• It is the end of expansion, distinguished by factors full use, high investment and
shortage of labour, particularly for high-skilled jobs. It is a phase of economic activity
characterized by rising demand, rising prices, rising investment, rising employment,
rising incomes, rising purchasing power and hence rising demand and so on. The
investors, therefore, voluntarily undertake risks and go in for investment. This further
fuels boom conditions through the working of the multiplier effect.
• In some books the three terms peak, prosperity and boom are used to refer to the same
thing.
3) Recession
• The recession is the stage that follows the peak phase. It is a state of an economy
marked by a decline in real output for two or more successive quarters. The demand
for goods and services starts declining rapidly and steadily in this phase. Producers do
not notice the decrease in demand instantly and go on producing, which creates a
situation of excess supply in the market. Prices tend to fall. All positive economic
indicators such as income, output, wages, etc., consequently start to fall.
• It is the time when aggregate economic activity is falling. Demand fall causing
unemployment and decreasing production levels. i.e. during the boom period, the
economy may get over- heated and the monetary authorities, the financial institutions
and the business itself may begin to play cautious. There may be cuts in investment,
resulting in cuts in employment, fall in incomes, decline in purchasing power and
demand. Prices may begin to fall.
• Sometimes in some books they refer to a recession as a contraction but it is the
contraction that causes a recession. Contraction is wider.
• A recession is a trough defined as negative GDP growth occurring over two
consecutive quarters and lasting for several months or longer.
4) Depression

3
 • A very severe recession.
• Sometimes, this phase is considered part of the Trough/slump phase but can
sometimes be considered distinct.
• Here, there is a commensurate rise in unemployment. The growth in the economy
continues to decline, and as this falls below the steady growth line, the stage is called
a depression.
• A depression is commonly defined as an extreme recession that lasts three or more
years or which leads to a decline in real gross domestic product (GDP) of at least
10%. The term depression is often used to refer to a particularly severe period of
economic weakness. Some economists use it to refer only to the portion of these
periods when economic activity is declining.
• The more common use, however, also encompasses the time until economic activity
has returned to normal levels.
• If effective corrective measures cannot be undertaken during a recession, the
economy may find itself go into depression. It is a stage when the business confidence
is at its lowest. Investment, employment, output, income and prices touch the bottom.
5) Trough
• In the depression stage, the economy’s growth rate becomes negative. There is further
decline until the prices of factors, as well as the demand and supply of goods and
services, contract to reach their lowest point.
• The economy eventually reaches the trough. It is the negative saturation point for an
economy. It is a low point in a business cycle, where output turns upward. There is
extensive depletion of national income and expenditure.
• A trough is the end of a contraction, characterized by a high rate of unemployment
and low consumption levels in relation to its real capacity. Troughs are where
employment and output bottom-out during a recession (downturn).
• In some books the three terms troughs or depressions or slumps mean the same thing.
6) Recovery
• After the trough, the economy moves to the stage of recovery. In this phase, there is a
turnaround in the economy, and it begins to recover from the negative growth rate.
Demand starts to pick up due to low prices and, consequently, supply begins to
increase. The population develops a positive attitude towards investment and
employment and production starts increasing.
• Employment begins to rise and, due to accumulated cash balances with the bankers,
lending also shows positive signals. In this phase, depreciated capital is replaced,
leading to new investments in the production process. Recovery continues until the
economy returns to steady growth levels.
• This completes one full business cycle of boom and contraction. The extreme points
are the peak and the trough.
• Expansion or recovery of previous employment, income and consumption levels, that
usually comes together with a rising in prices: time when aggregate economic activity

4
 is growing. Sustained recovery will find the level of investment, employment, output,
income and prices moving upwards.
• The recovery will enjoy rising employment, output, and income while unemployment
will fall. The recovery will gradually slow down as the economy once again assumes
its long term growth trends, and the recovery will transform into an expansion.
Note:
 The phases could as well be summarized into a fewer number where expansion and
recovery are considered as one phase, the recession as the second, the depression and
trough as one, and the peak as the last one.
 Recessions are usually brief (six to nine months) and are marked by falling
employment, output, income, prices, and interest rates. Most significantly, recessions
are marked by rising unemployment. The average recession lasts a bit less than one
year, and GDP falls 6 percent from peak to trough. i.e. contractions in economic
activity last for only a few quarters. The average expansion lasts almost four years,
and GDP rises 22 percent from trough to peak.
 Amplitude: maximum deviation from trend
 Frequency: number of peaks in real GDP that occur per year
 Seasonal trends are variations in data that are associated with a particular season in
the year.
 Secular trends are long-run trend (generally 25 or more years in macroeconomic data.
 The period of a cycle, i.e., the length of time required for the completion of one
complete cycle, is measured from peak to peak and from trough to trough. The
shortest of the cycle is called ‘seasonal cycle’.
 Recessions and expansions refer to the direction of change in economic activity, not
its level.

