Theessential function of any government in the economy is to providelegal framework and policy structures that are aimed at spurringeconomic growth. This can be done through a raft of measures, whichinclude income redistribution, correction of externalities, provisionof public goods and services, maintaining competition andregulations. These economic policies are drafted and enacted into lawby legislators. In doing so, it is important to understand some factsabout the economy.
Duringshort-term economic fluctuations, the following events have proventrue. The first fact is that the fluctuations are irregular andunpredictable, a situation commonly referred to as business cycle ineconomics. Secondly, most macroeconomic variables fluctuate togetherbut by different amounts while unemployment rises with fall inoutput. Short-run economic fluctuation differs from the long run intwo aspects. These are the changes in the money supply that affectonly nominal variables but not real variables in the long-run and theassumption of monetary neutrality that do not hold in the long-run(Blanchard, 2010).
Economicfluctuation is the business cycle from boom to recession todepression. The boom is a period of economic prosperity whilerecession represents a period of declining real GDP and depression ina severe recession. Aggregate demand is the total amount of goodsand services that the government and households are willing to buy atgiven price levels. The upsurge in aggregate demand leads to anexpansion of the economy. Aggregate supply, on the other hand, is theamount of goods and services that businesses are willing to supply ata given price. The decrease in the aggregate supply causes an upwardpressure on the economy.
Monetarypolicy can be contractionary or expansionary. Expansionary policylowers the rate of interest rates to increase the money supply in theeconomy thus increasing aggregate demand whereas contractionarypolicy restricts money supply in the economy by increasing the costof borrowing, which is the interest rates thereby decreasing theaggregate demand. Fiscal policy affects the aggregate demand as wellas the interest rates through government expenditure and taxation.Increased government expenditure increases the aggregate demandthereby pushing the interest rates up. Accommodative in relation tothe monetary and fiscal policy refers to the point where interestrates set by the central authority are aimed at creating economicgrowth (Andre & Elmar, 2014).
Whenthe economy is experiencing inflation, measures can be taken to raiseinterest rates. When this happens, consumer expenditure andinvestment reduce lowering the aggregate demand and resulting in afall in inflation. However, with a decline in real GDP, firms willsize down the number of jobs leading to unemployment. This causes atradeoff between inflation and unemployment in the short run. In thelong-term, as the economy is recovering the tradeoff disappears(Gonçalves & Salles, 2008).
Andre’,K. & Elmar, M. (2014). Stock Prices, News, and EconomicFluctuations: Comment. AmericanEconomic Association, vol.104, pp. 1439-1445.
BlanchardO., Dell`Ariccia G. & Mauro P (2010) "RethinkingMacroeconomic Policy", Journalof Money,Credit,andBanking, vol.42, pp. 199–215.
GonçalvesC, & Salles J (2008) “Inflation Targeting in EmergingEconomies: What do the Data Say?”, Journalof Development Economics,vol. 85, pp. 312–318.