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  • Government and the Business Cycle

    TEACHER: Hi, Student. The macroeconomic model that we built in the previous Modules is useful to explain the causes of the price level and deviations of actual GDP from potential.

    Now we will take a look at the cyclical nature of fluctuations in activity and the role of government in these cycles.

    Student, you will recall that on our first Module you asked me why you should be interested in macroeconomics. Here is a comprehensive answer:

    "Understanding the cyc1e in the economy is of vital importance for business because sustainable businesses have to ride out recessions as well as take advantage of booms".

    STUDENT: I see why the cycle in the economy is now known as the 'business cycle'.

    TEACHER: Good observation. Business cycles have been with us for almost as long as recorded history. The cyclical nature of economic activity has been equally apparent in recent times, and scholars have long tried to establish regularities in the data.

    Some have tried to make a case for the existence of a long-wave cycle, with a duration of about fifty years from peak to trough.

    However, when we refer to the business cycle today, we are talking about the shorter-term cycles in GDP, which usually have something in the range of five to ten years from peak to peak.

    The macro model we built up in previous Modules was a static model. In that model, a single shock leads to a period of adjustment; the economy eventually returns to the potential level of real GDP.

    Keynesian economists adopted the static analysis because they wanted to explain why the economy recessed while there was excess capacity and unemployment.

    It is possible, however, to approach the problem with dynamic models that can generate cycles as ongoing phenomena. In such models, a single shock may generate cycles for some time, or cycles may be an intrinsic characteristic of the models even without external shocks.

    In this Module we will:

    * Observe some of the empirical regularities in business cycles.
    * Review some of the economic analysis underlying many explanations of business cycles.
    * Outline the approaches of different schools of thought in economics to the analysis of business cycles.

    Characteristics of business cycles

    No two business cycles are exactly the same, but there are a surprising number of similarities in most recent cycles.

    Inflation And Unemployment

    We have extensively discussed in previous Modules the determination of GDP and the price level. This discussion is very similar to the determination of slightly different measures of the same phenomena; unemployment and inflation.

    Tell me please, Student, with what do you associate high unemployment?

    STUDENT: High unemployment is associated with recessions, so when GDP falls below its potential level unemployment rises. Conversely, when output is above potential GDP, firms are running above normal capacity and unemployment tends to be low.

    TEACHER: Correct. Inflation is the rate of change of the price level, so the same forces that cause the price level to adjust upwards will also tend to raise inflation.

    The exact relationship between inflation and unemployment depends upon both structural factors in the economy and the nature of the shocks. An increase in aggregate demand, for example, is likely to increase inflation and reduce unemployment.

    However, a supply shock that shifts the SRAS curve upwards to the left is likely to raise inflation and unemployment at the same time, as we have seen before.

    If we look at unemployment and inflation in the major trading nations since 1963, we will observe that:

    1. The dominant pattern in the 1980s (and probably also in the 1960s) was of a clear inverse relationship between inflation and unemployment, suggesting that shocks to aggregate demand were the key drivers of the cycle.
    2. In the 1970s there were two clear shocks to aggregate supply, associated with major oil-price rises in 1973 and 1979; as predicted by the theory, these supply shocks led to rising unemployment at times of simultaneous high inflation -sometimes known as stagflation. Such dramatic shocks to aggregate supply as occurred in the 1970s are, fortunately, quite rare, so it is more likely that the dominant pattern over the business cycle will be the one shown in the 1980s and early 1990s of an inverse relationship between inflation and unemployment.

    Industry Cycles

    Business cycles are important for most firms because almost all sectors of the economy are normally affected at the same time. Most sectors (or industries) tend to have an increase in output during a boom and a fall in output during a recession.

    Industrial sectors have very different volatility. Student, can you make an educated guess?

    STUDENT: I would say that for instance, manufacturing is much more volatile than food, because people always have to eat.

    TEACHER: Correct, but even the food sector has clear cycles. Those cycles are closely related to the cycle in the rest of the economy. Investment goods industries are generally among the most volatile.

    One of the reasons that some sectors are more volatile than others relates to the nature of the products involved. As we have seen from the food sector, people have to eat even when times are hard; however, they do not have to eat out, so the restaurant business is high1y cyclical, while food manufacturing and retailing is relatively stable.

    Another source of volatility relates to durability. Some products are bought infrequently and consume their services over an extended period of time. Such products include the capital equipment purchased by firms (investment goods) and the durable goods purchased by consumers. Durable expenditure is high1y volatile relative to non-durable expenditure. The reason for this is that purchases of durable goods (like cars, TVs, and hi-fi equipment) can be postponed when times are hard (as can the purchase of investment goods by firms.

    STUDENT: I guess there is a kind of "repressed demand" for this type of goods, which will free itself when the situation improves.