C. Main features/characteristics of business cycles

• Fluctuation of “aggregate economic activity”, not just a single economic variable: That is,
they involve fluctuations in many economic activities hence in many economic variables,
not only in GDP. Also note that fluctuations are in many economic activities but not in all
activities. Therefore, during a cycle some variables or activities do not follow the cycle or
move in opposite directions to the cycle.
• Similar phases: Every cycle has similar phases: a) Trough b) recovery/revival, c)
prosperity or boom/expansion, d) Peak, e) recession/contraction f) Depression. When
economic activity is falling we are in a contraction or recession (depression or slump).
The low point of the recession is called the trough (i.e. the end of a contraction). After the
trough the economy expands (expansion or a boom) till it reaches a peak (end of
expansion). After a peak a new recession starts and so on. Prosperity/expansion phase is
characterized by extreme activity in the business world

5
• Co-movement: – Prices, productivity, investment, and unemployment have regular
patterns of behavior. Almost all sectors of the economy are affected by the cyclical
movements. Most of the sectors move together in the same direction. During prosperity,
most of the sectors or industries experience an increase in output and during recession
they experience a fall in output. Comovement means that many economic variables move
together in a predictable way over the business cycle. The business cycle facts illustrate
comovement among all the variables that are either procyclical (moving in the same
direction as aggregate economic activity) or countercyclical (moving in the opposite
direction as aggregate economic activity). Only those variables listed as acyclical do not
show comovement.
• Recurrent: It exhibits a wave-like movement having a regularity and recognized patterns.
The business cycle is recurrent, as there are repeated episodes of contractions and
expansions over time. That is to say, it is repetitive in character. Cycles are recurrent in
the sense that they happen many times but are not periodic in the sense that they do not
happen at predictable times and for predictable length of time. Note that the fact that are
not periodic makes them harder to predict but also more interesting to analyze in the
sense that if you get them right you can take advantage of it (while there is not much
advantage in getting the date of Christmas right).
• Periodicity:
- These phases occur from time to time. However, they do not occur in for specific
times, their time periods will vary according to the industries and the economic
conditions.
- Their duration may vary from anywhere between two to ten or even twelve years.
Even the intensity of the phases will be different.
- For example, the firm may see tremendous growth followed by a shallow short-lived
depression phase.
- Periodicity of a trade cycle is not uniform, though fluctuations are something in the
range of five to ten years from peak to peak.
- Every cycle exhibits similarities in its nature and direction though no two cycles are
exactly the same.
- In the words of Samuelson: “No two business cycles are quite the same. Yet they
have much in common. Though not identical twins, they are recognizable as
belonging to the same family.” It does not last for fixed, predetermined length of time.
• Persistence: – Once an expansion or contraction begins it tends to continue for a period of
time. The business cycle also displays persistence, as declines in economic activity tend
to be followed by further declines for some time, while growth in economic activity tends
to be followed by further growth for some time.
• Different Durations: Expansion and recession phases can have different durations (the
time passing from peak to trough) and different amplitudes (the drop or increase in
aggregate economic activity relative to the trend).
 Expansions are usually longer than recessions.
 Depression lasts longer than prosperity.

6
  The process of revival starts gradually.
 The phase of prosperity comes to an end abruptly.
- The phases of a trade cycle do not display any regularity or uniformity. We cannot
determine the length, duration or intensity of each phase. This is one of the important
features of business cycles.
• Synchronic: Another one of the features of business cycles is that they are synchronic.
Business cycles are not limited to one firm or one industry. They originate in the free
economy and are pervasive in nature. A disturbance in one industry quickly spreads to all
the other industries and finally affects the economy as a whole. For example, a recession
in the steel industry will set off a chain reaction until there is a recession in the entire
economy.
• Market Economic system affected: Market/capitalistic economies witness cyclical
movements in economic activities. A socialist/command economy is free from such
disturbances.
• Major Sectors Are Affected: It’s been noticed that fluctuations occur not only at the level
of production but also in other variables such as employment, consumption, investment,
rate of interest, and price level. The investment and consumption of durable consumer
goods like houses and cars are continually affected by the periodical fluctuations. As the
process of consumption is deferred the courses of the Business Cycle are also affected
widely
• Non-uniform effects: i.e. Not all the industries are affected uniformly. Some are hit badly
during depression while others are not affected seriously. Investment goods industries
fluctuate more than the consumer goods industries. Further, industries producing
consumer durable goods generally experience greater fluctuations than sectors producing
nondurable goods. Further, fluctuations in the service sector are insignificant in
comparison with both capital goods and consumer goods industries.
 International in Character
Trade cycles are contagious. They do not limit themselves to one country or one
economy. Once they start in one country they will spread to other countries and
economies via trade relations and international trade practices. This is because, in this age
of globalization, dependence of one country on other countries is great. We have an
actual example of this when the Great Depression of 1929 in the USA, later on, had an
adverse effect on the entire global economy. So in an integrated global economy like
today’s the effects of a trade cycle spread far and wide.
• Difference in recovery of industries: During recovery, increase in output of consumer
goods usually precedes that of investment goods. Thus, the recovery of consumer goods
industries from recessionary tendencies is quicker than that of investment goods
industries.
• Prices: Just as outputs move together in the same direction, so do the prices of various
goods and services, though prices lag behind output. Fluctuations in the prices of
agricultural products are more marked than those of prices of manufactured articles.

7
• Profit variation: profits fluctuate more than any other income source. i.e. Profits tend to
be highly variable and pro-cyclical. Usually, profits decline in recession and rise in boom.
On the other hand, wages are more or less sticky though they tend to rise during boom.
Q: The length of each phase of a business cycle is ____?

a. Indefinite
b. Definite
c. Fixed
d. None of the above
Answer: The correct answer is A. The phases of a trade cycle do not display any regularity or
uniformity. We cannot determine the length, duration or intensity of each phase. This is one
of the important features of business cycles.

D. Causes of Business cycles

 Keynesians and classical differ sharply in their beliefs about how long it takes the
economy to reach a long-run equilibrium.
 Classical economists believe that prices adjust rapidly (within a few months) to
restore equilibrium in the face of a shock, while Keynesians believe that prices adjust
slowly, taking perhaps several years.
 Because of the time it takes for the economy’s equilibrium to be restored, Keynesians
see an important role for the government in fighting recessions.
 But because Classical economists believe that equilibrium is restored quickly, there’s
no need for government policy to fight recessions.
 Since Classical economists think equilibrium is restored quickly in the face of shocks,
aggregate demand shocks can’t cause recessions, since they can’t affect output for
very long.
 So classical economists think recessions are caused by aggregate supply shocks.
 Keynesians, however, think that both aggregate demand and aggregate supply shocks
are capable of causing recessions.
1) General causes
 The business cycle is caused by the forces of supply and demand, the availability of
capital, and expectations about the future. There are many different factors that cause the
economic cycle – such as interest rates, confidence, the credit cycle and the multiplier
effect. Some economists also point to supply side explanations, such as technological
shocks.
 The theories developed help answer the two major questions i.e. What causes business
cycles?
i. The Classical Theory:
- Aggregate supply shocks are the cause of business cycles. Examples of classical
economists are Adam Smith, Mill, Ricardo and Malthus.

