Business cycle
A business cycle is a cycle of fluctuations in the Gross Domestic
Product (GDP) around its long-term natural growth rate. It explains the
expansion and contraction in economic activity that an economy
experiences over time. A business cycle is completed when it goes
through a single boom and a single contraction in sequence. The time
period to complete this sequence is called the length of the business
cycle. A boom is characterized by a period of rapid economic growth
whereas a period of relatively stagnated economic growth is a
recession. These are measured in terms of the growth of the real GDP,
which is inflation adjusted.
Stages of the Business Cycle
In the diagram above, the straight line in the middle is the steady
growth line. The business cycle moves about the line. Below is a more
detailed description of each stage in the business cycle:
#1 Expansion
The first stage in the business cycle is expansion. In this stage, there is
an increase in positive economic indicators such as employment,
income, output, wages, profits, demand, and supply of goods and
services. Debtors are generally paying their debts on time, the velocity
of the money supply is high, and investment is high. This process
continues until economic conditions become favorable for expansion.
#2 Peak
The economy then reaches a saturation point, or peak, which is the
second stage of the business cycle. The maximum limit of growth is
attained. The economic indicators do not grow further and are at their
highest. Prices are at their peak. This stage marks the reversal in the
trend of economic growth. Consumers tend to restructure their
budget at this point.
#3 Recession
The recession is the stage that follows the peak phase. The demand
for goods and services starts declining rapidly and steadily in this
phase. Producers do not notice the decrease in demand instantly and
go on producing, which creates a situation of excess supply in the
market. Prices tend to fall. All positive economic indicators such as
income, output, wages, etc. consequently start to fall.
#4 Depression
There is a commensurate rise in unemployment. The growth in the
economy continues to decline, and as this falls below the steady
growth line, the stage is called depression.
#5 Trough
In depression stage, the economy’s growth rate becomes negative.
There is further decline until the prices of factors, as well as the
demand and supply of goods and services, reach their lowest. The
economy eventually reaches the trough. This is the lowest it can go. It
is the negative saturation point for an economy. There is extensive
depletion of national income and expenditure.
#6 Recovery
After this stage, the economy comes to the stage of recovery. In this
phase, there is a turnaround from the trough and the economy starts
recovering from the negative growth rate. Demand starts to pick up
due to the lowest prices and consequently, supply starts reacting, too.
The economy develops a positive attitude towards investment and
employment and hence, production starts increasing. Employment
also begins to rise and due to the accumulated cash balances with the
bankers, lending also shows positive signals. In this phase, depreciated
capital is replaced by producers, leading to new investment in the
production process. Recovery continues until the economy returns to
steady growth levels. This completes one full business cycle of boom
and contraction. The extreme points are the peak and the trough.
Explanations by Economists
John Keynes explains the occurrence of business cycles as a result of
fluctuations in aggregate demand, which bring the economy to shortterm equilibriums that are different from a full employment
equilibrium. Keynesian models do not necessarily indicate periodic
business cycles but imply cyclical responses to shocks via multipliers.
The extent of these fluctuations depends on the levels of investment,
for it determines the level of aggregate output.
On the contrary, economists like Finn E. Kydland and Edward C.
Prescott, who are associated with the Chicago School of Economics,
challenge the Keynesian theories. They consider the fluctuations in the
growth of an economy not as a result of monetary shocks, but a result
of technology shocks, such as innovation. It is generally rejected by
mainstream economists who follow the path of Keynes.
Theory of Real Business
Cycles and Economic
Fluctuation
Theory of Real Business Cycles and Economic
Fluctuation!
Introduction:
Most Economists believe that the classical model cannot
explain the short- run economic fluctuations because in this
model prices are flexible.
However the new classical economists believe that the
classical model can explain the short-run economic
fluctuations. They believe that it is best to assume that prices
are flexible even in the short-run.
Almost all microeconomic analysis is based on the assumption
that prices adjust to clear markets. New classical economists
argue that macroeconomic analysis should be based on the
same assumption. The leading new classical explanation of
economic fluctuations is called the theory of real business
cycles.
