Business cycles create instability in the economy. The period of boom or rising business activities is characterized by increase in output, employment, income, profits, saving and investment, wage rates, and there is overall optimism that prevails in the economy. A period of depression or recession is characterized by continual decrease in output, sales, employment, income, saving and investment, profits, wage rates, and overall pessimism prevails in the whole economy. Prof. J.M. Keynes was the first economist to suggest government intervention to avoid business fluctuations and bring stability. Government  policy could be used in a countercyclical manner to stabilize the economy.

The government can activate its fiscal policy to even out business fluctuations. The major tools of the fiscal policy are public expenditure and taxes. These two tools are to be used differently in the period of inflation and recession. To control inflation, the government may curtail or postpone its expenditure and impose new taxes or increase the rates of existing taxes. Conversely, for the elimination of recessionary gap. The government may increase its expenditure and resort to sharp reduction in tax rates and offer tax rebates and concessions. Government spending helps to generate new employment opportunities, as a result, the level of output and income also rises. Similarly reduction in the tax rate increases the personal disposable income and private spending. Increase in aggregate spending shifts the AE line upwards, as a result, the level of output (GDP) rises.

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