8
 - According to Adam Smith, the market forces is the invisible hand that would maintain
the stability in the economy by themselves.
- Classical economists view business cycles as representing the economy’s best
response to disturbances in production and spending. To Say, for example, “supply
creates its own demand” (Say’s law).
- Therefore, they view aggregate supply shocks as the major force behind changes in
output and employment –AD shocks do not output and employment AD shocks do
not matter as the economy is self-correcting. Unemployment arises due to the
inflexible wages and the interest rates.
ii. Keynesian Theory:
- Both Aggregate demand shocks and Aggregate supply shocks - volatile expectations -
are the cause of business cycles.
- Keynesian economists argue that because wages and prices adjust slowly,
disturbances in production and spending may drive the economy away from its most
desirable level of output and employment for long periods of time.
- The Keynesian theory of the business cycle regards volatile expectations as the main
source of economic fluctuations.
- Keynesian, monetarist, and rational expectations theories of business cycles assert
that fluctuations in aggregate demand are the source of business cycles.
- Writing in 1936 (the Great Depression), Keynes argued that the business cycle was
due to extreme swings in the total demand for goods and services.

2) Causes of each of the phases

Here's what causes each of the four phases of the boom and bust cycle. a)
Expansion: expansions occur when investment increases
 When consumers are confident, they buy now. They know there will be future income
from better jobs, higher home values, and increasing stock prices. As demand
increases, businesses hire new workers. The increase in consumer income further
stimulates demand. A little healthy inflation can trigger demand by spurring shoppers
to buy now before prices go up.
b) Peak:
• A healthy expansion can suddenly turn into a dangerous peak. It happens when there's
too much money chasing too few goods. It can either cause price inflation or an asset
bubble.
• If demand outstrips supply, then the economy can overheat. Investors and businesses
compete to outperform the market, taking on more risk to gain some extra return. This
combination of excess demand and the creation of risky derivatives created the
housing bubble in 2005.
• You can always recognize a peak by two things:
 First, the media says that the expansion will never end.

9
  Second, it seems everyone and his brother is making tons of money from
whatever the asset bubble is.
c) Recession:
• A contraction causes a recession. Recessions occur when investment decreases
• If the economy were entering a recession, you’d expect production, investment,
average labor productivity, and the real wage to decline because they are all
procyclical, and the unemployment rate to rise because it’s countercyclical.
• Three types of events trigger a contraction.
 They are a rapid increase in interest rates: Higher interest rates – causing lower
spending and investment
 A financial crisis, or runaway inflation.
 Fear and panic replace confidence. Investors sell stocks, and buy bonds, gold, and
the U.S. dollar. Co nsumers lose their jobs, sell their homes, and stop buying
anything but necessities. Businesses lay off workers and hoard cash.
 d) Trough:
• Total loss of consumer confidence.
• Extreme fear and panic
• Hyperinflation

E. Direction and Timing of Variables and the Business Cycle: Stylized Facts

 It is convenient to divide economic variables according to their direction and their

synchronization with the GDP cycle. i.e. two important characteristics of the cyclical
behavior: direction and timing
1. The direction in which a macroeconomic variable moves relative to the direction of
aggregate economic activity. Specifically,
 A procyclical variable: moves in the same direction as aggregate economic activity.
A variable is procyclical if its deviations from trend are positively correlated with the
output gap. Output fluctuates in the same direction in different sectors (although
different amplitudes may apply); investment and consumption are clearly pro-
cyclical: investment leads and is more volatile, consumption lags and is rather stable;
income: real wages and profits are pro-cyclical; employment and labour force are also
procyclical.
 A countercyclical variable: moves oppositely to aggregate economic activity. A
variable is countercyclical if its deviations from trend are negatively correlated with
the output gap.
 An acyclical variable: does not display a clear pattern over the business cycle. A
variable is acyclical if it is not procyclical nor countercyclical.

10
 2. The timing of the variable’s turning points relative to the turning points of the business
cycle. Specifically, for a
 A leading variable: the turning points occur before those of the business cycle. i.e.
Variables that tend to display their peak before the GDP peaks. A variable is leading
when it tends to predict upcoming movements in real GDP. If the peaks and troughs
of a variable occur before the peaks and troughs in aggregate economic activity, it is
said to be a leading variable. Examples: Stock prices, inventory investment, trade
balance, money growth
 A coincident variable: the turning points occur around the same time as those of the
business cycle. i.e. Variables that tend to display their peak at the same time as GDP
peaks. A variable is a coincident variable when it is positively correlated with GDP,
but not leading or lagging. If a variable’s peaks and troughs occur at the same time as
the peaks and troughs in aggregate economic activity, it is said to be a coincident
variable. Examples: industrial production, employment, unemployment rate,
consumption, business fixed investment, etc…
 A lagging variable: the turning points occur later than those of the business cycle.
Variables that tend to display their peak after the GDP peaks. A variable is lagging
when it tends to follow recent movements in real GDP. If a variable’s peaks and
troughs come after the peaks and troughs of aggregate economic activity, it is said to
be a lagging variable. Examples: Exports, Inflation, Nominal interest rates
 The fact that some economic variables are known to lead the business cycle is used to
develop an index of leading economic indicators. The index is used to forecast economic
turning points.
Examples

i. Production is a coincident and procyclical variable.

