CHAPTER 4.

ECONOMIC FLUCTUATIONS AND THEIR IMPACT ON

ECONOMIC GROWTH

4.1. Economic Fluctuations and Their Causes

Studying the history of countries' economic development shows that none of them have
developed uniformly over the long term; on the contrary, periodic development is
characteristic of all countries.

The periodic fluctuations in production, employment, and the inflation rate are
called economic cycles. Some economic cycles differ from others in the duration and
intensity of their transition periods. Nevertheless, they all consist of the same stages
(Figure 4.1).

Figure 4.1. Cyclical Development of the Economy

Economic cycles include four stages. The first stage is the stage where the highest level
of economic development is achieved, known as the "peak." This stage is characterized
by full employment in the economy, production operating at full capacity, and a rising
price level for products.

The next stage is the downturn (recession) stage. In this stage, production and
employment levels decrease, but the rate of price increase does not slow down. This
stagecan only lead to a slowdown in the rate of price increase if it is active and
prolonged.

At the trough, production and employment fall to their lowest level, and a period of
stagnation begins.

In the recovery stage, production and employment levels gradually

increase, reaching the level of full capacity utilization and full employment.
As noted above, although economic cycles have the same stages, they differ from each
other in duration and intensity. Therefore, economists believe it is more accurate to call
these processes not economic cycles, but economic fluctuations. Economists point to
three main factors as the primary causes of economic fluctuations.

The first group of scholars considers changes in technology and techniques as the main
cause of economic fluctuations. According to them, growth in the economy occurs as a
result of applying scientific and technical achievements. For example, the invention of
the automobile caused the rapid development of the fuel industry, oil extraction,
chemistry, and road construction materials industries. New technologies allow for a
manifold increase in production productivity and the mobilization of previously unused
resources. The fact that technical and technological innovations are not created
continuously causes fluctuations in the economy.

Another group of scholars links economic phases to political and random situations.

There are also scholars who link this process to monetary policy. That is, the more money
the state prints, the more its value decreases, and conversely, the less the money supply,
the faster the decline in production scale and the increase in the number of unemployed
accelerate. In short, there are various approaches to assessing economic phases. But all
economists support the idea that the levels of production and employment depend on
aggregate demand, or in other words, the amount of aggregate expenditure. Because
firms only produce their goods and services if there is demand for them. In other words,
if demand is not high, it is not profitable for firms to produce goods and services in large
quantities.

In turn, the level of employment and income in production is also low for this very
reason. The greater the amount of aggregate expenditure, the greater the profit from
increased production. Therefore, the levels of production, employment, and income
increase. Studying the causes of economic fluctuations and the factors influencing them,
and reducing the amplitude of economic fluctuations, is one of the important goals of the
macroeconomic policy of all governments.

In this context, let's cite the following example. The 2008 world financial-economic crisis
brought macroeconomic instability to almost all developed countries in the world. This
crisis began with a liquidity shortage in the US mortgage lending system. Then the scale
of this process expanded, leading to a weakening of the liquidity, i.e., solvency, of major
banks and financial structures, turning into a financial crisis. It led to a catastrophic drop
in the market value of the indices of the largest companies and shares in the world's
leading stock markets. All this, in turn, led to unemployment and other negative
consequences associated with a sharp decline in production and economic growth rates in
many countries.
This crisis, which initially manifested in the US mortgage markets, occurred as a result of
the intensification of the practice of granting mortgage loans to borrowers who lacked
sufficient solvency and had questionable debt repayment ability. Although, by its nature,
a mortgage loan is a loan secured by real estate, the US markets became sufficiently
"saturated" with such illiquid real estate, and their prices began to fall sharply. On top of
that, the sharp increase in operations by investment banks on the securitization of assets,
considered new financial "products" in the US mortgage markets, increased the
likelihood of downturn situations in the mortgage markets.

The US economy, due to the created conditions, became saturated with cheap credit
resources, and this led to a change in the monetary policy conducted by the Federal
Reserve System (Fed). As a result, in 2004-2006, the Federal Reserve System raised
interest

rates to 6.25%. The increase in the cost of credit led to a decrease in population demand
for mortgages and a reduction in debtor payments on loans. Consequently, at the
beginning of 2007, the problem related to the population's repayment of mortgage loans
in the US intensified. The situation where debtors refused to make payments rather than
repay loans secured by real estate expanded. Banks putting the real estate of clients
without solvency up for resale increased supply in the mortgage market, leading to a
sharp drop in market prices.

