Business Cycle and Fiscal Policy

Fiscal policy can be defined for our purposes very simply as anything relating to government spending and taxation. Before looking at the fiscal policy role of government in trying to influence the economy, one must first have an understanding of the business cycle. For a number of reasons which are widely debated, the economy goes through repeated periods of growth and contraction over time which can be broken down into the following phases.

1. Contraction where economic activity and growth slows and can turn negative
2. Trough where the economy stops contracting and a new expansion begins
3. Expansion or the speeding up of economic growth.
4. Peak where the growth of the economy maxes out and begins to turn downward

We could spend many months going over and debating why this is but for our purposes it is simply important to understand that, while the timing and length of each of these phases has varied widely, the above pattern repeats itself over and over again throughout history. This is important for us as traders to understand as different phases of the business cycle and changes in peoples forecasts of where the economy is in those cycles is arguably the greatest factor which effects the price level of every market.

Prior to the great depression the US Government had a pretty hands off approach in regards to the business cycle. Since the great depression however the government has played a much more active role in the economy with its stated goals being to act to facilitate full employment and price stability. To help understand these goals and the balancing act that goes on between them as they often conflict, lets look at how each relates to the different phases of the business cycle.

1. During an expansion we start to see more people employed as companies begin to sell more goods and services and need to hire more people to keep up with the demand. As economic growth picks up and more people are employed there are more people spending their paychecks which can cause prices to rise, something also known as inflation. Because of this effect on prices the government’s primary concern here will normally be trying to keep prices stable and inflation in check without hurting economic growth. The two things they can do in regards to Fiscal Policy to try and keep prices in check and inflation at bay are:

a. Raise Taxes: By raising taxes money is taken away from the consumer who now has less money to spend helping to counteract the demand that is pushing prices up and causing inflation.


b. Reduce Government Spending: If the government does not spend as much on projects such as roads and things such as education then this takes some of the demand which is working to drive prices up and causing inflation out of the picture as well.

This is important from a trading standpoint as while an increase in taxes or a reduction in government spending can help fight inflation it can also be seen as negative for the financial markets as demand is being taken out of the equation.

2. During a peak we start to see employment and the amount of goods and services produced and sold by companies begin to level off. At this stage the government normally becomes more concerned with preventing a deep contraction which is known as a recession, or severe contraction which is known as a depression. The two tools which they have in their fiscal policy to work with here are:

a. Reduce Taxes: By reducing taxes the government effectively puts money in the consumer’s pocket allowing them to spend more money and drive economic growth. This is what we are seeing now with the economic stimulus package which was recently passed and is giving tax rebate checks out directly to the consumer.


b. Raise Government Spending: If the government spends more on projects such as roads and on things such as education then this increases demand in general which helps drive economic growth.

3. During a contraction we start to see employment and the amount of goods and services produced and sold by companies start to fall. The fiscal policy tools that the government has at their disposal here are the two mentioned above. Although there are exceptions normally during this stage inflation is not a concern as demand is falling so the government can be more aggressive than they can during a peak.

A second factor which can become a concern here is deflation, where a lack of demand actually causes prices to fall. This, according to Wikipedia can be a large problem which “sets off a deflationary spiral where businesses slow or stop investing, because the investment risk is perceived as higher than just letting the money appreciate due to deflation.”

Lastly and potentially even more potent of a problem which can occur during a contraction is stagflation which is a period of slow or negative growth which is accompanied by inflation. When this happens you can see how policy makers hands are somewhat tied because they are getting hit from both sides so to speak.

4. During a trough we start to see the employment level and level of goods and services produced and sold by companies start to level off again. During this phase the expected action if any from the fiscal policy side would be to begin to reduce whatever policies had been put into place to help the economy grow as it moves into another expansionary cycle.

While many believe that Fiscal policy has shown to be an effective tool in regulating the business cycle, as government spending and taxation must be approved by both Congress and the President, managing the economy through the use of fiscal policy is normally seen as a lot more tedious than the second tool that government has at their disposal which is known as Monetary Policy.

The Federal Reserve can adjust monetary policy more quickly than the President and Congress can adjust fiscal policy. Because most contractions in economic activity last for only a few quarters, the timeliness of the policy response is crucial.

Monetary policy is under the control of the Federal Reserve System (central bank) and is completely discretionary. It is the changes in interest rates and money supply to expand or contract aggregate demand. In a recession, the Fed will lower interest rates and increase the money supply. In an overheated expansion, the Fed will raise interest rates and decrease the money supply. These decisions are made by the Federal Open Market Committee (FOMC) which meets every six to seven weeks. The policy changes can be done immediately, although the impact on aggregate demand can take several months. Monetary policy has become the major form of discretionary contracyclical policy used by the federal government. A source of conflict is that the Fed is independent and is not under the direct control of either the President or the Congress. This independence of monetary policy is considered to be an important advantage compared to fiscal policy.