    TEACHER: True. But when times look good, a high proportion of extra spending will go on these luxury items. Necessities, like food and shelter, will be purchased basically under any circumstances. Thus, industrial sectors producing consumer durable goods will see much greater fluctuations in demand across the business cycle than sectors providing non-durable consumption goods.

    Profits And Wages

    We should also comment that profits tend to be highly variable and pro-cyclical. This is because during booms the demand for the output of firms is rising and firms are able to increase their sales volume, while also (possibly) increasing their profit margins (price minus unit cost). It is also generally true that money-wage rates tend to rise during booms as firms increase their demand for labor and the labor market tightens.

    STUDENT: Booms are good for wage earners too, you mean.

    TEACHER: Yes, but the share of wages in national income tends to fall during booms as the share of profit rises. Conversely, the share of profits falls sharply in recessions and the share of wages rises.

    We now turn to theoretical explanations of business cycles.

    Theories of the cyc1e

    Systematic Or Random Shocks

    In economies dominated by agriculture, cycles could be caused by weather patterns, over-planting followed by under-planting , or perhaps even cycles in the incidence of crop diseases. In industrial economies, cycles could result from patterns of innovation (product cycles) or waves of productivity improvements. There are certainly, also, cycles in demand for exports from open economies resulting from cycles in the rest of the world

    Many empirical macro models have quite long lags in the timing between an occurrence and the expected consequences.. For example, if a fall in the rate of interest makes a new investment program profitable, it may take six months to plan it, three months to draw up contracts, six more months before spending builds up to its top rate, and another two years to complete the project. In the meantime, many other factors can appear and affect the cycle.

    Cyclical Adjustment Mechanisms

    There may be many ways of formulating a dynamic model of the economy so that it generates cycles. Here we outline one simple mechanism that can generate cycles in response to discrete changes in exogenous variables. It is called the multiplier-accelerator mechanism. No one believes any longer that it provides the explanation of cycles, though it probably captures one major element of cyclical fluctuations. To understand it, we need to return to a discussion of the causes of variations in investment.

    The accelerator theory of investment

    We have mentioned that investment changes in response to changes in interest rates. The accelerator theory of investment relies on another determinant of investment, real GDP.

    The demand for machinery and factories is obviously derived from the demand for the goods that the capital equipment is designed to produce. If there is a demand that is expected to persist, and that cannot be met by increasing production with existing industrial capacity, then new plant and equipment will be needed.

    Investment expenditure occurs while the new capital equipment is being built and installed. If the desired stock of capital goods increases, there will be an investment boom while the new capital is being produced. But if nothing else changes, and even though business conditions continue to look rosy enough to justify the increased stock of capital, investment in new plant and equipment will cease once the larger capital stock is achieved.

    This makes investment depend on changes in sales, and hence on changes in GDP.

    Taken literally, the accelerator proposes a mechanical and rigid response of investment to changes in sales (and thus to changes in GDP). It does so by assuming a proportional relationship between changes in GDP and changes in the desired capital stock, and by assuming a fixed capital-output ratio. Each assumption is to some degree questionable.

    Yet accelerator-like influences do exist, and they play a role in the cyclical variability of investment. Modern investment theories often include a flexible version of the accelerator, in which the coefficient is a function of other variables such as interest rates.

    Multiplier-accelerator interaction

    The theory linking systematic fluctuations in GDP to systematic fluctuations in investment expenditure unites the accelerator theory just discussed with the version of Keynesian multiplier theory that sees the multiplier as a process working over time as successive rounds of induced expenditure build up in response to some initiating shock.

    This multiplier-accelerator theory of the cycle is divided into three steps.

    * First, a theory of cumulative upswings and downswings explains why, once started, movements tend to carry on in the same direction.
    * Second, a theory of floors and ceilings explains why upward and downward movements are eventually brought to a halt.
    * And third, a theory of instability explains how, once a process of upward or downward movement is brought to a halt, it tends to reverse itself.

    Why does a period of expansion or contraction, once begun, tend to develop its own momentum? First, the multiplier process tends to cause cumulative movements. As soon as a revival begins, some unemployed people find work again. These people, with their newly acquired income, can afford to make much-needed consumption expenditures. This new demand causes an increase in production and creates new jobs for others. As incomes rise, demand rises; as demand rises, incomes rise.

    STUDENT: And just the reverse happens in a downswing, I suppose.

    TEACHER: Right. Unemployment in one sector causes a fall in demand for the products of other sectors, which leads to a further fall in employment and a further fall in demand.

