Why is cyclical unemployment targeted by stabilization policy

During a downturn, or recession, aggregate demand declines: household, business, government, and foreign sectors buy fewer goods and services. Unemployment increases because less output is produced, so fewer workers and other resources are needed.

Businesses face declining revenues and find themselves forced to cut costs. As a consequence, they lay off workers. Unlike the other types of unemployment, which are inherent either to a particular profession or a healthy, growing economy, cyclical unemployment can be avoided by stabilizing business-cyle fluctuations.

One of the primary policy goals of macroeconomics is to reduce or eliminate cyclical unemployment. To prevent cyclical unemployment, policymakers should focus on expanding output, which is most effectively achieved by stimulating demand. The goal of expansionary monetary and fiscal policies is to boost aggregate demand by cutting interest rates and taxes.

Additionally, policymakers may also depreciate the exchange rate in order to boost export demand or introduce specific legislation and initiatives that target particular areas of the economy. The goal of expansionary fiscal policy is to manage output and employment through increasing government spending and decreasing taxation.

Lower levels of taxation lead to higher levels of disposable income and an increase in consumption. An increase in consumption results in higher aggregate demand and higher gross domestic product GDP. Firms will respond to an increase in demand and higher GDP by increasing production, which requires more workers. Therefore, there will be less cyclical unemployment. Additionally, when there is strong economic growth and higher aggregate demand, there are fewer job losses, because companies remain in business.

The economist John Maynard Keynes was a proponent of expansionary fiscal policy during recessionary periods. According to Keynes, there are idle resources—capital and labor—during a recession. Therefore, it is the job of the government to create additional demand and intervene in order to reduce unemployment. The goal of expansionary monetary policy is to increase aggregate demand and economic growth through cutting interest rates.

Lower interest rates mean that the cost of borrowing is lower. This increases aggregate demand and GDP and decreases cyclical unemployment. Sometimes policymakers may also introduce specific initiatives that target particular areas of the economy in order to reduce unemployment and increase output.

Examples of these unique initiatives include streamlining the approval process for government projects that create jobs, giving businesses cash incentives for hiring workers, and paying businesses to train workers to fill specific positions.

Federal Reserve. Fiscal Policy. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. Expansionary policies take longer because Congress must vote for additional federal spending. This spending raises the budget deficit and re-ignites the bi-partisan debate on whether tax cuts or spending are more effective job creators.

Expansionary fiscal policies are government actions such as increasing or decreasing spending and taxes. A third option is for the government to extend unemployment benefits. According to some research, tax cuts are less effective in creating the demand needed to stop cyclical unemployment.

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Updated October 18, Reviewed by Toby Walters. To stop the cycle, Keynes argued, requires changes in policy in order to manipulate aggregate demand. He, and the Keynesian economists who followed him, also argued the reverse policy could be used to fight off excessive inflation during periods of optimism and economic growth.

In Keynesian stabilization policy, demand is stimulated to counter high levels of unemployment and it is suppressed to counter rising inflation. The two main tools in use today to increase or decrease demand are to lower or raise interest rates for borrowing or to increase of decrease government spending.

These are known as monetary policy and fiscal policy , respectively. Most modern economies employ stabilization policies, with much of the work being done by central banking authorities such as the U.

Federal Reserve Board. Stabilization policy is widely credited with the moderate but positive rates of GDP growth seen in the U. It involves using expansionary monetary and fiscal policy during recessions and contractionary policy during periods of excessive optimism or rising inflation. This means lowering interest rates, cutting taxes, and increasing deficit spending during economic downturns and raising interest rates, rising taxes, and reducing government deficit spending during better times.

Many economists now believe that maintaining a steady pace of economic growth and keeping prices steady are essential for long-term prosperity, particularly as economies become more complex and advanced. Extreme volatility in any of those variables can lead to unforeseen consequences to the broad economy.

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