Industries that produce more durable goods or capital goods are more sensitive to the
business cycle than the industries producing nondurable goods. ii. Consumption and fixed
investment expenditures are procyclical and coincident.
iii. Inventory investment is procyclical, leading, and strongly volatile.
- Consumption of durable goods, fixed investment, and residential investment are
strongly procyclical.
iv. The trade balance is procyclical and leading. It usually falls sharply before recessions.
Business cycles are often transmitted between countries through the trade balance.
v. Exports are procyclical and lagging
vi. Imports are procyclical
vii. Employment is strongly procyclical and coincident.
viii. The unemployment rate is strongly countercyclical and coincident.
ix. Average labor productivity tends to be procyclical and to lead the business cycle.
x. The conclusions about cyclicality of real wage remain elusive.

11
 xi. The money growth is procyclical and leads the cycle as well as it leads the CPI
inflation.
xii. Nominal interest rates are procyclical and lagging. (have a similar cyclical pattern as
inflation)
xiii. The real interest rate is acyclical. It may reflect the facts that individual business cycles
have different sources of cycles.

Variable Direction Timing

Industrial production ProCyclical Coincident
Consumption ProCyclical Coincident
Business fixed investment ProCyclical Coincident
Inventories ProCyclical Leading
Government spending Procyclical -
Imports ProCyclical -
Exports ProCyclical Lagging
Net Exports CounterCyclical Leading
Trade Balance ProCyclical Leading
Employment Procyclical Coincident
Unemployment CounterCyclical Lagging
Labor productivity ProCyclical Leading
Real Wage ProCyclical -
Money growth ProCyclical Leading
Inflation ProCyclical Lagging
Stock prices ProCyclical Leading
Nominal interest rates ProCyclical Lagging
Real interest rate Acyclical -
Price level CounterCyclical Coincident

F. Control of Business Cycle: Stabilization Policy

Introduction:

• Theories of a business cycle help provide an answer to how policymakers should respond to
cyclical fluctuations.
• The economic policies used by the government to smooth out the extreme swings of the
business cycle are called contracyclical or stabilization policies, and are based on the theories
of John Maynard Keynes. Stabilization policy refers to government actions designed to
smooth out sharp changes in output, employment, and the price level.

12
 - Contracyclical policy is increasing aggregate demand in recessions and decreasing
aggregate demand in overheated expansions.
• A stabilization policy is a macroeconomic strategy enacted by governments and central banks
to keep economic growth stable, along with price levels and unemployment.
• In a market economy (or market sector) the government has two types of economic policies
to control aggregate demand –
- fiscal policy: discretionary and non-discretionary (automatic stabilizers) -
monetary policy.
 When these policies are used to stimulate the economy during a recession, it is said that
the government is pursuing expansionary economic policies.
 And when they are used to contract the economy during an overheated expansion, it is
said that the government is pursuing contractionary economic policies.
• Thus in general, stabilization policies can be implemented with the aid of either monetary
and/or fiscal policy.
 Ongoing stabilization policy includes monitoring the business cycle and adjusting
benchmark interest rates to control aggregate demand in the economy.
• Note that the trade cycle cannot be controlled by a single operation.

I. Monetary policy to control trade cycle

a) What is the role of monetary policy in business cycles?

13

Monetary factors aggravate the operation of trade cycle.
- Monetary inflation, leading to higher income and profits, strengthens the boom
conditions.
- Similarly, monetary deflation reinforces the downswing in the economic activities
leading to depression.
- So, the monetary policy should be adopted in an anti-cyclical way. During the period
of upswing and boom, supply of money and credit should be controlled and regulated.
• Monetary policy is how the nation's central bank uses its tools to manage the economic
cycle. It adjusts liquidity by changing interest rates and the money supply.
• Economists view monetary policy as the first line of defense against economic
slowdowns. This is because the Central Bank can act faster than the president or Cabinet
(fiscal policy), and it is better equipped to judge the appropriate timing and magnitude of
economic stimulus.
• Monetary policy adjustments, that includes interest rates and the money supply, can play
an important role in combatting economic slowdowns.
- Such adjustments can be made quickly, and monetary authorities devote considerable
resources to monitoring and analyzing the economy.
• By insuring price stability, monetary policy can make an important contribution to
macroeconomic stability. Stable inflation expectations eliminate an important source of
macroeconomic instability.
• Monetary policy can offset a downturn because
- lower interest rates reduce consumers’ cost of borrowing to buy big items such as
cars or houses.
- For firms, monetary policy can also reduce the cost of investment.
- For that reason, lower interest rates can increase spending by both households and
firms, boosting the economy.
• The Central Bank can adjust monetary policy more quickly than the president and
Cabinet can adjust fiscal policy. Because most contractions in economic activity last for
only a few quarters, a prompt policy response is crucial. Yet fiscal policy in practice
responds slowly to changes in economic conditions: it takes time first to enact a stimulus
bill and then to implement it, and time for the spending increases or tax reductions to
reach consumers’ pockets. As a result, the effect of fiscal stimulus on household and
business spending may come too late.
• Whether and how much stimulus is needed depends on present economic conditions, on
projections of future conditions, and on possible risks to both economic activity and
inflation. Forecasting economic conditions—or even determining the current state of the
economy—is inherently difficult, given limitations in the data available and in
economists’ understanding of the world. But the Central Bank’s large and sophisticated
team of analysts is better positioned to accomplish this task than any other agency of the
central government. In addition, the Central Bank staff carries out this work independent
of political considerations.

