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v) On the other hand, while the nature of the public sector and government intervention helps to stabilise the economy and explains why the amplitude of the cycles has diminished in our recent past, there is also the possibility for the government to create a perverse outcome. Fiscal policy can be driven by political rather than economic considerations: expansionary policies are more likely to be implemented before an election, contractionary policies when the election is over (see chapter 15, question 2). If, for this reason, a contractionary policy is implemented during a recession, the effect would be to amplify, not to diminish, the magnitude of the cycle.

Yet, the overall effect of government intervention on the economic cycle is not certain. While the empirical evidence is consistent with less pronounced fluctuations, the mismanagement of fiscal and monetary policy might provoke an actual amplification of the cycle.

Q3 It is often assumed that business cycles have little effect on the long run growth of the economy. In other words, the business cycle represents transitory deviations around a given trend growth rate.

Do you agree? If this statement were true, why should economists be concerned with economic cycles?

This statement is based on the assumption that the growth rate in the economy is independent from fluctuations around the trend. Empirical evidence does not support this theory: instability in a country's growth rate seems to be negatively related to the growth rate itself. Instability of aggregate demand and prices is an impediment to growth and when stability is greater, growth is higher. Sustained growth creates a positive climate for innovation, competition and reallocation of resources which, in turn, tends to create faster growth.

However, if this statement were true, we should still be concerned with economic cycles for at least a couple of reasons.

i)  from a macroeconomic perspective, the short run economic and social costs of a recession, in terms of unemployment and inflation, are of concern not only for economists but for the whole society.  Given the average growth rate, a stable economy is to be preferred to an unstable one because it diminishes the costs associated with recession and with increased uncertainty.  For this reason a good understanding of economic cycles leads to a more effective deployment of the policy instruments available to reduce the amplitude and the related costs of these cycles.

ii) the cycle is important because in a world of imperfect capital markets and imperfect foresight, the timing of investment decisions can play a crucial role in determining the viability of a firm.

Q4 Discuss why official interest rates tend to move downwards between a peak and a trough in economic activity, and upwards between a trough and a peak. How would such a pattern in interest rates affect business decisions?

31/07/97

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