4.1 Introduction

In Chapter 3, we discussed the role of banks in augmenting savings and supporting economic growth in the long-term perspective. In macroeconomics, ‘long-run’ refers to the period in which all prices are flexible. In practice, long-run economic growth and developmental discussion for a country generally cover several decades.

There is another important dimension of economic growth often observed. This is in the form of short-term economic fluctuations. Short run refers to a time period in which the prices of some goods are assumed to be rigid or inflexible. The evolution of Keynesian macroeconomics in the aftermath of the Great Depression of the 1930s highlighted the occurrence of such regular short-term economic fluctuations. It was suggested that there are certain phases in which the economy witnesses rapid growth (boom) followed by periods of economic slowdown (recession). The periodic recurrence of such economic booms and recessions is popularly referred to as the business cycle phenomenon.

The question is why we need to be concerned with short-run economic fluctuations.

Our concerns arise as excessive economic fluctuations can have serious adverse effects on society. During economic downswings, sales, production and employment levels plummet. Most households earn their livelihood by participating in the production process in one form or the other. Fall in production and sales adversely affects the profits of industry and unemployment causes loss of income for households. Consequently, the livelihood and standard of living of people at large suffer. Any social-welfare-maximising government cannot afford serious risks to the livelihood and standard of living of its citizens.

Similarly, periods of economic boom, particularly if driven by rising aggregate spending in the economy as compared to the production capacity, cause high inflation. Inflation is nothing but a tendency of continuous surge in the general prices. With rising prices, people can afford to buy fewer goods and services for a given income.