I was reading Donald Low’s Behavioural Economics and Policy Design, examples from Singapore. Chapter 6 talks about discretionary transfer, and mentioned that Singapore had shifted to using interest rate to manage business cycle since 1980s. Let’s sort out some terms and know more about them.
Business cycle is the periodic raise and decline in GDP over a long period (wiki). It was introduced by French economist Jean C. L. Sismondi in 1819. The theory names several cycles according to cycle length and the study of business cycle also attempts to identify the stages in a cycle. It is a cycle, so, as you might have guessed there are stages of ups and downs. I will explain something not quite straightforward to the uninitiated or to people with some uninformed preconceptions about economic welfare prior to investigating the field. One of the cycles is called Juglar cycle. In the cycle a period of economic growth is identified as the expansion. During expansion, production increases, interest rates decrease, and prices increase. Let us ignore the interest rates first; production increase is tied to GDP increase, quite obviously.
But prices increase? Come to think of it, yes, the idea is simple. Products and services are worth more, and GDP will record a higher value as well. Just in case, GDP measures the total value of products and services. But during my earlier days, in Indonesia, we’re inculcated with the flow of idea, ever so simplistic, that prices increase means we can afford less, therefore it is bad. This idea ignored the fact that we are each a unit in the economy, and price increase can be driven by increase in others’ spending. The tricky parts may be here: 1. Is the spending reflective of wealth? A lot of the time credit card does the job and people go into debts. If it drives further production, it will help raise all the economic growth metric, at least one dimensionally, through absolute production output. Is this production sustained to induce further growth, or even help people out of their debts? In the end, the better metric to economic welfare may be this “second order derivative” (pardon the terminology abuse). I need to find out more, but we keep it on hold here. 2. Many a times the brunt is born by the middle to lower class workers. They earn income that is often stagnating, in the face of price increase! Smaller business may feel the pressure. They can jack up their prices as well; some succeed, some fail, still fair enough, but in the end the consumers pay higher prices while the country is boasting high growth. I think social inequality is really expressed well here.
Following the expansion stage in the Juglar cycle is the crisis (bankruptcy, stock market crashes), followed by recession and the recovery. Recession seems to include the reverse processes from expansion; prices drop, interest rate increases, output drops. To put forth what I have understood so far, economic performance of a country is seen from the collective perspective of entities that produce. This cannot be true since consumer spending keeps producers profitable, and so consumers are largely in the equation. Now, to reconcile this, while prices drop may mean affordability to lower income earner, we must remember a number of far reaching complex links 1. High interest rates keep producers from being profitable, thus they may lay off workers. Looking at the overall change, while some households might be relieved at prices drop, some others may be living in insecurity. 2. With production decline, in the extreme case there might be shortages, clearly a problem. We consider a non-shortage situation, and prices drop. It might seem like a good situation where spending is encouraged, but, that this situation is labelled negatively as recession, we are guided to believe that the losses (from unemployment etc) outweigh the gains from cheaper prices. Recall that firms had gone bankrupt in the previous stage; we can make sense of it this way.
The recovery stage constitutes the follow up. When prices drop far enough and people’s demand for compensation in their employment drops as far (when you’re unemployed you might start to be desperate and take up less paying jobs you’re overqualified to do), production and hiring can start to bounce back. Certainly, there are more complex factors to consider, but for now we see how interest rates can be used to fix the economy. The premise is simple enough. During recession interest rates are high, and producers will consider their production activities costly in the long terms. Fiscal policy can come to the rescue, adopting methods to lower the rates, effectively encouraging producers to produce. At the end of the day, profitability will drive the economy, not quite surprisingly.