© 2000 John Petroff
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© 2000 John Petroff |
4)- Explanations of the business cycleh
Explaining the business cycle attracted most talented economists and produced major theories in the first half of the 20th century. (Since then, however, economists have paid less and less attention to it.) The following are some of the most commonly mentioned theories. We start with the earliest and most simplistic interpretation of what is taking place.
a)- Price disequilibrium: Since prices tend to be high at the peak and low at the trough, the business cycle was first envisioned as a natural process of price adjustment to its equilibirum. An equilibrium is hardly ever reached right away. It may take several rounds of adjustment in supplied quantity expansion or contraction to get to it. By that time, conditions affecting demand have changed for the price equilibrium itself to have changed, thus requiring an adjustment process to take on new momentum.
b)- Outside forces: Exogenous
events can cause increased business revenues, such as
- innovations
- mining discoveries
- reduction in international trade barriers
- increased military spending
- unusually high agricultural yields
or on the contrary, a reduction in revenues from
- natural catastrophe
- reduction in government spending
- restrictions to trade and commerce
- poor agricultural harvest
Some of these have been previously mentioned as affecting industries.
All the other business cycle interpretations also make use of
these factors. What is specific to this theory is that it proposes
that a combination of these factors taking place simultaneously
is sufficient to keep the pendulum of the business cycle oscillating.
c)- Underconsumption: The theory focuses on the difference between wages of labor and profits of business owners. The first group devotes more income to consumption than the second. If a larger proportion of revenues is directed toward profits, the overall level of consumption falls. This causes a recession. Sales and profits disappear. Income goes back to wage earners who spend their income on consumption and push the economy back into expansion.
d)- Overinvestment: When interest rates are low more projects appear profitable and are started causing the economy to growth. When interest rates are pushed up by inflation and excessive lending, projects are no longer profitable and are curtailed: a recession starts. When interest rates drop, new investment is profitable again and the cycle takes off again.
e)- Innovations: Inventions occur continuously. But their commercial applications, i.e. innovations, do not. Innovations are put into production when market conditions are favorable, and that is when sales are expected to be solid. Then, projects appear profitable, and an economic expansion results. The new production is more efficient than in the past, and forces older less efficient businesses to close, thus, causing a recession. Poor sales prospects do not justify new innovations until the recovery.
f)- Psychological explanation: Overinvestment of businessmen is caused by overoptimism when business conditions are seen as promising, and consequently, many similar products are introduced, and many similar projects are started. Thus, overoptimism causes overheating of the economy which leads to subsequent closing of excessive plants. Overoptimism is the result of lack of information about the plans of competitors and a desire to capitalize on positive signs by too many people at the same time. Pessimism sets in when excess projects are terminated, and a recession results.
g)- Forced saving: In economic expansion, overinvestment takes place in durable goods because they are needed to produce consumer goods later. This causes shortages in consumer goods industries, which, in turn, cause inflation. Inflation, which constitutes force saving in the form of retained profits, eventually causes consumption to slow down and the economy to contract. Consumption resumes only when inflation subsides, production of durable goods slows down, and revenues return to consumer goods manufacturers.
h)- Acceleration: A relatively small change in consumer goods will cause a proportionally much larger change in durable goods (which are needed to produce the consumer good). Thus, durable goods industries are very unstable and cause the rest of the economy to go into business cycles. There is also an inventory version of the accelerator, which is just as popular.
i)- Multiplier: A small change in investment or government spending will cause a multiple change in aggregate output and aggregate income. This is true because the marginal propensity to consume is less than one. As an economy grows the level of investment and government spending needed for equilibrium changes, and business cycles will take place as long as actual spending does not equal needed spending.
j)- Overlending by banks: When bank reserves are plentiful, banks are eager to lend. Credit issued by banks allows more inventory to be purchased and sales to take off. When reserves are used up, banks stop lending: this cause a recession.
k)- Misguided central bank policies: Money supply is allowed to expand quickly to help fiscal policy push the economy out of a recession. Eventually, excessive money supply growth results in inflation which central banks combat by tightening money supply. This takes away bank reserves, prevents lending, and sends the economy into recession. Shifting policies from easy money to tight money, and back again, is what causes business cycles, or at least makes them worse.
If the above list is not enough, one can find yet more theories. There are those that pay attention to productivity of labor and unit labor costs. Others focus of international transmission of business cycles through international trade and exchange rates fluctuation. There are even theories that point to the role of unions. And naturally, there is a Marxist version of the business cycle.
It is not our goal to judge these theories. Although, the contribution of Keynesian and monetarist versions to improve fiscal and monetary policies certainly makes them stand out. The mere fact that there are so many logical explanations of business cycles, makes us aware that this is a complex process, and that many different phenomena need to be look at if one wants to avoid making mistakes in the assessment of the current or forthcoming state of the economy. Another lesson is that there are many forces at work, and one can easily be misled in believing that things will remain as they are. As mentioned already, in the 1960's economists believed that the business cycle was dead. At the other extreme, Americans in the 1930's could not see an end to the depression. Likewise, it would be dangerous to be lulled by the extended American prosperity experienced in the beginning of the 21st century.
See review questions Q-15B4.1 through Q-15B4.11.
See research assignments R-15B4.1.
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