14
 
• These decisions are made by the Bank of Uganda. The policy changes can be done
immediately, although the impact on aggregate demand can take several months.
Monetary policy has become the major form of discretionary contracyclical policy used
by the central government. A source of conflict is that the BoU is independent and is not
under the direct control of either the President or the Cabinet. This independence of
monetary policy is considered to be an important advantage compared to fiscal policy.
• Note that expansionary monetary policy is commonly called "easy money" while
contractionary monetary policy is called "tight money".
How Monetary Policy combats each phase of the Business Cycle
• The central bank of the country adopt all or chosen methods of credit control. The
weapons of credit control, such as bank rate, open market operations, reserve ratio, etc.
should be utilized to control inflationary tendencies and over-expansion of business
activity. a) Expansion:
In an overheated expansion, the central bank will raise interest rates and decrease the
money supply.
b) Peak: Central banks raise interest rates during an expansion to avoid the irrational
exuberance of a peak. If needed, they will sell Treasury bonds and other assets during
open market operations.
 Irrational exuberance is when investors are so confident that the price of an
asset will keep going up, they lose sight of its underlying value. They
overlook deteriorating economic fundamentals in the pursuit of ever-higher
returns. Instead, they get into a bidding war and send prices up even higher.
Irrational exuberance drives the peak phase of the business cycle.
c) Contraction: In a recession, the Central Bank will lower interest rates and increase the
money supply. Thus, the expansionary credit policy should be adopted to mitigate the
severity of recession and depression. That is, the Central Bank switches to expansionary
monetary policy if economic growth slows or even turns negative. For example, it can
lower interest rates and buy Treasuries in open market operations.
d) Trough:
- Central banks pull out all the tools to jump start the economy out of a trough. The
expansionary monetary policy is here used excessively.
- A variety of innovative programs such as Quantitative easing, are also used to keep
banks from collapsing. For example, in 2008, the Federal Reserve Bank of US, (Fed)
used this tool to help end the great recession. It also expanded its open market
operations in a program called quantitative easing.
 Quantitative easing is a massive expansion of the open market operations of a
central bank. It’s used to stimulate the economy by making it easier for
businesses to borrow money. The bank buys securities from its member banks
to add liquidity to capital markets. This has the same effect as increasing the

15
 
money supply. In return, the central bank issues credit to the banks' reserves to
buy the securities.
Limitation of the Monetary policy

• The potential of monetary policy to combat extreme events is limited, however, because
its primary tool is the short-run interest rate, and that rate can’t fall below zero.
That means that in a particularly severe downturn such as the recent Great Recession, the
Central Bank will reduce the short-run interest rate to zero, after which the Central Bank
can employ only less effective and well-understood policies such as asset purchases.

II. Fiscal policy

• Fiscal policy refers to the taxation, expenditure and borrowing by the government. Fiscal
policy reinforces monetary policy to stabilize the economy, that is, to overcome recession
and control inflation in the economy.
• Fiscal policy takes two forms:
- the expansionary fiscal policy e.g. tax cut or increase in government spending or
increase borrowing
- the contractionary fiscal policy e.g. tax increase or reducing government spending or
reduce borrowing
• Two ways fiscal policy can be used to control trade cycle are:
- Discretionary Fiscal Policy.
- Automatic stabilizer
These are called countercyclical fiscal policy. That is, a policy designed to offset the
fluctuations in the business cycle.
 Keynes and others have recommended compensatory finance or compensatory fiscal
policy to bring about stabilization of business activity.
- During recession, private expenditure in the form of consumption and investment
may decline due to the operation of some adverse factors.
- This decline in aggregate demand will reduce consumption, investment, employment
etc., leading to down turn and recession in the economy.
- At this juncture, effort by the government through additional expenditure (and
reduced taxes) will fill the gap in demand, consumption and investment.
- The main thrust of compensatory fiscal policy thus is that the government should
inject extra expenditure to reinstate demand.
- In effect, the government expenditure was able to compensate for reduced private
expenditure. This fiscal policy is called compensatory fiscal policy.
- Contra cyclical fiscal policy is to counter business cycles.
Discretionary fiscal policy:

16

 These are changes in tax or spending policy requiring legislative or administrative action
by the president or parliament.
 Taxation, Government Spending, and Government Borrowing have to be effectively
utilized to control the severity of boom or the difficulties of depression.
 The government will only use discretionary fiscal policy in a severe recession. For
example, in the US, the federal government resorted to a large fiscal stimulus – tax cuts
in 1981-82 recession and increased spending in 2008-09 recession. Both policies created
large deficits, which is the appropriate stabilization policy during a severe downturn.

17
  The discretionary fiscal policy is achieved through the budget tool – anti-cyclical
budgeting!
Anti-cyclical budgeting

• The fiscal policy could be implemented in a budgeting process using either

countercyclical or procyclical budget to stabilize the economy. Here, the budgetary
policy of the government is made in tune with the measures already indicated to combat
the instability created by business cycle.
• During times of depression, a policy of deficit budgeting should be adopted. This will
increase the flow of income in the economy. Hence, apply Budget Deficit-Fiscal Policy
during depression
 Deficit budgeting is an important method of overcoming depression. When
government expenditures exceed receipts (deficit financing), larger amounts are put
into the stream of national income than they are withdrawn. Thus the budget deficit
has an expansionary effect on aggregate demand.
 Budget deficit may also be secured by reduction in taxes and without government
spending. Reduction in taxes tends to leave larger disposable income in the hands of
the people and thus stimulates increased consumption expenditure. This, in turn,
would lead to increase in aggregate demand output, income and employment.
However, reduction in taxes is not so expansionary via increased consumption
expenditure because the tax relief may be saved and not spent on consumption.
• During upswing, surplus budgeting should be adopted. Thus, apply a Surplus
BudgetFiscal Policy during Boom:
 Surplus in the budget occurs when the government revenues exceed expenditures.
The policy of surplus budget is followed to control inflationary pressures with in the
economy. It may be through increase in taxation or reduction in government
expenditures or both. This will tend to reduce income and aggregate demand by the
multiplier times the reduction in government and private consumption expenditure.
 There may be budget surplus without government spending when taxes are raised.
Enhanced taxes reduce the disposable income with the people and encourage
reduction in consumption expenditure. The result is fall in aggregate demand, output,
income and employment.
• Thus, budgeting should be done in anti-cyclical method.
 According to Keynes, a recession requires deficit spending while an overheated
expansion requires a budget surplus.
 However, the budget process takes so long -- 12 to 18 months -- that it is difficult to
match discretionary fiscal policy with the business cycle.
Automatic stabilizer or Built-in-stabilizer

