Monetary Policy in Depression and in Inflation from Business Cycle

Monetary Policy in Depression:

In the atmosphere of depression, there is a need to encourage investment and so the loans are made cheaper to stimulate investment and increase the demand by increasing income and employment because a cheap money policy will discourage saving and promote investment.

It is said that the Monetary Policy has less scope in depression and fails to bring the economy out of depression, as the MEC is low and so the businessmen are scared to invest, even though the rate of interest is low. Rate of interest is the factor but not the only factor for investment.

Businessmen borrow when the business is expanding not when it is declining. However, we cannot say it is totally useless because it can stimulate demand for durable goods and private investment. But open market operation can increase the liquidity overall in the economy. Even if credit policy cannot turn the business cycle, it can create the necessary atmosphere for the other policies to be successful.

Monetary Policy in Inflation:

Inflation is faced at the prosperity phase when MEC is high, rising prices, output and employment. The condition in the economy is very optimistic and business activities are rapidly increasing. Though his condition cannot go on continuously, with the increase in consumer spending and investment spending, the credit condition in the economy becomes tight.

The banks start feeling difficult to cope with demand for credit. In such a situation, the rate of interest is raised by the banks to control the liquidity in the economy. The cash Reserve Ratio, Statutory Liquidity Ratio are raised and a tight money policy is in effect to control the boom from turning into inflation. The effect of Monetary Policy in inflation is much greater than in depression.

Now, we will try to understand how fiscal policy controls the business cycle in the next chapter of the blog.

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Multiplier-Acceleration Interaction Principle of Business Cycle

Samuelson’s model is regarded as the first step in the direction of integrating theory of Multiplier and the principle of Acceleration. His model shows how the multiplier and acceleration interact with each other to generate income, to increase consumption and investment, demand more than expected and how this causes economic fluctuations.

To understand Samuelson’s model, let us first understand derived investment. Derived demand is the investment in capital equipment, which is undertaken due to increase in consumption making new investment necessary. We will try to understand this interaction briefly. When autonomous investment takes place in a society, income of the people rises and the process of Multiplier start increasing the income, which leads to the increase in demand for consumer goods depending on the marginal propensity to consume.

If there is excess production capacity, the existing stock of capital would prove inadequate to produce consumer goods to meet the rising demand. Producers trying to meet the growing demand undertake new investments. Thus, increase in consumption creates demand for investment. This is derived investment.

This marks the beginning of Acceleration process, when derived investment takes place income increases further, in the same manner as it happens when the autonomous investment takes place. With increase in income, demand for consumer goods rises. This is how the Multiplier and the Accelerator interact with each other and make the income grow at a rate much faster than expected. With the help of both the Multiplier and Acceleration principle, Samuelson tried to relate the upswings and downswings of business cycle. There are some criticisms regarding the assumptions, they are as follows –

There is no government activity and no foreign trade

No excess capacity

One year lag in increase in consumption and investment demand

Though many economists had different approaches, some attribute business cycle to expansion and contraction of money supply some say it is due to the interaction of Multiplier & Acceleration which changes the aggregate demand and leads to fluctuations but some attribute it to the innovations in one sector which spreads to the rest of the economy that causes recession and boom.

There are other economists, who attribute fluctuation of business cycle to the politicians manipulating economic policies and some say supply shocks for e.g., 1970’s sharp increase in oil prices, increased inflation. All these theories have elements of truth. But they are not valid in all the places and time. The key is to understand them and combine these theories and use the knowledge of macro economics to decide when and where to apply it.

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