Consequently, at the beginning of 2007, the problem related to the population's

repayment of mortgage loans in the US intensified. The situation where debtors refused
to make payments rather than repay loans secured by real estate expanded. Banks putting
the real estate of clients without solvency up for resale increased supply in the mortgage
market, leading to a sharp drop in market prices.

Most financial economists explained that one of the real causes of the emerging financial
crisis was the "fruit" of the policy of excessive liberalization of the economy in
developed countries, i.e., they also explained it by the limited state intervention in the
national economy and particularly in financial markets through promoting the idea of a
"self-regulating market."

The emerging global financial-economic crisis seriously affected the economies of

countries that include the world's major financial centers. Its peculiarity is that the
financial crisis, under the influence of inflation, the collapse of a number of banks and
financial institutions, is intensifying in the form of an economic crisis based on
unemployment, declining production rates, and others. This shows that the specific
feature of the current world financial crisis is that it started from the financial sector of
the economy and moved to the real sector.
Analysis of numerous publications on the global crisis shows that for the developed
countries of the world, the starting point of the crisis was the instability of financial
markets, and the scheme of the crisis development was as follows:

Instability of Financial Markets → Reduction of Credit and Decrease in

Consumption → Contraction of Production and Export, Increase in Unemployment.

Accordingly, at the government level, when developing state programs to exit the crisis,
the issue of employment, taking urgent measures aimed at expanding production scale by
stimulating demand, is being prioritized.

4.2. Unemployment and Its Impact on Economic Growth

As a result of the unstable development of the economy, during periods of economic

downturn, production resources are not fully utilized.

Unemployment manifests as the underutilization of labor resources, one of the most

fundamental economic resources involved in creating GDP.

In macroeconomic analysis, the category of labor force is used more often than labor
resources.

The labor force or economically active population refers to the total number of the
working-age population who are employed and unemployed.

In the labor market, the law of supply and demand applies, as in other resource markets.
If the volume of real wages, considered the price of labor, increases, the demand for labor
decreases; if the volume of real wages decreases, the demand for labor increases, and the
supply of labor decreases. The demand for labor being less than the supply of labor leads
to unemployment.

The unemployed are a part of the labor force who are not engaged in social
production but are willing to work and are actively seeking work.

The unemployment rate is the ratio of the number of unemployed to the labor force
(in percentage) and can be determined by the following formula:

Unemployment Rate = (Number of Unemployed / Labor Force) x 100

The following types of unemployment exist:

Frictional Unemployment. This includes labor force who are seeking work or expect to
be provided with work in the near future. This type of unemployment mainly arises from
changing jobs or residences, graduating from educational institutions, and other reasons.
It always exists and is considered necessary to a certain extent.
Structural Unemployment. The group of structurally unemployed includes those who
became unemployed as a result of changes in the structure of demand for labor due to
changes in the production structure. It mainly includes groups of unemployed who need
to change and improve their qualifications, acquire knowledge, and master new
professions.

Cyclical Unemployment arises mainly from a decrease in demand for labor due to a
decline in production. A cyclical downturn means a decrease in aggregate demand for
goods and services, a corresponding decrease in aggregate demand, and consequently, a
reduction in population employment and an increase in unemployment.

Full employment does not mean 100% of the labor force is employed. On the contrary,
considering that frictional and structural unemployment are inevitable, we understand
that absolute full employment cannot be achieved. If there is no cyclical unemployment,
then full employment is achieved.

The unemployment during the period of full employment is called the natural rate of
unemployment.

This can only be achieved if the number of job seekers matches the number of job
vacancies. The natural rate of unemployment is equal to the sum of frictional and
structural unemployment.

The natural rate of unemployment is not constant, as it changes depending on the

economic situation, laws, and national traditions.

The natural rate of unemployment is defined as the average of the actual unemployment
rate that existed in the country over the last ten years and the forecasted unemployment
rates for the next ten years. In general, the labor force is divided into those employed and
unemployed actively seeking work.

The volume of products that can be created in the economy when all available resources
are fully utilized or at the natural rate of unemployment is called the
economy's production potential. A country's production potential is measured by the
potential GDP indicator.

Due to macroeconomic instability, during an economic downturn, the country does not
fully utilize its economic potential, and the created real GDP volume (Yh) lags behind the
potential GDP (Yp) volume. That is, a GDP gap (GAP) occurs.

