Explain how central bank and government budget policy influence the course of the business cycle
The idea
Monetary policy works through short rates, credit and the exchange rate. A common benchmark is the Taylor rule: target policy rate = neutral real rate + expected inflation + 0.5 × (output gap) + 0.5 × (inflation − target). With a 1% neutral real rate, 3% inflation against a 2% target and a 1% positive output gap, the rule gives 1 + 3 + 0.5 + 0.5 = 5%. Fiscal policy acts through changes in the deficit rather than its level, best judged cyclically adjusted: a widening deficit stimulates, a narrowing one restrains. The two combine: both easy supports strong growth, both tight restrains it. Traps include confusing deficit levels with changes, and ignoring the long and variable lags of both tools.
Formulas
Taylor rule for the policy rate
policy rate = neutral real rate + expected inflation + 0.5 × output gap + 0.5 × (expected inflation − inflation target)
- neutral real rate
- the short-term real rate consistent with steady growth and stable inflation
- expected inflation
- the inflation rate expected over the coming year
- output gap
- expected GDP less trend GDP, as a share of trend; positive when the economy runs hot
- inflation target
- the central bank's target rate of inflation
A yardstick for where policy should sit, not a forecast of what the central bank will do. A policy rate above it is tight, below it loose. Near zero the rule can call for a negative rate that policy cannot reach.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Capital Market Expectations, Part 1: Framework and Macro Considerations
- Explain what capital market expectations contribute to managing a portfolio and set out a structured process for building them
- Set out the obstacles an analyst meets when producing forecasts for capital markets
- Explain the ways in which unexpected outside events can shift the long-run growth path of an economy
- Explain how an assessment of trend economic growth feeds into long-run forecasts for asset returns
- Contrast the principal methods used to forecast the economy
- Explain how the stage of the business cycle shapes return expectations over short and long horizons
- Explain how inflation behaves across the business cycle and what it means for returns on cash, bonds, equities and real estate
- Read the yield curve's slope as a signal about the economy, and explain how it reflects the combined stance of monetary and fiscal policy
- Recognise and interpret how economies are connected through growth, interest rates and currencies