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BUSINESS CYCLE AND POLICIES


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Ankita Nigam (51) Ruchi Sharma (52) Ritika Chitnis (53) Chandana Awasthi (54) Tushar Tiwari (55) Rachna Chandrashekhar (56) Nirmal Gulabani (57) Bindal Thakkar (58) Sneha Kulkarni (59) Ankit Srivastava (60)

WHAT ARE BUSINESS CYCLES ?

Recurring and fluctuation level experienced in the aggregate economic activity of nation over a period of time. It varies from one year to ten or twelve years. Involves phases of growth and decline in an economy.

Business Cycles Contd…


measured by real G.D.P Average duration of expansion -45months. average duration of recession -11 months

THE STAGES

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EXPANSION Speed up in the pace of economic activity high level of effective demand resulting in high production Employment growth with rise in income. G.D.P growth rate is positive.

PEAK


Optimum production and rise in employment. Inflationary pressure and rise in bank rates. Rise in the prices of raw material and finished goods. indicator of an upcoming contraction

CONTRACTION

Slow down in economic activity. slow down in production output and employment rates. decrease in bank rates to boost business

TROUGH


Economic output the lowest. Unemployment is generally highest. G.D.P growth rate is negative.

RECOVERY

Expansions and rise in economic activities. Steady rise in output, income, employment, price and profits. Increase investments Business expansion takes place, stocks are activated.

WHO DETERMINES THE BUSINESS CYCLE STAGES?

The National Bureau of Economic Research (NBER) analyzes economic indicators to determine the phases of the business cycle.

WHAT CAUSES BUSINESS CYCLE?
The business cycle is affected by all the forces of supply and demand. When consumers are confident, they buy now knowing there will be income in the future from better jobs, higher homes values and increasing stock prices.

Causes of Business Cycle Contd..

Even a little healthy inflation can trigger demand by spurring shoppers to buy now before prices go up. As demand increases, businesses hire new workers, which further stimulates more demand. This is the Expansion phase. In the Contraction phase, confidence is replaced by fear or even panic. Consumers sell their homes, and stop buying. Businesses lay off workers, and hoard cash. Confidence must be restored to before the Trough can be hit, and the economy re-enters a new Expansion phase.

Causes of Business Cycle Contd..
In addition to demand, the business cycle is also heavily dependent on the availability ofcapital. This is known as liquidity, and is itself dependent upon interest rates. Too much capital will turn a healthy expansion into a peak, at which point greed will bid up the price of assets, often causing inflation.

Causes of Business Cycle Contd..

At this point, a stock market correction may indicate that assets are overvalued, creating fear and a contraction. The Federal Reserve lowers interest rates to spur the economy into expansion during a trough. It raises rates during an expansion to avoid too much of a peak. A trough usually is accompanied by a recession and a bear market, while an expansion is usually signaled by a bull market and inflation.

Business Policies

Business policies refer to the actions that the Government takes in the economic field to cover the systems for setting interest rates and Government budget.

Business Policies
Monetar y Policies

Fiscal Policies

Monetary Policies

Harry Johnson defines it as a “policy employing central bank‟s control of the supply of money as an instrument of achieving the objectives of general economic policy.” It is a programme of action undertaken by the monetary authorities, generally the Central Bank, to control and regulate the supply of money with the public & the flow of credit.

Scope of monetary policy

The scope spans the entire area of economic transactions that the monetary authorities can influence by making changes in monetary policy instruments. The scope depends upon two factors: The level of monetization of the economy The level of development of capital market. The monetary policy to have a widespread impact on the economy, other capital sub-markets must have a strong financial link with the commercial banks.

Instruments of monetary policy
Quantitativ e measures

Qualitativ e measures

It refers to the economic variables that the central bank can change at its discretion with a view to controlling and regulating the supply and demand for money and availability of credit. Also called as „weapons of monetary control‟ & „the Nuts & Bolts of monetary policy‟.

Quantitative Measures


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It is a traditional measure of monetary control. It is classified as follows: Open market operations Discount rate Cash reserve ratio Statutory liquidity Requirement(SLR)

Open Market Operations
•It is sale and purchase of government securities and treasury bills by the central bank of the country.
•The central bank carries out its open market operations through the commercial banks & not directly with the public. •The sale of government bonds & securities affect the supply of credit by affecting the credit creation capacity of the banks & demand for credit by changing the rate of interest. •The buy-back of government bonds & securities increases the monetary flow from central bank to the public through commercial banks.

Discount Rate
Also known as Bank rate, RBI Act 1935 defines it as“Standard rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under this act.”  When central bank wants to increase the credit creation capacity of commercial banks it decreases the discount rate & when it decides to decrease the same, it increases the discount rate.  When central bank changes their discount rate, commercial banks also change their own discount rate generally with a difference of 1%.

Cash Reserve ratio

It is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank. It is expressed as a percent of depositors balances the bank must have on hand as cash. CRR are non-interest bearing deposits & hence a handy tool for central bank to control money supply. When economic conditions demand a contractionary monetary policy, the central banks raises the CRR & vice-versa.

