increase, inducing people to spend more until effects of the initial decline were completely offset. Using AS/AD model, explained in Chapter 11, students could graphically represent these fluctuations.
vi) Real business cycle theory emphasises the role of exogenous technology shocks in the context of a flexible price market economy.
Business is particularly interested in fluctuations because the level of turnover and profits depends on the position of the economy in the cycle. If the economy is leading towards a trough and expectations are bad, investment decisions are likely to be postponed to avoid further losses. Low sales and lack of remuneration can sometimes jeopardise the survival of the business and have a negative chain-effect on other firms. While some firms are more sensitive to cycles than others, the exposition of business to fluctuations in the economic activity rises the importance of forecasts for a more precise planning of future business activity.
Q2 Would you expect government intervention to increase, or to diminish, the amplitude of business cycles?
Government intervention mainly affects business cycles by reducing their amplitude but, on the other hand, some economists believe that governments can have perverse effects on cycles because of pro-cyclical policies. We can distinguish between the effects of the presence of the public sector and the effects of a change in economic policy:
i) Government spending is less sensitive than private spending to cyclical conditions. This is due to the nature of the services provided by the government (health, education, justice and other public goods have stable demand also during a recession) and to the lesser sensitivity of state corporations to market forces (their investment decisions are less sensitive to fluctuations in expected profits). Therefore, because public spending is more stable than private spending, if the share of the public sector in GDP increases, cyclical amplitudes diminish .
ii) Automatic stabilisers play a role in moderating the effect of private sector's volatility, thus decreasing the amplitude of cycles.
iii) Apart from automatic instruments, also fiscal activism can stabilise the economy. Although in the 1990s there is a much more critical approach to expansionary policies, the ability of governments to counter the effects of major crashes or downturns in the private sector has diminished fluctuations in the business cycle.
iv) Government intervention reduces economic fluctuations by stabilising expectations. If economic agents and markets believe that the government would intervene, should the economy reach a 'floor' or a 'ceiling' in real growth, the approach to those levels would automatically reverse expectations on the future and would help to invert the direction of the cycle.