Business cycle and inflation

The business cycle or economic cycle is known for its upward and downward movement around GDP growth in the long run. While inflation is defined as a continuous rise in the price level. Inflation affects the business cycle, such that if inflation expectations are correct, the cyclical economy operates at full employment. If aggregate demand increases faster than expected, real GNP increases above maximum capacity, creating an inflationary gap. Conversely, if aggregate demand growth is slower than expected, an economic downturn occurs with a decline in the level of inflation. Business cycle theory follows a main trend, whereby the maximum capacity of GDP grows at a constant rate, while aggregate demand growth fluctuates. If aggregate demand increases faster than maximum capacity, a rise in the price level occurs, leading to an inflationary gap. When aggregate demand is slower than peak capacity growth, economic decline with deflationary gaps occurs.

The economic cycle consists of different stages, and the policies followed track the impact of those stages on the economy:

Expansion or recovery phase:

  • Stability of price level.
  • Slow growth in economic activity.
  • Low interest rate.
  • Reducing merchandise inventory.
  • Increased demand for products to compensate for low inventory.

Peak stage:

  • Increase in price level.
  • Rapid growth in overall production.
  • An increase in the level of income and employment.
  • Raising interest rates to reduce inflation.

Crisis or stagnation stage:

  • A fall in the price level.
  • Decrease in GDP.
  • Requesting loans from banks.
  • Increase in stock of goods.

Depression or trough stage:

  • Decrease in price level.
  • Widespread unemployment.
  • Trade depression.
  • Reducing interest rates and buying government bonds to encourage investment.

Fiscal and monetary policies are used to fight economic crises, incorporating government spending and taxes into fiscal policy, and money supply and interest rates into monetary policy. It is especially effective when all factors of production are fully employed and depend on achieving economic stability.

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