An economic cycle comprises several phases viz. recession, recovery and boom. In the recovery phase, individuals and businesses borrow and invest more causing the aggregate demand to rise up which leads to boom or expansionary pressures in the economy. This boom brings with it problems like inflation and high imports etc. In such a situation, the government needs to take some action through various macroeconomic policies for the purpose of stabilisation of economy. Thus, the recessionary pressures enter the economy characterised by weak investment and business slow down (Smith, 2003). The economy displays several peaks and troughs over a cyclical phase (see Fig 1).
The responsibility of government to stabilise the economy leads it to make use of various macroeconomic policies in order to manage the cyclical economic fluctuations. As an advisor to the government, I would like to recommend the use of monetary and fiscal policies for the purpose of curtailing cyclical fluctuations. Macroeconomic policies like monetary and fiscal policies can be utilised by government to control economic fluctuations. Macroeconomic factors like taxation and government spending fall within the realm of fiscal policy whereas inflation, interest rates, exchange rates and other monetary factors are relevant to the monetary policy. ...
Most particularly, changing interest rates on the part of the government affects inflation, supply of money and credit, exchange rates, foreign and domestic investment and business expansions etc. All these factors put a great impact on the cyclical pressures in the economy.
Monetary policy can be utilised in two dimensions under cyclical fluctuations in business. In the case of expansionary pressures or boom in the economy, the government can undertake a "monetary tightening" policy which calls for increasing the interest rates and exchange rates followed by a decreasing level of money and credit flow in the economy and consequently the economy will slow down. On the contrary, when economy suffers from recessions, the government could go for a "monetary loosening" policy which entails a reduction in interest rates followed by an increase in the supply of money and credit in the economy causing the economy to expand (Smith, 2003). Government needs to maintain the economy in a stable condition because of the effects of both expansion and contraction in the economy. The use of monetary policy through central bank ensures that the economy can resist the pressures of high boom as well as easily rise up from recessions.
The government's attempt to affect the supply of money and credit in the economy through interest rates results in several dimensions. In the case of recessions, governments can reduce the interest rates which would consequently enhance the money and credit available for businesses and individuals to invest in the economy (see Fig 2). This would lead to an increase in investment and employment opportunities leading to output maximisation and thus economic growth. In this situation " money supply is the key variable