Statutory liquidity Requirement(SLR)

RBI has imposed another reserve requirement in addition to CRR. SLR in a way compels the commercial banks to invest in government securities or bonds. SLR is the proportion of the total deposits which commercial banks are statutorily required to maintain in the form of liquid assets in addition to CRR. SLR was imposed because commercial banks used to covert their liquid asset into cash to replenish the fall in their loanable funds due to rise in CRR.

Qualitative Measures

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They lead either to expansion or contraction of total credit and the impact on all the sectors of the economy is uniform. Following are the common qualitative control measures: Credit Rationing Change in lending Margins Moral Suasion Direct Control

Credit Rationing:
•In order to overcome the problem of shortage of institutional credit available for business sector, the central bank adopted the following two measures: a) Imposition of upper limits on the credit available to large industries & firms. b) Charging a higher or progressive interest rate on bank loans beyond a certain limit .

Moral Suasion:
• • It is a method of persuading & convincing the commercial banks to advance credit in accordance with the directives of the central bank in overall economic interest of the country. Under this method, the central bank writes letter to hold meetings with the banks on money & credit matters.

Change in Lending Margins:
•The banks advance money more often than not against a mortgage of property. •Banks provide loans only upto a certain percentage of the value of the mortgaged property . The gap between the value of mortgaged & amount advanced is called “Lending Margin.”

•This method was used for the first time by RBI in 1949 with the objective of controlling speculative activity in stock market. However this method is no more used widely in India.

Direct Control:
When all other methods prove ineffective, the monetary authorities resort to direct control measures with clear directive to carry out their lending activity in a specified manner.

Transmission mechanism of Monetary policy

The basic approach of monetary policy is to change the money supply. So the working mechanism of monetary policy has to be traced through the effects of change in money policy & its effect on real variables.

The central theme of the transmission mechanism is portfolio adjustment by the households & the firms.

Portfolio Adjustment

It refers to reallocation of total investment between different forms of assets. The need for adjustment in portfolio arises due to change in money in the form of wealth, which causes disequilibrium in portfolio. Disequilibrium in portfolio makes asset holders adjust their portfolio to regain their equilibrium position. This is called portfolio adjustment process. In this process of adjustment, the equilibrium levels of incomes & prices change.

Portfolio Process
The Keynesian Approach

Adjustment

The Monetari st Approach

Keynesian Approach vs Monetarist Approach
Keynesian Process: Increase in money supply Increase in cash balance Increase in demand for financial assets Fall in interest rate Increase in investment Increase in the aggregate demand Monetarist Process: Increase in Money supply Increase in cash balance Increase in demand for real assets Increase in aggregate demand

The Keynesian Approach

Under this process of portfolio adjustment process, the firms & households tend to increase their financial assets and not in the real assets.

According to Keynesian approach, increase in demand for financial assets, pushes the price of financial assets up. As a result, the interest rates go down; which increases investment and thus the level of income.
Increase in income causes a rise in aggregate demand, which further results in increase in equilibrium level of income and continues till new equilibrium point is achieved.

The Monetarist Approach

Under this process of portfolio adjustment process, the firms & households tend to increase their demand for real assets and not in the financial assets. Monetarists treat cash balance and real assets as close substitutes. In this Approach, the aggregate demand can change without change in the interest rate.

Limitations of Monetary Policy
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Time Lag

a. Inside Lag : - Identifying the nature of the problem - Identifying the source of the problem - Assessing the magnitude of the problem - Choice of appropriate policy action - Implementation of policy actions
b. Outside Lag : Time taken by the household and firms to react to the policy action taken.

2) Problems in Forecasting
Requires magnitude of problems like, a. Recession b. Inflation to be correctly assessed

3) Non – banking Financial intermediaries
The proliferation of non – banking financial intermediaries have reduced the share of the commercial banks in the total credit control.

4) Underdeveloped Money and capital Markets Effectiveness of monetary policy is less in less developed countries

Effectiveness of open Market Operation
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When commercial bank posses excess liquidity, the open market does not work effectively In buoyant market, effective control for credit through the open market is doubtful In period of depression, open market operations are not effective for lack of demand for credit In countries were banking system is not developed and security capital markets are not interdependent, open market operations have a limited effectiveness

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Monetary Policy of India
- Policy Objective
Major Objective : a. Economic Growth b. Social Justice c. Price stability
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Targets
To achieve the objective, RBI adopted a reconciliatory approach that incorporates the various kinds of interactions between real and monetary sectors.

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Monetary Measures To control money supply, RBI is using traditional measures: Open Market Operation, CRR and Bank Rate

FISCAL POLICIES

Fisc means state treasury Fiscal policy refers to policy concerning the use of „state treasury‟ or Government finances to achieve the macroeconomic goals. Fiscal policy is a means by which a government adjusts its levels of spending in order to monitor and influence a nation‟s economy.

