Business Cycles

When a country is experiencing instability, governments would attempt to alter the current economic situations by implementing policies. Governments control fluctuations in economic activities through three policies when necessary; fiscal, monetary and supply-side policy. Fiscal and monetary policy alters the economy by creating changes in the aggregate demand. On the other hand, supply side policy changes the aggregate supply in the economy.

Fiscal policy stabilizes the economy via changes in government spending or tax. (Sullivan and Sheffrin, 2006) In a recession, an expansionary fiscal policy is most suitable to recover the economy from its slump. The government would increase government expenditure and decrease taxation to increase the GDP level.

With the aid of a diagram, an increase in government expenditure would increase the aggregate demand (AD), thus shifting the AD curve to the right (AD1). This would then increase the GDP level (yp). Similarly, a reduction tax would also increase AD, shifting the AD curve to the right. The increase would also result in an increase in the GDP level.

Diagram XXX Adapted from (Sullivan and Sheffrin, 2006)

On the contrary, contractionary fiscal policy aims to stabilize the economy during a boom, when there is excessive economic growth, leading to "overheating". (Sullivan and Sheffrin, 2006) The government would decrease government expenditure or increase tax rates to decrease the aggregate demand. When there is a decrease in government expenditure, AD would decrease thus shifting the AD curve to the left (AD1), causing a decrease in overall GDP level (yp). Correspondingly, an increase in tax would also decrease the average household income, thus leading to a fall in consumption spending. This causes a decrease in the aggregate demand. This is shown in the shift of the AD curve to the left, causing a decrease in GDP.

Diagram xxx Adapted from (Sullivan and Sheffrin, 2006)

Monetary policy is also used as a tool for economy stabilization and fine-tuning purposes. Monetary policy affects the aggregate demand via changes in money supply. The tools available to control money supply are interest rates and government bonds. Similar to fiscal policy, there is also expansionary and contractionary monetary policy.

Expansionary monetary policy is to increase aggregate demand and GDP level. With the aid of diagram xxx, the government first reduces interest rates (r0 to r1) which will cause a shift in money supply curve, indicating increase in money supply. Concurrently, investments would also increase (I0 to I1), which leads to an increase in aggregate demand leading to output growth. (y0 to y1) Besides that, when government purchase bonds from the public, it will also increase the money supply, leading to the same effects, which are increase in investments and aggregate demand, finally leading to an output growth.

Diagram XXX Source: Sullivan and Sheffrin (2003)

Diagram XXX Source: Sullivan and Sheffrin (2003)

On the contrary, contractionary monetary policy is implemented by increasing interest rates and selling bonds. Government increase rates or sell bonds to the public, it decrease the money supply This will then lead to a fall in investments and aggregate demand, creating an overall drop in output growth.

For example, expansionary fiscal policy was implemented by the United States government during 2001 as the country's economy was showing signs of slowing down and possibility of a recession. (Anon, 2001) The September 11th terrorist attacks in New York amplified the importance of fiscal policy to achieve economy recovery and stabilization. (Sullivan and Sheffrin, 2006)

In 2001, the US economy was experiencing a low in consumer's confidence. Consumer spending reduced tremendously, which caused a sudden decrease in national output level. In relation, the national unemployment rate also soared immensely during the year. It is announced that the US economy has officially entered a recession in March 2001. (Anon, 2001) In September 2001, the terrorist attack on New York's world trade center caused a major downturn of the US economy. America suffered major loss of consumer's confidence, which resulted in a sudden increase of unemployment rate in the country. BBC reported that the unemployment rate soared from "4.9% in September to 5.4% in October". (Anon, 2001) On average, the US economy suffered an approximate