According to this analysis, the assumption that have been
used for long-run may also apply for short-run study. Most
importantly, real-business-cycle theory holds that the
economy obeys the classical dichotomy nominal variables are
assumed not to influence real variables. To explain
fluctuations in real variables, real-business-cycle theory
emphasis real changes in the economy, such as changes in
fiscal policy and production technologies. This theory
excludes the nominal variables to explain economic
fluctuations.
Here we examine a simple theory of real business cycles.
A Review of the Economy under Flexible Prices:
The real-business-cycle theory is a new theory of fluctuations
which requires the IS-LM model, under the assumption of
flexibility of prices. We then modify it to develop a real model
of short-run fluctuations.
In the IS-LM model we used the following equations
for the goods and money markets:
Y = C (Y – T) + l(r) + G………….. IS
M/P = L(r, Y)…………. LM
The first equation is the IS equation, which states that income
Y is the sum of C, I, G consumption, depends on disposable
income (Y – T) investment depend on the real interest rate, r,
Govt. expenditure, G which is autonomous. The second
equation is the LM equation which states that the supply of
real money balances, M/P equals the demand, which is the
function of the interest rate and the level of income. For
simplicity we are assuming that expected inflation is zero, so
that, the nominal interest rate equals the real interest rate.
To analyse the short-run fluctuations with the IS-LM model,
we assume that price level is fixed. If prices are flexible, then
the price level adjusts so that output is at its natural rate: Y =
Y = F (K, L). These three equations determine three
endogenous variables: the level of output Y, the real interest
rate r, and the price level P.
Fig. 17.1 shows the equilibrium of the economy with flexible
prices. The level of output is at its natural rate y which is
determined by the supply of factors of production and the
production function. The interest rate is determined by the
intersection of the is curve and the vertical line y the natural
rate of output. The price level adjusts, so that the lm curve
crosses the intersection of the other two curves.
It may be noted that the LM curve is not very important here
as the prices are flexible and the price level adjusts to
equilibrate the money market where the other two curves
intersect. For the purpose of understanding the real variables,
such as output and interest rate, we can ignore the money
market.
The two key relationships under flexible prices can be shown
in Fig 17.2. These two relationships are real aggregate demand
and real aggregate supply. The is curve is called here the real
aggregate demand curve, which shows that the demand for
goods and services is a function of the interest rate Real
aggregate supply shows the supply of goods and services,
which is determined by the supply of factors of production
and the availability of technology.
In Fig. 17.2, the interest rate is on the vertical axis instead of
price level as we have already seen in the case of aggregate
demand and aggregate supply curves. In business-cycle
theory, we are interested in real variables and not nominal
variables, so the price level is unimportant. We are now
developing a different theory of economic fluctuations.
A Real-Business-Cycle Model:
We now turn our model of the economy under flexible prices
into a model of fluctuations. The new feature of the model is
the behaviour of labour supply. In a classical model the supply
of labour is fixed which determines the level of employment.
Yet employment fluctuates over the business cycle. II we
maintain classical assumption that labour market clears, as
new classical economists do, then we must examine what
causes fluctuations in the quantity of labour supplied.
After discussing the determinants of labour supply, we modify
classical model, aggregate income to include changes in
labour supply. The supply of output depends in part on the
supply of labour, which means that the greater the number of
hours people are willing to work, the more output the
economy can produce. We examine how various events
influence labour supply and aggregate income according to
real-business-cycle theory.
Inter-Temporal Substitution of Labour:
Real-business-cycle theory states that the quantity of labour
supplied depends on the incentives that workers receive at
any point in time. When workers are well rewarded, they wish
to work more hours, and vice versa. This willingness to
reallocate hours of work over time is called the inter-temporal
substitution of labour. For example, a second year college
student has two years summer vacations left before
graduation. He wishes to work for one of these summers and
to relax during the other summer. How should he choose
which summer to work?
Let W1 be his real wage in the first summer, and W2 the real
wage he expects in the second summer. Choosing which
summer to work means comparing these two wages. Since the
student can earn interest on money earned earlier, money
earned in the first summer is worth more than money earned
in the second summer.
Let r be the real interest rate. If the student works in the first
summer and saves his earnings, he will have (1 + r) W1 a year
later. If he works in the second summer, he will have W2. The
inter-temporal relative wage is (1 + r) W1/W2. Working in the
first summer is more attractive if the interest rate is high or if
the wage is high relative to wage expected to prevail in the
future.
