Directions (1-10): Read the following passage carefully and answer the given questions:
Ideal time: 10-12 min
The United States and all other modern industrial economies experience significant swings in economic activity. In some years, most industries are booming and unemployment is low; in other years, most industries are operating well below capacity and unemployment is high. Periods of economic prosperity are typically called expansions or booms; periods of economic decline are called recessions or depressions. The combination of expansions and recessions, the ebb and flow of economic activity, is called the business cycle.
Business cycles as we know them today were codified and analyzed by Arthur Burns and Wesley Mitchell in their 1946 book Measuring Business Cycles. One of Burns and Mitchell’s key insights was that many economic indicators move together. During an expansion, not only does output rise, but also employment rises and unemployment falls. New construction also typically increases, and inflation may rise if the expansion is particularly brisk. Conversely, during a recession, the output of goods and services declines, employment falls, and unemployment rises; new construction also declines. In the era before World War II, prices also typically fell during a recession (i.e., inflation was negative); since the 1950s prices have continued to rise during downturns, though more slowly than during expansions (i.e., the rate of inflation falls). Burns and Mitchell defined a recession as a period when a broad range of economic indicators falls for a sustained period, roughly at least half a year.
Just as there is no regularity in the timing of business cycles, there is no reason why cycles have to occur at all. The prevailing view among economists is that there is a level of economic activity, often referred to as full employment, at which the economy could stay forever. Full employment refers to a level of production in which all the inputs to the production process are being used, but not so intensively that they wear out, break down, or insist on higher wages and more vacations. When the economy is at full employment, inflation tends to remain constant; only if output moves above or below normal does the rate of inflation systematically tend to rise or fall. If nothing disturbs the economy, the full-employment level of output, which naturally tends to grow as the population increases and new technologies are discovered, can be maintained forever. There is no reason why a time of full employment has to give way to either an inflationary boom or a recession.
Business cycles do occur, however, because disturbances to the economy of one sort or another push the economy above or below full employment. Inflationary booms can be generated by surges in private or public spending. For example, if the government spends a lot to fight a war but does not raise taxes, the increased demand will cause not only an increase in the output of war matériel, but also an increase in the take-home pay of defense workers. The output of all the goods and services that these workers want to buy with their wages will also increase, and total production may surge above its normal, comfortable level. Similarly, a wave of optimism that causes consumers to spend more than usual and firms to build new factories may cause the economy to expand more rapidly than normal. Recessions or depressions can be caused by these same forces working in reverse. A substantial cut in government spending or a wave of pessimism among consumers and firms may cause the output of all types of goods to fall.
Another possible cause of recessions and booms is monetary policy. The Federal Reserve System strongly influences the size and growth rate of the money stock, and thus the level of interest rates in the economy. Interest rates, in turn, are a crucial determinant of how much firms and consumers want to spend. A firm faced with high interest rates may decide to postpone building a new factory because the cost of borrowing is so high. Conversely, a consumer may be lured into buying a new home if interest rates are low and mortgage payments are therefore more affordable. Thus, by raising or lowering interest rates, the Federal Reserve is able to generate recessions or booms.
This description of what causes business cycles reflects the Keynesian or new Keynesian view that cycles are the result of nominal rigidities. Only when prices and inflationary expectations are not fully flexible can fluctuations in overall demand cause large swings in real output. An alternative view, referred to as the new classical framework, holds that modern industrial economies are quite flexible. As a result, a change in spending does not necessarily affect real output and employment. For example, in the new classical view a change in the stock of money will change only prices; it will have no effect on real interest rates and thus on people’s willingness to invest. In this alternative framework, business cycles are largely the result of disturbances in productivity and tastes, not of changes in aggregate demand.