    A second major factor is the accelerator theory. New investment is needed to expand existing productive capacity and to introduce new methods of production. When consumer demand is low and there is excess capacity, investment is likely to fall to a very low level; once demand starts to rise and entrepreneurs come to expect further rises, investment expenditure may rise very rapid1y. Furthermore, when full employment of existing capacity is reached, new investment becomes one of the few ways available for firms to increase their output.
    A third major explanation for cumulative movements is expectations. All production plans take time to fulfill. Current decisions to produce consumer goods and investment goods are very strongly influenced by business expectations. Such expectations can sometimes be volatile, and sometimes self-fulfilling. If enough people think, for example, that bond prices are going to rise, they will all buy bonds in anticipation of the price rise, and these purchases will themselves cause prices to rise. If, on the other hand, enough people think bond prices are going to fall, they will sell quickly at what they regard as a high price and thereby actually cause prices to fall.
    This is the phenomenon of self-realizing expectations. It applies to many parts of the economy. If enough managers think the future looks rosy and begin to invest in increasing capacity, this will create new employment and income in the capital-goods industries, and the resulting increase in demand will he1p to create the rosy conditions whose vision started the whole process.

    One cannot lay down simple rules about so complicated a psychological phenomenon as the formation of expectations, but there is a bandwagon effect. Once things begin to improve, people expect further improvements, and their actions, based on this expectation, he1p to cause further improvements. On the other hand, once things begin to worsen, people often expect further worsening, and their actions, based on this expectation, he1p to make things worse.

    Controversies about the cause of cycles and the role of government

    Many of the different schools of thought in economics have had their own approach to explaining business cycles. We concentrate here on the views of the major macro schools of thought. It is of importance to note the contrasting views of the role of government in the business cycle. For Keynesians the instability that triggered cycles was in the private sector and it was for government to step in and stabilize the cycle. Other schools, however, see government as part of the problem; and extreme views see it as the major cause of instability.

    The Monetarist Approach

    Monetarists believe that the economy is inherently stable because private-sector expenditure functions are relatively stable and price adjustment will bring the economy back to potential GDP. In addition, they believe that shifts in the aggregate demand curve arise mainly from policy-induced changes in the money supply.

    According to monetarists, fluctuations in the money supply cause fluctuations in GDP. This leads the monetarists to advocate a policy of stabilizing the growth of the money supply. In their view this would avoid policy-induced instability of the aggregate demand curve.

    The Keynesian Approach

    The traditional Keynesian explanation of cyclical fluctuations in the economy has two parts. First, it emphasizes variations in investment as a cause of business cycles and stresses the non-monetary causes of such variations, such as expectations, or as Keynes put it, ‘animal spirits'.

    Keynesians reject what they regard as the extreme monetarist view that only money matters in explaining cyclical fluctuations. Many Keynesians believe that both monetary and non-monetary forces are important in explaining cycles. Although they accept serious monetary mismanagement as one potential source of economic fluctuations, they do not believe that it is the only, or even the major, source of such fluctuations. They believe that most fluctuations in the aggregate demand curve are due to variations in the desire to spend on the part of the private sector and are not induced by government policy.

    Keynesians also believe that the economy lacks strong natural corrective mechanisms that will always force it easily and quickly back to full employment (potential GDP). They believe that, while the price level rises fairly quickly to eliminate inflationary gaps, prices and wages fall only slow1y in response to recessionary gaps. As a result, Keynesians believe that recessionary gaps can persist for long periods of time unless they are eliminated by an active stabilization policy.
    The second part of the Keynesian view on cyclical fluctuations concerns the alleged correlation between changes in the money supply and changes in the level of economic activity. In so far as this correlation exists, the Keynesian explanation reverses the causality suggested by the monetarists. Keynesians argue that changes in the level of economic activity often cause changes in the money supply.

    According to Keynesians, fluctuations in GDP are often caused by fluctuations in autonomous expenditures. Further, they believe that fluctuations in GDP usually cause fluctuations in the money supply.

    A shift of emphasis within the Keynesian school has come about in recent years, associated with what is now called the New Keynesian school. Early Keynesians focused mainly on the use of aggregate demand (especially fiscal) policies to stabilize the cycle. New Keynesians would be happy to see GDP kept close to its potential level by whatever means possible, including monetary and fiscal policies

    Macroeconomics: the unfulfilled promise

    In the 1950s and 1960s, it was widely believed that the business cycle had been abolished. Many economists thought that the newly invented tools of macroeconomic stabilization policy meant that recessions could be avoided. Indeed, the 1950s and 1960s were a period of relative stability. Unemployment and inflation were both low, and, although there were cycles in activity, these cycles did not involve any major fall in output, only variations in positive growth rates.

    In contrast, since the early 1970s there have been four recessions during which output fell (1974-5, 1980-1, 1991-2 and 2000- 2002).

    When most major countries experience a similar cycle the explanation probably lies not in any single country but in worldwide economic forces. Globalization of the world economy has tied most economies closer together and there is little that any one government can do in the face of a shift of world aggregate demand. Realistically, therefore, the business cycle is here to stay and business people are going to have to learn to live with it.

    Macroeconomics was invented in order to give governments the tools to control business cycles. However, most now believe that monetary and fiscal polices have only a modest role in the stabilization of the business cycle. The business cycle is a global phenomenon that most governments cannot influence.


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