According to real-business-cycle theory, all workers calculate
cost-benefit analysis to decide when to work and when to
enjoy leisure. If the wage is temporarily high or if the interest
rate is high, it is good time to work. If the wage is temporarily
low or if the interest rate is low, it is a good time to enjoy
leisure.
Real-business-cycle theory uses the inter-temporal
substitution of labour to explain why employment and output
fluctuate. Shocks to the economy that cause the interest rate
to rise or the wage rate to be temporarily high cause people to
want to work more—which raises employment and output.
Real Aggregate Demand and Real Aggregate
Supply:
Real-business-cycle theory incorporates inter-temporal
substitution of labour into the classical model of the economy.
Our analysis of labour supply shows that the interest rate
influences the attractiveness of working today.
The higher the interest rate, the greater the amount of labour
supplied, and the greater the amount of output produced. Fig.
17.3 shows the real-business-cycle model of the economy.
Because of inter-temporal substitution of labour, the real
aggregate supply curve slopes upward rather than vertically,
which means a higher interest rate makes working more
attractive, which increases labour supply and, thus, output.
The real interest rate adjusts to equilibrate real aggregate
supply and real aggregate demand. We can use this model to
explain fluctuations in output. Any shock to the economy that
shifts aggregate demand or aggregate supply changes
equilibrium output. Inter-temporal substitution of labour
leads to a corresponding change in the level of employment as
well.
To explain shifts in real aggregate demand and supply, realbusiness-cycle theorists have emphasised changes in fiscal
policy and in technology. We now examine these sources of
short-run fluctuations.
Fiscal Policy:
An increase in government purchases is shown in the realbusiness-cycle model. Fig. 17.4 shows an increase in
government purchases shifts the real aggregate demand curve
rightward. The result is higher output and a higher real
interest rate.
It may be noted that there are similarities between this
explanation of the effects of fiscal policy and the one we saw in
the IS-LM model. An increase in government purchases shifts
the real aggregate demand curve outwards for the same
reason that it shifts the IS curve outwards in the IS-LM
model. In both cases, the result is higher output and a higher
interest rate. Thus, the two models make similar predictions.
However, there are important differences between the two
explanations. In the IS-LM model, prices are stable, and
aggregate demand determines output and employment;
labour supply and inter-temporal substitution play no role in
explaining how fiscal policy influences output.
In a real-business-cycle model, prices are flexible, and
workers inter-temporally substitute labour. The expansion of
output results from an increase in labour supply; people
respond to the higher interest rate by choosing to work longer
hours.
Technology:
Many theorists emphasise the role of shocks in technology. To
see how technological shocks cause fluctuations, suppose
some improvements in technology are available, such as,
faster computers. According to this theory, this change affects
the economy in two ways.
Firstly, the improved technology increases the supply of goods
and services. As the production function is improved, more
output is produced for any given input. The real aggregate
supply curve shifts outwards.
Secondly the availability of the new technology rises the
demand for goods. For example, firms wishing to buy these
computers will raise their demand for goods. For example,
firms wishing to buy these computers will raise their demand
for investment goods. The real aggregate demand curve shifts
outwards as well.
Fig. 17.5 shows two effects. A beneficial shock to the
technology raises both real aggregate supply and real
aggregate demand. In Fig. 17.5(a), demand shifts more than
supply. In Fig. 17.5(b), demand shifts less than supply.
The Debate over Real-Business-Cycle Theory:
Economists disagree about the validity of real-business-cycle
theory.
At the heart of the debate are four basic issues:
(a) The importance of technology shocks.
(b) The interpretation of unemployment.
(c) The neutrality of money.
(d) The flexibility of wages and prices.
(a) The Importance of Technological Shocks:
Real-business-cycle theory assumes that the economy
experiences fluctuations in its ability to turn inputs into
outputs, and that these fluctuations in technology cause
fluctuations in output and employment. When the available
production technology improves, the economy produces more
output with the same inputs. Because of inter-temporal
substitution of labour, the improved technology also leads to
greater employment.
This theory often explains recessions as periods of technology
regress. According to this theory, output and employment fall
during recessions because the available production technology
deteriorates, which reduces output and the incentive to work.
