© 2000 John Petroff
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© 2000 John Petroff |
3)- Monetary and fiscal policies over the business cycle
The description of the business cycle above has omitted any government intervention. In the 19th century, business cycles were especially severe with periods of deflation that caused a large proportion of businesses to fail, and high levels of unemployment to prevail. Governments (in the US and the UK in particular) came under pressure to intervene in order to reduce the hardship of severe recessions. Since excessive bank lending was a reason for bank failures, as well as corporate bankruptcies, monetary policies also had to be formulated by central banks to prevent these problems.
Unfortunately, in the early part of the 20th century, government policies were actually the opposite of what was desirable and caused business cycles to be even worse. For instance, in the United States, the discipline of a balanced budget was seen as a moral duty for a government facing a recession in the early 1930's, and taxes were raised at the onset of the great depression. Improvements in fiscal policy were based on teaching of John Maynard Keynes and his followers. A first application of recommended increased spending was observed in the New Deal of Franklin D. Roosevelt. In 1946, the US Employment Act stipulated government's obligation to take measures to prevent excessive unemployment. The results were soon left, as recessions after world war II were much milder than before and US unemployment rate never dropped below 10% (compared to twice that much before). In the 1960's, economists even believed that they could fine tune the economy to avoid recessions.
But, that was not to be. Keynesian economics neglected monetary policy which it considered as only useful (or accommodating) to assist fiscal policy. To make it easier for government to undertake its spending, the Fed had to help government borrowing. This crowded out private borrowing and delayed recovery. Likewise, money supply was allowed to grow without restraint in expansion, putting in place inflationary forces for economic overheating to push the economy into recession. Improvement in monetary policy was not seen until the teaching of Milton Friedman was accepted in the 1980's, and steady smooth growth of money supply was recognized as an essential component of economic stability. Since then the business cycle appears so far to be even milder in the last two decades (e.g. going down less that one percent in the 1991 recession), and, as noted before, the expansion phases are much longer.
See review questions Q-15B3.1 through Q-15B3.6.
See research assignments R-15B3.1 through R-15B3.3.
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