GAP = Yh-Yp / Yp * 100

Potential GDP refers to the possible production volume under conditions of full
utilization of the country's production resources.
When calculating potential GDP, it is assumed that unemployment does not absolutely
not exist in the country, but that it exists at its natural rate.

The impact of the unemployment rate on economic growth is mainly that as the
unemployment rate rises, the economy cannot achieve the potential GDP volume.
Therefore, at the country level, maintaining and regulating unemployment at its natural
rate is of great economic importance. The higher the actual unemployment rate is above
its natural rate, the larger the GDP gap. That is why potential GDP is greater than actual
GDP.

The English economist Arthur Okun mathematically proved the quantitative relationship
between the unemployment rate and the GDP gap. Therefore, this law is called OKUN'S
LAW. The essence of the law is that if the actual unemployment rate increases by one
percent above its natural rate, i.e., if cyclical unemployment constitutes 1 percent, the
national economy produces 2.5 percent less GDP.

A lower GDP level, in turn, means relatively lower incomes for participants in production
and a reduction in opportunities for investing in the future development of the economy.

Okun's law allows for determining the volume of product losses at different levels of
unemployment. Currently, this coefficient, called the β coefficient, is considered to be in
the range of 2% to 3%.

Okun's law can be expressed in a formula as follows:

GAP = -2.5[ u – u*]

Where: u* – natural rate of unemployment;

u – actual unemployment rate.

By combining the formula expressing the GDP gap with Okun's law formula, we obtain
the following formula:

Yh – Yp / Yp * 100 = - β [ u – u*]

Let's pay attention to the inverse aspect of the quantitative relationship explained by
Okun's law. Economic research shows that a 2-3% growth in GDP does not necessarily
lead to a 1% reduction in cyclical unemployment. That is, the initial 1% economic growth
can be achieved through increased efficiency in resource use due to scientific and
technological progress, and at this time, population growth also causes the number of
unemployed not to decrease. Every 2-3% economic growth above the initial 2-3% leads
to a 1% reduction in cyclical unemployment. Therefore, to eliminate 1% cyclical
unemployment, an annual economic growth of 4-6% must be ensured.
 4.3. The Relationship Between Inflation and Unemployment.

Inflation (from Latin inflatio - swelling, bloating, tightening) – the steady rise in the
average (general) price level in a country over a certain period, the long-term decrease in
the purchasing power of money. Inflation is among the main disruptive factors of a
market economy; the higher its rate, the greater its dangerous impact on the economy.
Especially in countries transitioning from one economic system to another, the impact of
inflation on the economy is quite dangerous. Because this period is associated with the
liberalization of prices and a corresponding sharp rise in their general level.

But during inflation, not all goods' prices rise continuously: some may remain stable,
while others may even fall.

The term "inflation" was first used in North America during the Civil War of 1861-1865.
The term inflation described the situation where the paper money supply in circulation
increases excessively compared to the real supply of goods. But such a description of
inflation is imperfect and does not reveal its causes. In general, inflation means a
violation of macroeconomic equilibrium, an imbalance between demand and supply, as a
form of violation of the laws of money circulation.

Representatives of the Keynesian school believe the cause of such imbalance is excessive
demand under conditions of full employment. Therefore, they believe that if the level of
capacity utilization is low, increasing purchasing power, in other words aggregate
demand, through budget deficits and additional money printing will not lead to inflation.

Proponents of the neoclassical approach believe the source of inflation is excessive

growth in production, an increase in production costs. Thus, Keynesians approach
inflation from the demand side, while neoclassicists approach it from the supply side.

If in the economy the mass of goods and services grows slower than aggregate demand,
or if aggregate demand increases while supply remains unchanged, this imbalance is
eliminated through a rise in the price level. As a result, the purchasing power of the
monetary unit decreases, and the national economy's need for an additional money supply
arises.

Inflation is not only a disruption of money circulation but also a sickness of the entire
reproduction mechanism, a result of macroeconomic disruptions. Besides the rise in
prices and the decrease in the purchasing power of the monetary unit, inflation has the
following three signs of manifestation:

1. Change in exchange rates;

2. Change towards higher credit costs and shorter terms;
3. Increase in the price of the consumer basket consisting of daily necessities.

Inflation is measured using price indices - the deflator and the consumer price index.
The relative change in the average (general) price level is called the inflation rate (rate
of price increase). In macroeconomic models, the inflation rate can be expressed as
follows:

π = P – P – 1 / P-1

where: π– annual inflation rate;

P - current year's price index;

P₋₁ - previous year's price index.

