Economies go through alternating periods during which the output of goods and services expands then contracts. This pattern is often called the business cycle. These cycles are part of the capitalist free market system. For the most part, politicians, business leaders and others don’t want recessions or downturns in the economy. Recessions are periods of time during which the economy’s output of goods and services declines for a period of time.

Shocks

Recessions often begin with what economists call shocks. Shocks are unfortunate events such as natural disasters, the introduction of poor government policies, warfare or sharp increases in prices such as oil. If the prices of goods and services were free to adjust to changes in demand and supply caused by shocks, the economy would be normally be able to recover quickly. However, not all prices are free to adjust to shocks. Economists call these prices sticky. The price of a person’s wage, for example, may be under contract for some period of time due to the collective bargaining process. Even if wages and salaries are not part of a union contract, it can be very difficult to adjust them downwards without repercussions. Because of sticky prices, recovery from recessions can take a long time.

Full Employment Output

Full employment is a situation in which everyone who wants a full-time job can get one. Full employment output is the monetary amount of output produced in the economy when there is full employment in the labour market. For economists, this is a measure of how well an economy is doing. Maximum output is not the same as full employment output. Maximum output, which is larger, is a situation where everyone is working as much as humanly possible. This is not sustainable. Full employment is not the same as having a zero unemployment rate. Even in the best of times, some workers will be unemployed for a variety of reasons. Frictional unemployment describes workers who have left one job but not yet found another. Seasonal unemployment includes all seasonal workers who are unemployed due to the seasonality of their work. Structural unemployment refers to unemployment caused by the economy’s decrease in specific demand for certain goods and services or worker’s lack of skills. Cyclical unemployment includes workers who are temporarily unemployed due to a downturn in business activity.

Macroeconomic Policy Goals

Macroeconomic policy has two goals. To aim to have the long-run average growth rate as high as possible. The second goal is to reduce the business cycle fluctuations around that long-run average growth rate.

Returning to Full Employment Output

After an economic shock, price adjustments can return an economy to producing at full employment. Suppose that aggregate (total) demand for goods and services in an economy sharply declines. There becomes an excess supply of goods. Excess supplies of goods cause prices to lower because suppliers want to sell their excess inventories. Once the excess inventories begin to sell off, an economy again produces at full employment output. The speed at which prices adjust varies from shock to shock and from firm to firm. In the end, an economy always want to return to full employment output.

Inventory Levels

All firms keep a watch on their inventories, at least periodically. For many companies, the money tied up in inventory is a large part of their investment. For this macroeconomic discussion, we are concerned with the decisions firms make to maintain a certain level of inventory. Firms want to have enough inventory on hand to meet the normal fluctuations in customer demand, but not too much inventory on hand as this is wasteful. For manufacturers, they need to plan production runs based on their customer demand projections. For this discussion, assume that all businesses that hold inventory for resale also have a target level of inventory that they wish to have on hand at all times. John M. Keynes explained that unexpected changes in aggregate demand would result in changes in a firm’s inventory levels. Large changes in aggregate demand would force firms to cut or raise production levels. During a recession, when aggregate demand falls, inventory levels rise above target levels and firms cut back their production plans. To save money they lay off workers which shows up in higher unemployment rates.

Fiscal Policy

Fiscal policy concerns itself with how governments tax and spend. To help end a recession, a government may decide to either lower taxes or increase spending. By lowering taxes, governments can indirectly increase aggregate demand because consumers will have larger after-tax income to spend on buying more goods and services. Disposable income is defined as gross income less taxes on that income. Discretionary income is defined as gross income less taxes less expenditures on necessities, where necessities are shelter, clothing and food. Governments could choose to increase aggregate demand directly by buying more goods and services in the marketplace. Both of these policies will stimulate the economy and both are likely to increase government budget deficits.

Recessions and Government Spending

If an economy is in or is heading towards a recession, governments will often increase their spending to stimulate the economy. Demand for goods and services thus increases, causing businesses to hire more workers, to increase the low inventories of goods or lack of services available. Since more people are now working than before, these people have more money to spend and the economy will be stimulated even more. There are three ways for governments to pay for what they spend: print more money, raise taxes or borrow the money. During a recession, governments can print more money and then spend it to help the economy get back to full employment output. The problem with this approach is that when all of this extra money gets spent it tends to drive up prices, which is inflation. If the government can print a lot more money and start spending it before people realize it, it will stimulate the economy in the short run, until people respond to this policy by raising prices. Raising taxes is another way for governments to pay for things they’ve purchased in order to stimulate the economy. However, when you raise taxes, people have less disposable and discretionary income, and they spend less. This policy may work to some extent in the short run. The most popular way for the government to stimulate the economy through government spending, is to borrow money and then spend it. Eventually that borrowed money has to be paid back, along with interest. One reason that you can be confident that the government will pay back is because their borrowing is secured by future tax revenues. Governments will often refinance their bonds coming due by simply issuing new bonds to pay the due ones. This is called rolling over the debt and is common.

Lower Interest Rates

Lower interest rates stimulate consumer spending by making it more attractive to borrow money to purchase houses, automobiles or other household items.  Businesses respond to lower interest rates because investment projects that were not profitable, become profitable. It buys government bonds to increase the money supply.  The increased money supply causes interest rates to fall.

Money Supply and the Federal Reserve

In the United States, changes in the money supply are controlled by the Federal Reserve Bank. This bank is often referred to as the Federal Reserve or the Fed. The Fed has the exclusive right to print currency in the United States, but when it wants to change the money supply it uses a more subtle approach called open-market operations.

Open-Market Operations

When the Fed buys and sells U.S. government bonds, it is engaging in open-market operations. If the Fed wants to increase the money supply, it buys bonds on the open (public) bond market. To buy bonds, the Fed must pay cash, which circulates more money in the economy. Conversely, if the Fed wants to decrease the money supply, it sells bonds. Those who purchase those bonds pay cash that then becomes removed from circulation when the Fed stores it in its vault.

Monetary Policy

Monetary policy is the manipulation of the money supply and interest rates by governments in order to stabilize or stimulate the economy. Governments will change the supply of money in order to change the price of borrowing money, in order to manipulate interest rates. The basics of supply and demand apply here. The equilibrium interest rate is determined by the intersection of the money demand curve with the money supply curve. If the money supply suddenly increases, the price of money falls. Since the price of money is the interest rate, you can say that governments can influence the interest rate in a downward direction by increasing the money supply. In the United States the Federal Reserve relies on open-market operations to change the money supply and ultimately interest rates. If the Fed wants to stimulate the economy as a result of borrowing by businesses for investment projects and borrowing by consumers to buy things, it can buy government bonds in order to increase the money supply, which causes interest rates to fall (and bond prices to rise), which causes more businesses and people to borrow and spend. This increased spending helps to pull the economy out of a recession because increased spending creates more demand for goods and services, which causes companies to hire more workers (or entrepreneurs to start businesses) to bring the economy back to full employment output.

Rational Expectations Limit Monetary Policy

Monetary policy can work, but only to a certain point. The government’s ability to use it by increasing in the money supply to stimulate the economy is limited by rational expectations and the fears that people have about inflation. Investors know that increases in the money supply can cause inflation. Investors don’t like periods of high inflation when they’ve invested money in financial securities at a fixed rate of return. As a result of this, the U.S. Federal Reserve has to increase the money supply only moderately.