Procyclical
Procyclical describes variables that move in the same direction as the business cycle, increasing during expansions and decreasing during contractions. The term is used to characterise the behaviour of economic variables and, importantly, of policies and financial conditions that amplify rather than dampen fluctuations.
Procyclical Variables
Many economic variables are procyclical. Output, employment, investment, consumption of durables, and corporate profits all rise in expansions and fall in contractions. Credit growth, asset prices, and commodity prices are also procyclical, often amplifying the cycle.
The degree of procyclicality varies. Investment is more volatile than consumption, and durables more than nondurables, reflecting the scope for postponing purchases. The identification of procyclical variables informs the analysis of the sources of fluctuations and the design of stabilisation policy.
Procyclical Policies
The term is often applied to policies that amplify the cycle. Procyclical fiscal policy is expansionary in booms and contractionary in downturns, exacerbating fluctuations. Procyclical monetary policy is accommodative when the economy is strong and tight when it is weak, similarly amplifying swings.
Procyclical policies can arise from several sources. Fiscal revenues are procyclical, since tax collections rise in booms, and expenditures may also be procyclical where transfers fall in expansions. Political incentives may favour spending in good times and austerity in bad. Institutional constraints, including rules that link spending to revenue, can reinforce procyclicality.
Financial Procyclicality
Financial systems are inherently procyclical. Credit and asset prices rise together in expansions and fall together in contractions, and the interaction between them amplifies the cycle. Leverage increases in booms, when asset values are high and risk appears low, and deleveraging in busts, when values fall and risk rises.
Regulatory frameworks can also be procyclical. Capital requirements tied to asset risk become less binding in booms, when measured risk is low, and more binding in busts, when risk rises, amplifying credit cycles. This recognition has motivated the development of countercyclical capital buffers and other macroprudential tools designed to lean against the cycle.
Policy Responses
Policies to counter procyclicality include rules that constrain fiscal discretion, including balanced-budget rules with escape clauses and structural balance targets. Macroprudential policy aims to moderate the financial cycle through countercyclical capital requirements, loan-to-value limits, and other instruments.
The design of these policies involves trade-offs between discipline and flexibility, and their effectiveness depends on the ability to identify the cycle in real time and on the institutional capacity to act. The recognition of procyclicality has been a central theme in the reform of fiscal, monetary, and financial frameworks.
Cyclicality of Fiscal Policy
The cyclicality of fiscal policy has attracted substantial attention. In advanced economies, fiscal policy has generally been countercyclical or acyclical, with automatic stabilisers and discretionary measures leaning against the cycle. In many emerging economies, by contrast, fiscal policy has been procyclical, expansionary in booms and contractionary in downturns.
The procyclicality of fiscal policy in emerging economies is attributed to several factors, including limited access to credit in downturns, the procyclicality of commodity revenues, and political pressures for spending in good times. The result is that fiscal policy amplifies rather than moderates fluctuations, exacerbating booms and deepening busts.
Institutional Responses
Institutional responses to procyclicality include fiscal rules that constrain discretion, such as balanced-budget rules and structural balance targets, and the establishment of fiscal councils to provide independent analysis and forecasts. Structural balance targets, which adjust for the cycle, allow stabilisers to operate while ensuring sustainability.
The design of these institutions involves trade-offs between discipline and flexibility. Rules that are too rigid may prevent necessary responses to shocks, while those that are too flexible may fail to constrain. Escape clauses, which permit deviations in exceptional circumstances, are one way to balance the two.
Monetary Policy and the Cycle
Monetary policy is generally countercyclical, easing in downturns and tightening in booms, in pursuit of price stability and, where mandated, full employment. The response of monetary policy to the cycle is constrained by the zero lower bound and by the lags in transmission.
The interaction between monetary and fiscal policy affects the cyclicality of the overall policy stance. Where monetary policy is constrained, fiscal policy may need to take a larger role in stabilisation. The coordination between the two is a central issue in macroeconomic policy, particularly in deep downturns.
Financial Sector Procyclicality
The financial sector is inherently procyclical, and its behaviour amplifies the cycle. Credit and asset prices rise together in expansions and fall together in contractions, and leverage increases in booms and declines in busts. These dynamics can generate financial crises and deepen recessions.
Macroprudential policy, including countercyclical capital buffers, loan-to-value limits, and other tools, aims to moderate the financial cycle. The design of these tools is challenging, since they must be calibrated in real time and their effects are uncertain. Nonetheless, the recognition of financial procyclicality has become a central element of the policy framework.