To measure inflation quantitatively, macroeconomics also uses the method called the
"Rule of 70." This method allows determining how many years it will take for the price
level to double under conditions of stable inflation. For this, it is enough to divide 70 by
the annual inflation rate:

Number of years required for prices to double = 70 / π

For example, if the annual inflation rate is 7%, prices will double in approximately 10
years, i.e., (70:7 = 10).

The "Rule of 70" is also used when it is necessary to calculate in how many years real
GDP and savings will double.

When the economy in its development approaches the potential level, it is forced to
choose one of the alternative options, such as increasing the employment level or
reducing the inflation rate. Because in the short term, there is an inverse relationship
between the unemployment and inflation rates. Reducing unemployment means
allocating additional funds for job creation. At the same time, this also leads to an
increase in the amount of wages. Both cases lead to a rise in the price level, i.e., demand-
pull inflation occurs.

The interdependence between the indicators of unemployment and inflation was

identified by the English economist A.W. Phillips and is called the Phillips curve (Figure
4.2).

The Phillips curve characterizes the inverse relationship between unemployment and
inflation rates.
 Figure 4.2. Phillips Curve

Depending on the characteristics of the country's economy, as well as the type of inflation
present, the combination of inflation and unemployment rates on the Phillips curve may
differ. This choice depends on the expected inflation rate. The higher the expected
inflation rate, the higher the actual inflation rate at any level of unemployment (compared
to a situation with a low expected inflation rate). The acceptable levels of unemployment
rate and inflation rate can be described by the following formula:

π = π_exp + f (Yh – Yp / Yp ) + ε

Where π - actual inflation rate; π_exp - expected inflation rate;

f ( Yh – Yp / Yp ) - demand-pull inflation;

f - empirical coefficient determining the slope of the Phillips curve;

ε - external price shock (cost-push inflation).

According to Okun's law, the GDP gap, i.e., (Yh – Yp) / Yp, depends on the change in
cyclical unemployment, so the short-term Phillips curve equation can be described as
follows:

π = π_exp - β [ u – u*] + ε

From the given equation, it can be seen that the actual inflation rate is directly related to
the expected inflation rate and the level of external price shocks, and inversely related to
the cyclical unemployment rate.

Based on the Phillips curve, the government can, for the short term, choose any
combination of unemployment and inflation rates based on the goals of economic policy.

4.4. Stabilization Policy and Its Types

As the market economy constantly develops on the path of the welfare of human society,
the volumes of social production grow, and the volume of products intended for
consumption also increases. This requires the state to carry out its constantly changing,
improving, and developing macroeconomic policy to ensure that the changing economic
proportions in society constantly remain mutually proportional.

Currently, the increasing number of states based on a market economy on a global scale,
the development of the theory of achieving macroeconomic stability in society, further
increases its relevance worldwide.

The state, its institutions, and structural bodies play an important role in the efficient
functioning of any country's economy and ensuring macroeconomic stability. In this, the
ratio between the market, on one hand, and the state's regulatory mechanisms, on the
other, is of decisive importance. Throughout the 20th century, at various stages of world
economic development, alternating strengthening and weakening of regulatory
mechanisms by the market and the state were observed. Accordingly, in some periods,
the concept of strengthening the role of the state in economic theory and policy prevailed
(the Keynesian doctrine that dominated economic theory from the 1940s to the 1970s),
while in later periods, the concept of the unlimited possibilities of market-based
regulatory mechanisms in economic development (monetarism, neoliberalism, and other
economic theories that had great influence in the 1980s and 1990s) dominated.

Regardless of whether the economy is based on market relations or administrative-

command principles, its regulation by the state is an objective necessity for any
government as a crucial condition for ensuring macroeconomic stability.

The specific directions, forms, and scales of macroeconomic policy are determined by the
socio-economic characteristics of the country in a given period. World experience has
formed several different approaches to implementing stabilization policy.

The first of these is called the monetarist approach. It is based on reducing the level of
currency depreciation, stabilizing money circulation by sharply reducing the money
supply and total effective demand. The drawback of this approach is that it leads to a
decrease in the physical volume of production and a halt in investment activity.

The second is an approach based on stimulating production and entrepreneurial activity,

assisting in implementing structural changes, and eliminating imbalances in the economy.
Here, a consistently tight fiscal and monetary policy is carried out in close connection
with measures to limit excess demand that cannot be covered by goods.

