Government Policy Business Cycle

Business cycles create instability in the economy. The period of boom or rising business activities is characterised by increase in output, employment, income, profits, saving and investment, wage rates, and there is overall optimism that prevails in the economy. A period of depression or recession is characterised by continual decrease in output, sales, employment, income, saving and investment, profits, wage rates, and overall pessimism prevails in the whole economy. Prof. J.M. Keynes was the first economist to suggest government intervention to avoid business fluctuations and bring stability. Government policy could be used in a countercyclical manner to stabilize the economy.

The government can activate its fiscal policy to even out business fluctuations. The major tools of the fiscal policy are public expenditure and taxes. These two tools are to be used differently in the period of inflation and recession. To control inflation, the government may curtail or postpone its expenditure and impose new taxes or increase the rates of existing taxes. Conversely, for the elimination of recessionary gap, the government may increase its expenditure and resort to sharp reduction in tax rates and offer tax rebates and concessions. Government spending helps to generate new employment opportunities, as a result, the level of output and income also rises. Similarly, reduction in the tax rate increase the personal disposable income and private spending. Increase in aggregate spending shifts the AE line upwards, as a result, the level of output (GDP) rises.

Government Policy for the Removal of Recessionary Gap

Recessionary gap refers to a situation when the actual GDP is less than the potential GDP.

In both the parts (i) and (ii) of the initial equilibrium is E₀, where the actual GDP is Y₀ at the price level P₀. In part (i), actual GDP(Y₀), than the potential GDP (Y*). To remove this recessionary gap (Y* - Y₀), the wage rates and the price of other inputs could be reduced so that the SRAS₀ curve shifts rightwards to SRAS₁. At the new equilibrium E₁, actual GDP rises and become equal to potential GDP(Y*). It is important to note that a higher level of GDP is attained at a lower price level P₁.

The recessionary gap is removed by shifting to AD₁. By using the expansionary fiscal policy, i.e., lowering taxes and increasing spending, the government helps to raise the level of aggregate demand. At the new equilibrium E₁, where the AD₁, curve intersects the SRAS₀ curve, the level of GDP rises to its potential level (Y*)

Limitations: The major limitation of the fiscal policy for removing recessionary gap is that it may stimulate the economy just before private sector spending recovers on its own. As a result, the economy may overshoot its potential output, leading to the opening of inflationary gap. Therefore, the fiscal policy which was introduced to promote economic stability will only create economic instability.

Government Policy for the Removal of Inflationary Gap

Inflationary gap refers to a situation when actual GDP exceeds the potential GDP.

In both the parts (i) and (ii) of the, initial equilibrium is E₀, where the actual GDP is Y₀ and the price level P₀. Since actually GDP (Y₀) is more potential than GDP (Y*), it opens inflationary gap.

In part (i), to remove the inflationary gap, an excess demand may be created so that input prices and wage rates rise. This will shift SRAS₀ curve leftwards to SRAS₁. At the new equilibrium E₁, the actual GDP become equal to the potential GDP (Y*), but at a higher price level P₁.

In Part (ii), to remove the inflationary gap, the government may resort to a contractionary fiscal policy, increasing tax rates and reducing spending so that AD₀ curve shift downwards to AD₁. At the new equilibrium E₁, the actual GDP becomes equal to the potential GDP (Y*), but at a lower price level P₁.

Limitations: The major limitation of the fiscal policy is that while the government may be spending less and the private sector also decides to reduce its spending, the GDP may fall below the potential level, thus opening up a recessionary gap.

“Government taxes and spending shift the AD curve and hence can be used to remove persistent GDP gaps.”

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