SCOPE OF FISCAL POLICY

Scope of fiscal policy is the number of fiscal instruments and target variables. Fiscal instruments are the variables that Government can change and make strategy at its own discretion.

The target variables are the macro variables that are intended to be changed to achieve the intended results.

FISCAL INSTRUMENTS
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Budgetary Balance Policy Government Expenditure Taxation Public Borrowings

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TARGET VARIABLES
1. 2. 3. 4. 5. 6.

Intended change in the aggregate demand Private disposable income Private consumption expenditure Private savings and investments Exports and imports Level and structure of prices

Objectives of Fiscal Policy
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To achieve desirable price level To achieve desirable consumption level To achieve desirable employment level To achieve desirable income distribution

Increase in capital formation.

KINDS OF FISCAL POLICY

DISCRETIONAR Y

NON DISCRETIONAR Y

DISCRETIONARY FISCAL POLICY

It is the deliberate change in the government expenditure and taxes to influence the level of national output and prices. It aims at managing the aggregate demand for goods and services. Expansionary fiscal policy is used when the economy is in recession. Contractionary fiscal policy is used to control the inflation in the economy.

EXPANSIONARY FISCAL POLICY
FISCAL POLICY TO CURE RECESSION

AS
P R I C E
L E V E L

AD1 AD2

0

Y2

Y1

Recession occurs when the aggregate demand decreases due to the fall in private investment. When the government adopts expansionary fiscal policy, it raises its expenditures without raising taxes or cuts down on taxes with no change in expenditure of increases expenditure and cuts down on taxes as well. This leads to the government having a deficit budget policy.

TWO FISCAL METHODS TO GET THE ECONOMY OUT OF RECESSION Increase in government expenditure To increase the aggregate demand the government increases its spending and buys various types of goods and materials and employs workers. The effect of this increase in expenditure is both direct and indirect.

Reduction in taxes This is another measure to cure recession and achieve expansion in output and employment. The reduction in taxes increases the disposable income and leads to the increase in consumption spending by the people.

CONTRACTIONARY FISCAL POLICY
FISCAL POLICY TO CONTROL INFLATION

AS
P R I C E
L E V E L P2

P 1

AD2 AD1

0

Y1

Y2

Inflation in the economy occurs due to a situation of excess demand. This could occur because of large increases in consumption demand, investment expenditure or a bigger budget deficit caused by too large an increase in government expenditure. When contractionary policy is adopted, the government reduces its expenditure or increases its taxes. In this case, the government is planning for a budget surplus.

FISCAL MEASURES TO CONTROL INFLATION Reducing government expenditure To decrease the aggregate demand in the economy the government reduces its spending on goods and services. This creates a surplus in the budget and removes the excess demand from the economy.

Increase in taxes Taxes can be increased to reduce aggregate demand. The hike in taxes reduces the disposable income leading to reduction in consumption demand.

NON DISCRETIONARY FISCAL POLICY
AUTOMATIC STABALIZERS

The tax structure and expenditure pattern are so designed that taxes and government spending vary automatically inappropriate direction with changes in national income. They automatically raise aggregate demand in times of recession and reduce it in times of inflation and help in ensuring economic stability.

AUTOMATIC FISCAL STABALISERS


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Personal Income Taxes Corporate Income Taxes Transfer payments Corporate dividend policy

Fiscal Policy and macro Economic growth
1. Fiscal Policy for economic growth

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Progressive taxation of personal and corporate incomes Widespread taxation of all kinds of consumer goods Taxation of luxury goods at a prohibitive rate Imposition of exorbitantly high duty on import of consumer goods

Fiscal Policy and macro Economic growth Contd..
2. Public borrowings and economic growth
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External debt Internal debt

Fiscal Policy and macro Economic growth Contd..
3.Fiscal policy for employment  Heavy taxation of capital intensive goods  Subsidization of labour intensive groups  Heavy duty on imports of capital intensive technology  Concessions in customs for import of inputs for labour intensive products

Fiscal Policy and macro Economic growth Contd..
4. Fiscal Policy for Stabilization:  Automatic stabilization policy is used for the developed countries  Contra-cyclical fiscal policy should be used for least developed economies.

Fiscal Policy and macro Economic growth Contd..
5.Fiscal policy for economic equality  Spending government money on projects that enhance the earning capacity of the low income people like free education.  Reallocating capital expenditure so as to enhance the employment opportunities for unemployed and underemployed people  Making provision for financial aid for the unemployed for their self-employment  Making provision for unemployment relief and unemployment insurance

Fiscal Policy and macro Economic growth Contd..
6. Fiscal policy and external balance:  Imposition of heavy import duty especially on the import of consumer goods.  Subsidization of exports.

Limitations of Fiscal Policy


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Inaccuracy of forecasting Dynamic multiplier Decision and execution lags Underdeveloped countries

REFERENCES

Financial-education.com Useconomy.about.com