REGULATING THE BUSINESS CYCLE

Because of the severity of the Great Depression, action was taken during the 1930s to both promote recovery and to reduce the likelihood and severity of future business downturns. Legislation known as New Deal programs created federal unemployment insurance, the Social Security system, the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission (SEC).

Unemployment insurance provides workers with income when they are laid off. Social Security furnishes some income to retired or disabled persons. These two programs thus provide greater income stability because people retain some purchasing power even when they are no longer working. The FDIC gives consumers confidence in their financial institutions and helps prevent a repeat of the massive withdrawals of funds or bank panic that led to the collapse of several thousand banks during the Great Depression. The SEC helps prevent financial fraud by requiring corporations that publicly trade their stock to report accurate financial information.

Other aspects of New Deal legislation also helped promote economic stability. The New Deal’s National Industrial Recovery Act of 1933 enabled workers to bargain collectively in trade unions. Although not as powerful as they once were, labor unions help prevent spiraling wage declines that have worsened previous downturns. Similarly, government support of crop prices shields farmers from disastrous loss of income. Whether or not these changes represent all or part of the explanation, the fact remains that since the Great Depression all economic contractions have been significantly less severe.

Beyond these structural changes, the government can also engage in direct intervention to counter a recession. Two main counter-cyclical policy options are available: monetary policy and fiscal policy. Economists disagree on the effectiveness of these options.

Monetary policy involves control of the money supply and interest rates by a central bank. In the United States the central bank is known as the Federal Reserve System, or simply the Fed. These controls determine the amount of credit available to businesses and consumers and the cost of that credit. By reducing the rate of money supply growth and allowing interest rates to rise, the Fed reduces the amount of available credit and increases the cost of borrowing in order to slow an economic expansion. This practice is known as contractionary monetary policy. Alternatively, expansionary monetary policy involves increasing the rate of growth in the money supply and lowering interest rates. In this fashion the Fed increases the availability of credit and lowers the cost of borrowing in an effort to stimulate the economy.

Fiscal policy consists of changes in government spending or taxation or both. If the government seeks to constrain an economic expansion by engaging in contractionary fiscal policy, it can lower its purchases of goods and services, reduce the amount of money it spends on social services and subsidies, or increase taxes. Expansionary fiscal policy involves the opposite actions—namely, increases in purchases of goods and services, increases in social service spending and subsidies, or reductions in taxes—in an effort to stimulate production and employment.

In discussing the relative merits of monetary and fiscal policies as counter-cyclical tools, economists often argue over which policy to pursue. Some economists note that changes in monetary policy can be implemented quickly whereas changes in fiscal policy take much longer. The Fed’s Open Market Committee, for example, makes decisions regarding the money supply and interest rates. All that is needed to change monetary policy is a vote by this committee. Fiscal policy, on the other hand, typically requires the approval of both the legislative and executive branches of the federal government. For example, a lowering of taxes needs approval from both the U.S. House of Representatives and Senate as well as the approval of the U.S. president, approvals that sometimes may take longer than a year to secure.

However, many economists also note that it takes fiscal policy less time than monetary policy to have an impact on the economy once a specific action has been implemented. For example, a fiscal-policy reduction in the personal income tax will show up immediately in higher take-home pay for workers. By contrast, consumers and business firms may take awhile before they modify their spending in response to a monetary-policy change, such as a reduction in interest rates. For example, not everyone goes out to buy a new car just because the interest rate on car loans has decreased.