18
 • A second type of fiscal policy is built into the structure of government taxes and
spending. This is referred to as "nondiscretionary fiscal policy" or more commonly as
"automatic stabilizers".
• The progressive income tax and the welfare system both act to increase aggregate
demand in recessions, and to decrease aggregate demand in overheated expansions.
These automatic changes in spending and taxes will generate a deficit in recessions and a
surplus in overheated expansions. The size of these automatic changes can be quite large.
For example, in the US, in the 2008-09 recession the deficit stimulus due to the automatic
stabilizers was much larger than the stimulus created by the legislative changes in taxes
and spending (discretionary fiscal policy).
• Justification for automatic stabilizers:
 When fluctuations take place in the economy, the available monetary and fiscal
tools cannot be geared quickly to set right the imbalance.
 Further it is also too much to expect the government officials to act quickly to the
tempo/speed of change in economic activity.
• So, the policy makers make provisions for automatic adjustments in the fiscal structure.
Hence the use of Automatic stabilizers.
• These built-in-stabilizers or automatic stabilizers will automatically come into play in
proportion to the rise and fall of economic activity.
• Definition: Automatic stabilizers are features of the tax and transfer systems that temper
the economy when it overheats and stimulate the economy when it slumps, without direct
intervention by policymakers. i.e. Automatic stabilizers offset fluctuations in economic
activity without direct intervention by policymakers.
• Examples of built-in-stabilizers:
 The progressive rate of taxation is one of the important built-in-stabilizer in the tax
structure. By this method, the tax rates are so fixed that in the upward phase of the
trade cycle, with increase in national income, the tax yield will go up automatically at
a faster rate without any change in the tax structure.
 Another important built-in-stabilizer is the unemployment insurance scheme.
- During periods of prosperity or upswing, the employers pay taxes and the employees
pay some amount towards unemployment insurance scheme. This money gets
accumulated.
- During times of depression and the consequent unemployment, the public spending
is automatically effected by doling out money to the unemployed people.
- Thus, the flow of money is regulated automatically from the people to the
government in times of prosperity, and from government to the people in times of
adversity. The built-in-stabilizers play a strategic role in fighting recessions.
How Fiscal Policy combats each phase of the Business Cycle

a) Expansion:

19
 - During expansion, it can employ contractionary monetary policy by raising interest
rates and slowing the flow of credit into the economy to reduce inflationary pressures
and the need for a market correction.
- During this time of boom, the government can mop up extra or the surplus money
through attractive borrowing schemes.
- When the economy is in the expansion phase, politicians are content because their
constituents are happy.
b) Peak:
- During this irrational exuberance phase, the contractionary policy is excessively
used.
- In an overheated expansion, a contractionary fiscal policy requires higher taxes and
reduced spending.
- Note however that many politicians would avoid pursuing the contractionary fiscal
policy to avoid the peak as they may not get re-elected by either raising taxes or
cutting spending.
c) Contraction:
- In a recession, an expansionary fiscal policy involves lowering taxes and increasing
government spending.
- During the periods of recession and depression, the government should reduce
substantially the taxes and leave more money in the pockets of individuals for
spending and investment.
- Thus, the expansionary fiscal policy is moderately used to control for the recession.
- Note that during this phase, elected officials are quick to cut taxes and increase
spending to create jobs, demand, and confidence.
- The best unemployment solution in a contraction is government spending on public
works and education jobs.
d) Trough:
- Governments use all tools at their disposal to control for the trough including
innovative non-traditional tools. For example, bailing out crumbling big companies
that employ many people. In the US for example, an Economic Stimulus Act was
passed in 2009 which helped end the Great Recession/financial crisis/credit crunch
of 20072009.
Note:

• There is no fool-proof method of solving the problem of trade cycles. All measures suggested
must be carefully coordinated and implemented to achieve economic stabilization.
• These stabilization objectives should not be interpreted rigidly. We cannot expect them to
eliminate all fluctuations in employment, output and prices. Cyclical fluctuations are an
inherent characteristic of capitalist society and cannot be eliminated completely but can be
controlled reasonably if measures are effectively adopted.
• Some fluctuations may be beneficial to economic growth. Therefore, stabilization policy
should be applied only to suppress inappropriate fluctuations.

