Several theorists attempted to formalize the theory behind business cycles to no avail. Explanatory variables offered by these theorists were either insignificant or in contradiction with accepted economic principles. In any case, the ratio of GDP to the potential GDP can serve as an indirect measurement of the level of production fluctuation in the economy. If the ratio is close to 1, then the level of business cycle in an economy is also minimal. If the variance is large, then the economy experiences high levels of production fluctuations.
In order to remove these fluctuations, actual GDP must equal potential GDP. If an economy achieves potential GDP, then it is Pareto Efficient. Hence, the amount of fluctuations (which characterized inefficiency) is close to zero. The determination of fiscal policies is solely the function of the government. Fiscal policies refer to expenditures a government undertakes to provide goods and services and to the way in which the government finances these expenditures (like taxes and subsidies).
In the United States, some of the agencies concerned with setting fiscal policies are as follows: agencies of the federal government like the Defense Department, Trade Department, and the Bureau of Internal Revenue, and agencies of state governments. Generally, fiscal policies can be undertaken by all levels of government. The general functions of these bodies are as follows: 1) Provide goods and services that the market will usually not provide; 2) Provide economic infrastracture that will facilitate the flow of goods and services in an economcy;
3) Increase government spending during times of uncertainty, economic crisis, and recessions; 4) Provide businesses and investors an elaborate system of information in order to reduce transaction costs; 5) And, create incentives schemes in order to encourage increased production (or create an optimal tax system where firms that produce negative externalities would be heavily taxed to reach the social optima). Fiscal policies encourage increased production in two ways.
By providing incentive schemes or subsidies to particular industries, the government can expect a long-term increase in the economys output. Increasing government expenditure is seen by investors and firms as a sign of expected economic growth (psychological). By increasing government expenditure, the national income increases by a certain amount depending on the government multiplier (note that Y = C + I + G + NX). An increase in G reflects an increase in Y. This induces other participants in an economy to spend more (therefore save less).
Increased government spending also has bearing on employment, inflation, and general wage levels. Sustained government spending results to sustained inflation. Employment is ambiguously affected (this depends on the capacity of the economy to create jobs). Wage levels decreases in the long-run because of lower aggregate demand for labor. In many cases, fiscal policies are matched with monetary policies in order to achieve a desirable economic state. However, the use of monetary policies is more complicated. Hence, a separate analysis must be reserved for this topic.