The empirical evidence is strongly on the side of the view that deviations from full employment are often the result of spending shocks. Monetary policy, in particular, appears to have played a crucial role in causing business cycles in the United States since World War II. For example, the severe recessions of both the early 1970s and the early 1980s were directly attributable to decisions by the Federal Reserve to raise interest rates. On the expansionary side, the inflationary booms of the mid-1960s and the late 1970s were both at least partly due to monetary ease and low interest rates. The role of money in causing business cycles is even stronger if one considers the era before World War II. Many of the worst prewar depressions, including the recessions of 1908, 1921, and the Great Depression of the 1930s, were to a large extent the result of monetary contraction and high real interest rates. In this earlier era, however, most monetary swings were engendered not by deliberate monetary policy but by financial panics, policy mistakes, and international monetary developments.
- Which of the following is TRUE in the context of the passage?
a) Boom in an economy can be caused by cutting down the government expenditure.
b) Central bank is solely responsible to bring a boom/ recession in the economy by changing the interest rates.
c) Full employment level of output can be maintained in an economy forever.
d ) After world war II the inflation rates fall but didn’t become negative as compared to before world war II.
A) Both b) and c)
B) Both b) and d)
C) Both c) and d)
D) Only b)
- In a perfect scenario of Full employment what can cause a business cycle to occur ?
a ) A wave of optimism among consumers and producers.
b) When government’s expenditure exceeds its income.
c) When government’ income exceeds its expenditure or reduction in government spendings.
d) Pessimism among government officials.
A) All of these
B) Both a) and b)
C) Both b) and c)
D) All a), b) and c)
E) Only b)
- Prewar depressions , including the one of 1908,1921 and great depression of 1930s was the result of which phenomena?
A) increase in money supply
B) decrease in money supply
C) Rise in real interest rates.
D) both A) and B)
E) both B) and C)
- what theory does the alternative view or classical view hold ?
A) Modern economies are rigid.
B) change in spending does not necessarily change output and employment.
C) both A) and B)
D) business cycles are the result of changes in aggregate demand
E) both B) and D)
- How the monetary policy affects the spending habits of public?
A) It influences the size and growth rate of money stock and eventually the rates of interests.
B) In case of high interests, a firm may postpone its decision to build a factory.
C) Monetary policy stances adopted by the central bank can throw an economy into expansion or depression.
D) Monetary policy affects magnitude of the money supply in the economy.
E) All of these.
- In an economy, where interest rates are low what could be the possible outcome ?
A) Such an economy reflects a period of depression.
B) Public will be willing to borrow more as cost of money rises .
C) Banks will be willing to lend more .
D) The monthly repayments of mortgage will decrease.
- What can we infer from the paragraph regarding full employment situation ?
A) Full employment is an economic situation of optimal utilization of all resources available.
B) Full employment is an economic situation in which all available resources are being used in the most efficient way that they wear out, break down, or insist on higher wages and more vacations.
C) Full employment is the situation of employment provided to all the skilled labour.
D) all of these.
- What was the main cause of business cycles in the US post world war II ?
A) Changes in public and private expenditure.
B) changes in demand pattern
C) Monetary policy
D) disturbances in the economy.
- What can be the suitable title of the passage ?
A) monetary policy
B) business cycles
C) Keynesian view and alternative view on business cycles.
D) Effects of business cycles on unemployment .
- What is recession according to Burns and Mitchell ?
A) When a broad range of economic indicators falls for a short period.
B) When a broad range of economic indicators falls for a very long period may be 1 year .
C) When a broad range of economic indicators falls for a unrelenting period of time like 6 months.
D) All of these.
Some Extra Points:
- Full employment is an economic situation in which all available labor resources are being used in the most efficient way possible. Full employment embodies the highest amount of skilled and unskilled labor that can be employed within an economy at any given time.
- Business cycle – Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough. Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.
A period of economic decline or negative growth.
The highest value reached by some quantity in a time period.
The lowest turning point of a business cycle
The act or process of expanding.
- Monetary policy – The Reserve Bank of India (RBI) uses the monetary policy to manage liquidity or money supply in a manner that balances inflation and at the same time aids growth. It affects the money supply in the economy by changing the interest rates in turn affecting the demand of products which is responsible for infaltion/deflation.