Question

How does the Central Bank stabilize the business cycle and what are its limits in doing so?

Answer 1

The central bank have two main tools for the stabilization of the economic output over a business cycle: fiscal policy and monetary policy. A fiscal policy means when government adjust spending to stimulate production or taxing used to influence and monitor the economy. Fiscal policy can be used to close the (a) recessionary gap and (b) inflationary gap. Monetary policies are the actions taken by central banks to control the monetary as well as financial status with the goal of attaining low inflation and sustainable growth in the economy. The techniques that are used by the central bank under monetary policies to alter the money supply include the reserve requirements, discount rate, and the open market operations.

Monetary policy ineffective under fixed exchange rates and fiscal policy is more effective under fixed exchange rates. Under fixed exchange rates the governments need to choose macroeconomic policies that are consistent with the fixed exchange rate change. However this is not the case under other exchange rate systems. Monetary policy cannot be applied during recession period. The proponents of expansionary monetary policy state that during the recession if bank reduces the interest rates for consumers to spend more money during a global recession then in that case the export sector would suffer. The fiscal policy changes take a long period of time to enact and yet more time to become operational and effective. Thus fiscal policy must target forecasts of where the economy will be in the future.