20
 G. The Ugandan Business Cycle
Uganda’s real GDP grew at 2.9 percent in FY20, less than half the 6.8 percent recorded in FY19,
due to the effects of the COVID-19 (coronavirus) crisis, and is expected to grow at a similar
level in FY21, but downside risks are high. Economic activity stalled during the latter part of the
fiscal year due to a domestic lockdown that lasted over four months, border closures for
everything but essential cargo, and the spillover effects of disruption in global demand and
global supply chains due to the COVID-19 pandemic. This resulted in a sharp contraction in
public investment and deceleration in private consumption, which hit the industrial and service
sectors hard, particularly the informal service sector. On a calendar year basis, real GDP growth
is expected to contract by up to 1 percent in 2020, compared to 7.5 percent growth in 2019, and,
as a result, real per capita GDP growth is expected to contract by about 4.5 percent. Even if GDP
growth rebounds strongly by 2022, the level of per capita GDP is likely to remain well below its
pre-COVID trajectory. As a result of these impacts, the COVID-19 crisis is threatening to
reverse some of the gains made on structural transformation and the declining poverty trend of
the past decade. This transformation was characterized by a reduction in the workforce employed
in on-farm agriculture and a take-off in industrial production, largely in agro-processing.
However, following the COVID shock, there have already been widespread firm closures,
permanent layoffs in industry and services, a rapid slowdown of activity particularly in the urban
informal sector, and a movement of labor back to farming. At the same time, household incomes
have fallen, which is concerning given the high levels of vulnerability to poverty, limited social
safety nets, and impacts this might have on human capital development and Uganda’s capacity to
benefit from its demographic transition. Source:
https://openknowledge.worldbank.org/handle/10986/34893?show=full
Question:
Explain the business cycle effects alluded to in the above text.

H. Impact on Business Operations – Practical illustration

(Source: https://www.oyengyeng.com/2100/ )
How the business cycle affects business operations may be best explained by looking at how one
business responds to these cycles.
Normal Maintenance is a small business that provides a variety of construction services to
homeowners. They specialize in roofing, deck installations, siding, and general home
maintenance.
They employ three full-time workers, who typically work forty hours per week for an average of
twelve dollars per hour.

21
The company has been in business in the same town for than twenty years and has a solid
reputation for quality work and reliability.
Expansion

• Normal Maintenance is busy and has recently had to turn down jobs because it lacks the
capacity to do all the work offered.
• Homeowners now want to make home repairs and improvements which they had had to
put off during the sour economy. With the economy improving, others are fixing up their
homes to sell.
• Faced with so much demand, the owner of Normal Maintenance must decide whether to
pay his existing workers overtime (which will increase the costs for each job and reduce
profits) or hire additional workers.
• The competition for qualified construction labor is steep, and he is concerned that he will
have to pay more than his usual rate of twelve dollars per hour or possibly get workers
who are not as qualified as his current crew.
• He is, however, able to charge higher prices for his work because homeowners are
experiencing long waits and delays getting bids and jobs completed.
• The owner purchases a new truck and invests in additional tools in order to keep up with
the demand for services. Customers are willing to pay more than usual so they can get the
work done.
• Business is expanding to such an extent that Normal Maintenance and its suppliers are
starting to have trouble obtaining materials such as shingles and siding because the
manufacturers have not kept pace with the economic expansion.
• In general, business is great for Normal Maintenance, but the expansion brings
challenges.
Peak

• At the peak of the business cycle, the economy can be said to be “overheated.”
• Despite hiring additional workers, the owner and crews of Normal Maintenance are
working seven days a week and are still unable to keep up with demand.
• They can’t work any harder or faster. As a result, the crews are exhausted and the quality
of their work is beginning to decline. Customers leave messages requesting work and
services, but the owner is so busy he doesn’t return phone calls.
• Jobs are getting started and completed late as the crews struggle to cover multiple job
sites. As a result, customer complaints are on the rise, and the owner is worried about the
longterm reputation of the business.
• Neither the business nor the economy can sustain this level of activity, and despite the
fact that Normal Maintenance is making great money, everyone is ready for things to let
up a little.

22
Contraction

• As the economy begins to contract, business begins to slow down for Normal
Maintenance. They find that they are caught up on work and they aren’t getting so many
phone calls.
• The owner is able to reduce his labor costs by cutting back on overtime and eliminate
working on the weekends. When the phone does ring, homeowners are asking for bids on
work—not just placing work orders.
• Normal Maintenance loses out on several jobs because their bids are too high. The
company begins to look for new suppliers who can provide them with materials at a
cheaper price so they can be more competitive.
• The building material companies start offering “deals” and specials to contractors in
order to generate sales. In general, competition for work has increased and some of the
businesses that popped up during the expansion are no longer in the market.
• In the short term the owner is confident that he has enough work to keep his crew busy,
but he’s concerned that if things don’t pick up, he might have to lay off some of the less
experienced workers.
Trough

• On Monday morning, the crew of Normal Maintenance show up to work and the owner
has to send them home: there’s no work for them. During the week before, they worked
only three days, and the owner is down to his original crew of three employees.
• Several months ago he laid off the workers hired during the expansion. Although that was
a difficult decision, the owner knows from hard experience that sometimes businesses fail
not because their owners make bad decisions, but because they run out of money during
recessions when there isn’t enough customer demand to sustain them.
• 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 company’s remaining work comes from people
who have decided to fix up their existing homes because the economy isn’t good enough
for them to buy new ones.
• The owner increases his advertising budget, hoping to capture any business that might be
had. He is optimistic that Normal Maintenance will weather this economic storm—
they’ve done it before—but he’s worried about his employees paying their bills over the
winter.
• The owner of Normal Maintenance has been in business for a long time, so he’s had
some experience with the economic cycle. 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.

