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The easiest place to start is at the low point of the cycle–and to talk about every place in the world except the US.
the target for government policy
A typical rule governing policy action would be for a country to act so as to maintain the highest sustainable (that is, non-inflation-inducing) rate of economic growth.
At its low point, activity in an economy is advancing at considerably less than that. The economy may even be contracting. The cause may be prior action by the government to slow the economy from a previous overheated state (policy actions are blunt tools: most often they overshoot their objective) or the economy may have been hit by an out-of-the-blue event, like an oil shock or a financial crisis.
In either case, companies are laying off workers, reducing inventories, closing now-unprofitable operations …all of which is causing the slowdown to feed on itself.
The traditional remedy to break the downward spiral is to lower interest rates–we might also describe this as lowering the cost of money by making a much larger quantity available to borrow.
What does this do?
In theory, and often also in practice, companies have a list of new capital projects they are ready to implement but which are unprofitable at the high interest rates/weak growth that accompany/trigger a slowdown. By lowering rates, the monetary authority makes at least some of those projects into moneymakers. So companies commit to new capital projects. They hire planners and construction firms; they buy machinery; they hire workers to staff new plants.
As these formerly unemployed workers get paychecks, they begin to consume more–they buy clothes, and then houses and new cars. They begin to eat restaurant meals and go on vacations again. As consumer-oriented service industries see their businesses picking up, they begin to hire again, too–adding to the new wave of consumer spending. At the same time, the supply chain begins to expand inventories to be able to satisfy rising demand. Similarly, manufacturers hire more workers and begin to expand their own productive capacity.
In this way, self-feeding slowdown turns into self-feeding expansion.
At some point, the economy reaches full employment. Companies want to continue to expand because they now see many profitable investment projects. But there are no more unemployed workers. So firms begin to offer higher wages to bid workers away from other firms. They begin to raise prices to cover their higher costs. This activity doesn’t create more output, however. It only creates inflation.
Either in anticipation of, or in reaction to, budding inflation the monetary authority begins to raise interest rates to cool down the now feverish expansion. It keeps rates high until it begins to see signs of slowdown–inventory reductions, new project cancellations, layoffs.
The economy eventually reaches a low point …and the cycle begins again.
–in the model just described, industry recovers first, followed by consumers. This happens in most of the world. In the US, however, as soon as interest rates begin to decline, the consumer typically begins to spend again. Business follows with a lag.
–conventional wisdom is that money policy actions need 12 – 18 months to take full effect. In the current situation, short-term interest rates have been effectively at zero for eight years (!!) without seeing a sharp surge in economic growth in either the US or the EU.
–economists have been concerned for years that there’s been no oomph in capital spending in the developed world, despite low rates. The traditional model explains he concern–business capital spending is thought to be a key element in any recovery.
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