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The explanation of fluctuations in the business cycle

DEFINATION:

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession)

In 1946, economists Arthur F. Burns and Wesley C. Mitchell provided the now standard definition of business cycles in their book Measuring Business Cycles:

Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.

According to A. F. Burns:

Business cycles are not merely fluctuations in aggregate economic activity. The critical feature that distinguishes them from the commercial convulsions of earlier centuries or from the seasonal and other short term variations of our own age is that the fluctuations are widely diffused over the economy--its industry, its commercial dealings, and its tangles of finance.

Theory:

The first systematic exposition of periodic economic crises, in opposition to the existing theory of economic equilibrium, was the 1819 Nouveaux Principes d'économie politique by Jean Charles Léonard de Sismondi. Prior to that point classical economics had either denied the existence of business cycles, blamed them on external factors, notably war, or only studied the long term. Sismondi found vindication in the Panic of 1825, which was the first unarguably internal economic crisis, occurring in peacetime. Sismondi and his contemporary Robert Owen, who expressed similar but less systematic thoughts in 1817 Report to the Committee of the Association for the Relief of the Manufacturing Poor, both identified the cause of economic cycles as overproduction and underconsumption, caused in particular by wealth inequality. They advocated government intervention and socialism, respectively, as the solution. This work did not generate interest among classical economists, though underconsumption theory developed as a heterodox branch in economics until being systematized in Keynesian economics in the 1930s.

Classification by periods:

In 1860, French economist Clement Juglar identified the presence of economic cycles 8 to 11 years long, although he was cautious not to claim any rigid regularity.[4] Later, Austrian economist Joseph Schumpeter argued that a Juglar cycle has four stages:

expansion (increase in production and prices, low interests rates);

crisis (stock exchanges crash and multiple bankruptcies of firms occur)

recession (drops in prices and in output, high interests rates);

recovery (stocks recover because of the fall in prices and incomes).

In this model, recovery and prosperity are associated with increases in productivity, consumer confidence, aggregate demand, and prices.

In the mid-20th century, Schumpeter and others proposed a typology of business cycles according to their periodicity, so that a number of particular cycles were named after their discoverers or proposers:[5]

the Kitchin inventory cycle of 3–5 years (after Joseph Kitchin);[6]

the Juglar fixed investment cycle of 7–11 years (often identified as 'the' business cycle);

the Kuznets infrastructural investment cycle of 15–25 years (after Simon Kuznets);

the Kondratiev wave or long technological cycle of 45–60 years (after Nikolai Kondratiev).[7]

Interest in these different typologies of cycles has waned since the development of modern macroeconomics, which gives little support to the idea of regular periodic cycles

Occurrence:

There were frequent crises in Europe and America in the 19th and first half of the 20th century, specifically the period 1815–1939, starting from the end of the Napoleonic wars in 1815, which was immediately followed by the Post-Napoleonic depression in the United Kingdom (1815–30), and culminating in the Great Depression of 1929–39, which lead into World War II. See Financial crisis: 19th century for listing and details. The first of these crises not associated with a war was the Panic of 1825.

Business cycles in the OECD after World War II were generally more restrained than the earlier business cycles, particularly during the Golden Age of Capitalism (1945/50–1970s), and the period 1945–2008 did not experience a global downturn until the Late-2000s recession. Economic stabilization policy using fiscal policy and monetary policy appeared to have dampened the worst excesses of business cycles, and automatic stabilization due to the aspects of the government's budget also helped mitigate the cycle even without conscious action by policy-makers.

In this period the economic cycle – at least the problem of depressions – was twice declared dead; first in the late 1960s, when Phillips curve was seen as being able to steer the economy – which was followed by stagflation in the 1970s, which discredited the theory, secondly in the early 2000s, following the stability and growth in the 1980s and 1990s in what came to be known as The Great Moderation – which was followed by the Late-2000s recession. Notably, in 2003, Robert Lucas, in his presidential address to the American Economic Association, declared that the "central problem of depression-prevention [has] been solved, for all practical purposes."

Note however that various regions have experienced prolonged depressions, most dramatically the economic crisis in former Eastern Bloc countries following the end of the Soviet Union in 1991; for several of these countries the period 1989–2010 has been an ongoing depression, with real income still lower than in 1989.

Explanation of Buisness Fluctuation:

The explanation of fluctuations in aggregate economic activity is one of the primary concerns of macroeconomics. The main framework for explaining such fluctuations is Keynesian economics. In the Keynesian view, business cycles reflect the possibility that the economy may reach short-run equilibrium at levels below or above full employment. If the economy is operating with less than full employment, i.e., with high unemployment, Keynesian theory states that monetary policy and fiscal policy can have a positive role to play in smoothing the fluctuations of the business cycle.

There are a number of alternative heterodox economic theories of business cycles, largely associated with particular schools or theorists. There are also some divisions and alternative theories within mainstream economics, notably real business cycle theory and credit-based explanations such as debt deflation and the financial instability hypothesis

Keynesian

According to Keynesian economics, fluctuations in aggregate demand cause the economy to come to short run equilibrium at levels that are different from the full employment rate of output. These fluctuations express themselves as the observed business cycles. Keynesian models do not necessarily imply periodic business cycles. However, simple Keynesian models involving the interaction of the Keynesian multiplier and accelerator give rise to cyclical responses to initial shocks. Paul Samuelson's "oscillator model"[15] is supposed to account for business cycles thanks to the multiplier and the accelerator. The amplitude of the variations in economic output depends on the level of the investment, for investment determines the level of aggregate output (multiplier), and is determined by aggregate demand (accelerator).