In the Republic, during the transition period, the second approach was prioritized to
achieve macroeconomic stability. This is an approach aimed at achieving an advanced
production structure, comprehensively encouraging promising sectors and productions,
identifying the most critical links (oil, energy, grain, cotton processing industry, etc.), and
thereby restructuring the economy. Along with identifying leading sectors considered
superior to others, restructuring their internal structure was also taken into account.

The third is a method aimed at implementing institutional reforms, liberalizing the

economy, and increasing the competitiveness of the national economy. This method is
adopted after achieving macroeconomic stability, i.e., it is used to strengthen stability.
The third method is a new method that became a separate approach at the end of the 20th
century.

World economic practice shows that responsible goals such as halting the decline in
production, curbing the inflation rate and sharply reducing it, and ensuring
macroeconomic stability cannot be achieved in a short time. This goal is achieved only
through the successful implementation of a series of reforms over several years. Also, to
achieve macroeconomic stability, partially implemented reforms or the impact of
separately taken monetary and fiscal policy are certainly not sufficient. For this, it is
necessary for the government to develop and successfully implement a set of
macroeconomic stabilization programs covering a series of clearly targeted structural and
economic reforms. Therefore, the macroeconomic stabilization program, in turn, requires
the implementation of the following measures: institutional reforms; price liberalization;
reform of business entities; reform of the financial system; ensuring the convertibility of
the national currency for current operations; creating a modern payment system; creating
a securities market; ensuring the transparency of economic policy and the financial
system; accelerating the processes of de-statization and privatization of property;
fundamentally changing the real sector of the economy; fully forming market
infrastructure; and others.

As a result of the measures mentioned above, the processes of liberalizing and developing
the economy accelerated, and the foundation was laid for an economy where the market
mechanism fully functions.

In implementing the macroeconomic stabilization policy, the government coordinated the

activities of the Central Bank and the Ministry of Finance in accordance with the goals of
the structural and economic reforms being implemented in the country.

When developing the stabilization program, the necessity of carrying out a balanced
monetary policy together with a policy supporting the structural restructuring of key
sectors and productions was taken into account.

The most fundamental task of macroeconomic policy is to choose and implement the
most optimal strategy for ensuring macroeconomic stability with the aim of improving
the population's standard of living and ensuring the growth of its income. Therefore, in
implementing macroeconomic policy, correctly choosing effective ways to achieve the
highest level of macroeconomic stability and applying them in practice is of great
importance.
 Brief Conclusions

Macroeconomic stability, i.e., providing all sectors of the economy with resources,
helping to achieve full employment and a stable price level, and encouraging economic
growth, is considered the most important task of the state. Stabilizing the economy –
based on eliminating shortages – is creating conditions for maintaining macroeconomic
equilibrium and reviving production.

The system of macroeconomic stabilization measures includes limiting money emission,

reducing the state budget deficit, ensuring a positive interest rate, and others.

Inflation means the steady rise in the average (general) price level in a country over a
certain period and the long-term decrease in the purchasing power of money. The
negative impact of inflation on the economy manifests itself in disrupting normal
economic relations.

The inflation rate is measured using price indices.

Based on the causes, demand-pull inflation and cost-push inflation are distinguished.
These two types of inflation often occur in a mixed form.

Unexpected inflation redistributes income between debtors and creditors, different strata
of the population, and the state and the population.

The inverse relationship between unemployment and inflation rates is reflected in the
Phillips curve.

Based on the Phillips curve, the government can, for the short term, choose any
combination of unemployment and inflation rates.

Stabilizing the economy is an inevitable process on the path to forming market relations.
It is primarily aimed at eliminating shortages. The state of shortage forces taking
measures to change the quality and type of produced goods and services to prevent crisis,
obliges reducing production costs, improving product quality and consumer properties,
and increasing its competitiveness. All this ultimately leads to ensuring a favorable
balance between demand and supply in the market. In a broader sense, stabilization is,
first of all, maintaining balance in the macroeconomy, not allowing a sharp decline in
production and mass unemployment. Also, it is a state policy pursued with the clear goal
of preventing currency depreciation and maintaining the balance of payments at a stable
level.

Questions for Control and Discussion

1. What do you understand by economic fluctuations?
2. Is the nature of inflation correctly explained only by the excess of money in
circulation?
3. What is unemployment and what types do you know?
4. How do the approaches of Keynesians and Neoclassicists differ in explaining
inflation?
5. Talk about the socio-economic consequences of inflation?
6. What is the main goal of stabilization policy?
7. What is the most fundamental task of macroeconomic policy?