23
 REVIEW QUESTIONS
1. What are the four phases of a business cycle?
2. How long do business cycles last?
3. How do seasonal variations and long-term trends complicate measurement of the
business cycle?
4. Why does a business cycle affect output and employment in capital goods and consumer
durable goods industries more severely than in industries producing nondurables?
5. How does the Monetary Policy Combat the Business Cycle?
6. How does the Fiscal Policy Combat the Business Cycle?
7. What are automatic stabilizers and how do they work to influence business cycle?
8. Using examples, distinguish among the following terms:
a) Procyclical variable, Countercyclical variable, and Acyclical variable
b) Leading variable, Lagging variable, and Coincident variable
Short Review Questions
1) What causes recessions? Answer: Technology shocks (sometimes called supply shocks) are
important. These include changes in the prices of imported and exported raw materials.
Also, fiscal policy and monetary policy, which can affect aggregate demand. There is debate
as to the importance of other shocks to aggregate demand.
2) What are the major determinants of consumption expenditures? Answer: Permanent income
(current plus future), interest rates, and possibly age.
3) How does consumption behave over the business cycle? Answer: It is procyclical but less
volatile than GDP.
4) How does consumption react to temporary increases in transfer payments or temporary
reductions in personal taxes? Answer: Little or no reaction.
5) What are the major determinants of investment expenditures? Answer: Interest rates and
expectations about the future productivity of capital.
6) How does investment behave over the business cycle? Answer: It is procyclical and more
volatile than GDP.
7) In a closed economy, what are the major determinants of real interest rates? Answer: Saving
and investment.
8) How does the real interest rate behave over the business cycle? Why? Answer: It may be
procyclical or countercyclical, depending on whether investment or saving shifts more.
Empirically, it seems to be somewhat procyclical.
9) How does the trade balance behave over the business cycle? Answer: Theoretically, it may
be procyclical or countercyclical, depending on whether investment or saving shifts more.
Empirically, it seems to be somewhat countercyclical.
10) How do temporary increases in government purchases affect GDP? Answer: They increase
GDP.

24
11) What are some arguments against countercyclical fiscal policies? Answer: Practical problems
of implementation, such as lags.
12) The Wall Street Journal of January 14, 1994 stated that "Retail sales increased 0.8% in
December and 1993 sales jumped 6.2%, the strongest annual gain in four years. Sales of
durable goods rose 1.7% last month . . . "Bond prices fell on the stronger-than-expected retail
sales report. The Treasury's 30-year issue fell almost one point."
a) Based on your knowledge of business cycle facts, does the pattern of total retail sales and
durables sales for December 1993 make sense? What could account for this pattern?
b) A fall in bond prices implies higher interest rates. Why might news of stronger-
thanexpected retail sales lead to higher interest rates?
Answer:
a) The pattern makes sense. Overall retail sales in December increased by 0.8%, while sales
of durables increased 1.7%. The economy currently seems to be in the expansion phase of
the business cycle, as indicated by the fact that retail sales for the full year showed the
strongest gain in four years. Durables sales are more volatile than sales of nondurables
and services over the cycle, so we should expect durables sales to increase more than
overall retail sales during an economic expansion.
b) The retail sales figures are a sign that the economic expansion is stronger than previously
expected. If the expansion is expected to persist for a while, it can imply a higher
expected future marginal product of capital. This increases investment demand (shifts the
curve to the right). If investment rises more than saving during the expansion, interest
rates will increase.
13) What would you expect to happen to production, investment, average labour productivity,
real wage and unemployment rate if the economy were entering a recession? Answer: If the
economy were entering a recession, you’d expect production, investment, average labor
productivity, and the real wage to decline because they are all procyclical, and the
unemployment rate to rise because it’s countercyclical.
14) Why is expenditure on durable goods more sensitive to the business cycle than expenditure
on non-durable goods and services?
Answer:
Expenditure on durable goods is more sensitive to the business cycle than expenditure on
nondurable goods and services, because people can more easily change the timing of their
expenditure on durables. When economic activity is weak, and people face the danger of
losing their jobs, they avoid making durable goods purchases. Instead, they may drive their
cars a little longer before buying new ones, get the old washing machine repaired instead of
buying a new one, and put off buying new furniture until a new expansion indicates greater
income security. So in a recession, durable purchases decline a lot, but when an expansion
begins, durable purchases pick up substantially.
15) Use an illustration to explain the effects of a
a) demand shock on the business cycle.
b) Supply shock on the business cycle

25
Answer:
Figure 8.9 illustrates the effects of a demand shock. The economy begins in equilibrium at point
A, where the LRAS, SRAS, and AD curves intersect. The demand shock shifts the aggregate
demand curve to the left to AD’. In the short run, the equilibrium is at point B, where AD
intersects SRAS. This is a point at which output has declined (a recession), but the price level is
unchanged. Over time, the short-run aggregate supply curve shifts down to SRAS¢, restoring
long-run equilibrium at point C. At this point, output is back at its full-employment level and the
price level has declined. Thus the result of a demand shock on the price level is that the price
level is unchanged in the short run and declines in the long run. Since the 1973–1975 recession
was one in which the price level rose sharply, it must not have been due to a demand shock.

Figure 8.9

Answer:
Figure 8.10 illustrates the effects of a supply shock. The economy begins in equilibrium at point
A, where the LRAS, SRAS, and AD curves intersect. The supply shock shifts the long-run
aggregate supply curve to the left to LRAS¢. The new equilibrium is at point B, where AD
intersects LRAS’. This is a point at which output has declined (a recession), but the price level
has risen.

26
 Figure 8.10
16) Explain what is meant by growth being ‘too rapid’ in relation business cycle.
Answer:
Growth that is “too rapid” most likely refers to a situation in which the aggregate demand curve
has shifted to the right and, in the short run, intersects the SRAS curve at a level of output that’s
greater than the full-employment level of output (Figure 8.11). This situation is associated with
inflation because, in the long run, prices will rise, shifting the SRAS curve up to intersect with
the LRAS and AD curves. The shock that is implicitly assumed to be hitting the economy is an
aggregate demand shock, since that’s the only shock that increases output in the short run and
inflation in the long run.

Figure 8.11

27
References
https://www.youtube.com/watch?list=RDCMUCGtbVv_ACgV7difdVZ92NMw&v=XIpBFdg9
mx0&feature=emb_rel_end

28