Critics of this theory are sceptical that the economy
experiences large shocks in technology. It is common
knowledge that technological progress takes place gradually.
It is difficult to think that technology can regress. The
technological knowledge may slow down, but it is hard to
imagine that it would go into reverse.
Advocates respond by taking a broad view of shocks to
technology. They argue that there are many events that—
although not literally technological in nature—nevertheless,
affect the economy as much as technological shocks do. For
example, bad weather or increases in world oil prices have
effects similar to adverse changes in technology. Whether
such events are sufficiently common to explain the frequency
and magnitude of business cycles is open to question.
(b) The Interpretation of Unemployment:
Real-business-cycle theory assumes that fluctuations in
employment reflect changes in the amount people want to
work. Alternatively, it assumes that the economy is always on
the labour supply curve: everyone who wants a job at the
going wage rate can find one. To explain fluctuations in
employment, advocates of this theory argue that changes in
wage rates and interest rates cause inter-temporal
substitution of labour.
Critics of this theory believe that fluctuations in employment
do not reflect changes in the amount people want to work.
They do not think desired employment is very sensitive to real
wage and the real interest rate. They point out that
unemployment fluctuates substantially over the business
cycle.
The high unemployment in recessions suggests that the
labour market does not clear: if people were voluntarily
choosing not to work in recessions, they are not, in fact,
unemployed. These critics conclude that, wages do not adjust
to equilibrate labour demand and supply, as the realbusiness-cycle model assumes.
Advocates of this theory argue that unemployment statistics
are difficult to interpret. The mere fact that the
unemployment rate is high does not mean that inter-temporal
substitution of labour is unimportant. Individuals who
voluntarily choose not to work may call themselves
unemployed to received unemployment benefits.
Alternatively; they may call themselves unemployed because
they would be willing to work.
(c) The Neutrality of Money:
This theory assumes that money is neutral which means
monetary policy is assumed not to affect real variables, such
as output and employment. The neutrality of money not only
gives this theory its name, it is also the most radical feature of
the theory.
Critics point out that the evidence does not support the
assumption of neutrality of money. They argue that
reductions of money growth and inflation are always
associated with periods of high unemployment. Monetary
policy appears to have a strong influence on the real economy.
Advocates of the theory argue that their critics confuse the
direction of causation between money and output. They also
claim that money supply is endogenous: fluctuation in output
might cause fluctuations in money supply.
For example, when output rises—because of beneficial
technological shock— the quantity of money demanded rises.
The central bank may respond by raising money supply to
accommodate the greater demand. This endogenous response
of money to economic activity may give the illusion of nonneutrality of money.
(d) The Flexibility of Wages and Prices:
Real-business-cycle theory assumes that wages and prices
adjust quickly to clear markets. Proponents of this theory
believe that the stickiness of wages and prices is unimportant
for understanding economic fluctuations. They also believe
that the assumption of flexible prices is methodologically
superior to the assumption of sticky prices, because it ties
microeconomic theory to macroeconomic theory more closely.
Most of microeconomic analysis is based on the assumption
that prices adjust quickly to equate demand and supply.
Advocates of this theory believe that macroeconomists should
base the analysis on the same assumption. Critics argue that
money wages and prices are inflexible—which explains both
the existence of unemployment and monetary non-neutrality.
To explain stickiness of prices, they rely on the various new
Keynesian theories.
Conclusion:
Real-business-cycle theory reminds us that our understanding
of economic fluctuations is not good enough. Fundamental
questions about the economy remain open to dispute. Is the
stickiness of wages and prices a key to our understanding of
economic fluctuations? Does monetary policy have real effects?
The way economists answer these questions influence the way
they view the role of the economic policy. Those who believe
that wages and prices are sticky often believe that fiscal and
monetary policy should be used to try to stabilise the
economy. Price stickiness is a type of market imperfection,
which leaves open the possibility that government policies can
raise economic benefits.
By contrast, the theorists believe that the government’s ability
to stabilise the economy is limited. They view the business
cycle as the efficient and natural response of the economy to
technological changes. Most models of this theory do not
include any market imperfection and believe that the invisible
hand guides the economy to an optimal allocation of
resources. These two views of economic fluctuations are a
source of frequent and heated debate. It is this kind of debate
that makes macroeconomics an attractive field of study.