In the Keynesian tradition, Richard Goodwin[citation needed] accounts for cycles in output by the distribution of income between business profits and workers wages. The fluctuations in wages are almost the same as in the level of employment (wage cycle lags one period behind the employment cycle), for when the economy is at high employment, workers are able to demand rises in wages, whereas in periods of high unemployment, wages tend to fall. According to Goodwin, when unemployment and business profits rise, the output rises

Credit/debt cycle

One alternative theory is that the primary cause of economic cycles is due to the credit cycle: the net expansion of credit (increase in private credit, equivalently debt, as a percentage of GDP) yields economic expansions, while the net contraction causes recessions, and if it persists, depressions. In particular, the bursting of speculative bubbles is seen as the proximate cause of depressions, and this theory places finance and banks at the center of the business cycle.

A primary theory in this vein is the debt deflation theory of Irving Fisher, which he proposed to explain the Great Depression. A more recent complementary theory is the Financial Instability Hypothesis of Hyman Minsky, and the credit theory of economic cycles is often associated with Post-Keynesian economics such as Steve Keen.

Post-Keynesian economist Hyman Minsky has proposed a explanation of cycles founded on fluctuations in credit, interest rates and financial frailty, called the Financial Instability Hypothesis. In an expansion period, interest rates are low and companies easily borrow money from banks to invest. Banks are not reluctant to grant them loans, because expanding economic activity allows business increasing cash flows and therefore they will be able to easily pay back the loans. This process leads to firms becoming excessively indebted, so that they stop investing, and the economy goes into recession.

While credit causes have not been a primary theory of the economic cycle within the mainstream, they have gained occasional mention, such as (Eckstein & Sinai 1986), cited approvingly by (Summers 1986).

Real business cycle theory

Within mainstream economics, Keynesian views have been challenged by real business cycle models in which fluctuations are due to technology shocks. This theory is most associated with Finn E. Kydland and Edward C. Prescott, and more generally the Chicago school of economics (freshwater economics). They consider that economic crisis and fluctuations cannot stem from a monetary shock, only from an external shock, such as an innovation.

There were great increases in productivity, industrial production and real per capita product throughout period from 1870-1890 that included the Long Depression and two other recessions.[16][17] See:Long depression#A profit depression with real growth There were also significant increases in productivity in the years leading up to the Great Depression. Both the Long and Great Depressions were characterized by overcapacity and market saturation.[18][19]

Over the period since the Industrial Revolution, technological progress has had a much larger effect on the economy than any fluctuations in credit or debt, the primary exception being the Great Depression, which caused a multi-year steep economic decline. The effect of technological progress can be seen by the purchasing power of an average hour's work, which has grown from $3 in 1900 to $22 in 1990, measured in 2010 dollars.[20] There were similar increases in real wages during the 19th century. See: Productivity improving technologies (historical) A table of innovations and long cycles can be seen at: Kondratiev wave#Modern modifications of Kondratiev theory

Carlota Perez blames "financial capital" for excess speculation, which she claims is likely to occur in the "frenzy" stage of a new technology, such as the 1998-2000 computer, internet, dot.com mania and bust. Perez also says excess speculation is likely to occur in the mature phase of a technological age.[21]

RBC theory has been categorically rejected by a number of mainstream economists in the Keynesian tradition, such as (Summers 1986) and Paul Krugman

Politically-based business cycle

Another set of models tries to derive the business cycle from political decisions. The partisan business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. Regime A adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high. The replacement, Regime B, adopts contractionary policies reducing inflation and growth, and the downwards swing of the cycle. It is voted out of office when unemployment is too high, being replaced by Party A.

The political business cycle is an alternative theory stating that when an administration of any hue is elected, it initially adopts a contractionary policy to reduce inflation and gain a reputation for economic competence. It then adopts an expansionary policy in the lead up to the next election, hoping to achieve simultaneously low inflation and unemployment on election day.[22]

The political business cycle theory is strongly linked to the name of Michał Kalecki[23] who argued that no democratic government under capitalism would allow the persistence of full employment [This sentence is confusing, and the reference given does not support this statement. Please clarify and correct the reference], so that recessions would be caused by political decisions. Persistent full employment would mean increasing workers' bargaining power to raise wages and to avoid doing unpaid labor, potentially hurting profitability. (He did not see this theory as applying under fascism, which would use direct force to destroy labor's power.) In recent years, proponents of the "electoral business cycle" theory have argued that incumbent politicians encourage prosperity before elections in order to ensure re-election—and make the citizens pay for it with recessions afterwards.

Henry George

Henry George's theory identifies land price fluctuations as the primary cause of most business cycles.[26] The theory is generally ignored in most of today's discussions of the subject[27] despite the fact that the two great economic contractions of the last 100 years (1929–1933 and 2008-??) both involved speculative real estate bubbles.

George observed that one of the factors that is absolutely necessary for all production — land — has an inherent tendency to rise in price on an exponential basis as the economy grows. The reason for this is that the quantity of land (the stock of locations and natural resources) is fixed, while its quality is improved due to improvements such as transportation infrastructures and economic development of the surroundings. Investors see this tendency as the economy grows and they buy land ahead of the boom areas, withholding it from use in order to take advantage of its increased value in the future. In every booming economy prices of land, housing and rents increase far more rapidly than the overall rate of inflation.[citation needed] Speculation in land concentrates profits in landholders and diverts economic resources to speculation in land, squeezing profits away from production that has to occur on this land.[citation

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