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Why Business Cycles Occur

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Published: Thu, 27 Apr 2017

This essay is about the detailed analysis of why business cycles occur. It outlines all factors which play a part in the occurrence of business cycles. The factors are, the fiscal policy where the government main controls two aspects, taxes and spending. The policy determines when it is necessary to reduce or increase taxes and when it is necessary to increase or reduce spending. Monetary policy, the role of the central banks in increasing the supply of money, when to reduce the supply and determining the interest rate of borrowing money. Aggregate demand and aggregate supply the effect they have in causing business cycles, the two establish the country’s Gross Domestic Product (GDP).The shocks in the supply of products can have effect in demand hence affecting the GDP. Business cycles have different stages which are expansion, peak, contraction or recession and trough or boom. These are all explained in detail and what they stand for.

Business cycles or economic cycles are the recurring and variable levels of economic doings that an economy experiences over a period of time. These fluctuations happen around a long-term growth trend, and involve changes over time between periods of comparatively rapid economic growth also known as boom or expansion, and periods of comparative stagnation also known as economic decline or contraction or commonly recession. Business cycles can be put into five stages which are growth (expansion), peak, recession (contraction), trough and recovery. While they are called cycles they do not specifically follow same pattern or a predictable cycle, they are measured by taking into account the growth rate of real gross domestic product this article looks into why these cycles occur.

Economic growth is like the growth of a human being, it shows large initial rates of growth over 100 per cent for babies the first year. As they get older, the rate of growth gradually falls off. At the approach of maturity the, rate of growth finally reaches zero as argued by Dewey and Dakin (2010, p. 1). During an economic expansion there is significant growth until it reaches peak. Governments today have a duty to control the rate of growth of the economy through a fiscal policy. The Peak of the economy this is when employment and the production of goods and services begins to level off. This is a concern to the government as the graphs start showing that the economy is heading for a contraction. At this point the government reverses the actions of the fiscal policy on a growing economy, by reducing taxes and increasing the government spending, for example building roads. ”A decrease in taxes has the opposite effect on income, demand, and GDP. It will boost all three, which is why people cry out for a tax cut when the economy is sluggish. When the government decreases taxes, disposable income increases. That translates to higher demand (spending) and increased production (GDP). So, the fiscal policy prescription for a sluggish economy and high unemployment is lower taxes”. (Gorman, 2011). Recession or contraction is normally the slowdown in economic action. Indicators of Macroeconomics show that bankruptcies and the unemployment rate are on the rise, while employment, inflation, investment spending, household income, business profits, and GDP fall. Trough is a stage of the economy’s business cycle that determines the end of a period of failing business activity and the shift to expansion.

Fiscal Policy, during the economic expansion we begin to see more people employed as companies start to sell more goods and services and require employing more people so they can keep up with the demand. As economic growth increase and more people are employed there will be more people spending their pay cheques which can cause prices to go up, something also called inflation. Because of this basis on price increase the government’s primary concern will generally be trying to maintain of keep prices constant and inflation in check without affecting economic growth. There is two major things they can do in regards to Fiscal Policy to try and keep prices in check and inflation at bay are: Raising taxes and reducing government spending, by raising taxes money is taken away from the consumer who now has a lesser amount of money to spend helping to counteract the demand that is pushing prices up and causing inflation. By raising or reducing taxes, the government significantly influence households’ level of disposable income. A tax raise will reduce disposable income, because it takes money away from households. Tax reduction will boost disposable income, because it gives households more money. Disposable income is the major aspect driving consumer demand, thereby accounting for two-thirds of entire demand.

To reduce economic growth and inflationary pressure, usually government raises taxes and maintain spending constant, or reduce spending and maintain taxes constant. To inspire growth and cut unemployment, the government can reduce taxes and maintain spending constant or raise spending and keep taxes stable. The government can follow its fiscal policy purpose more forcefully by concurrently changing both taxes and spending. For example, in a slow economy, the government could reduce taxes and boost spending at the same time. Each could be changed either by little amounts, so that neither taxes nor spending are changed too drastically, or by big amounts to deliver a stronger measure of fiscal stimulus. Which is the same, in an overheated economy, the government can raise taxes and reduce spending, if it wanted to reduce growth.

Monetary Policy is certainly one of the key elements which have a bearing in business cycles. Monetary policy is a process where monetary authority of any particular country has measures to control the money supply with particular focus on the interest rate to encourage economic expansion and stability. The main targets of monetary policy is to create a balance of three, stable prices, low unemployment and low inflation. The theory of monetary policy is centred on two aspects, expansionary and contractionary, which translate to a more rapid money supply and the slow money supply respectively. Expansionary policy is widely used to reduce unemployment during economic contraction or recession by lowering interest rate, which is a favourable move for business people as more lines of credit becomes available and at a low interest rate. Hence contractionary policy slows down the inflation to maintain the value of assets. Monetary policy focuses on the relationship between the rates of interest in an economy, which means the price which money is borrowed and the total money supply. It is the monetary police which regulate the outcome of the economic growth, unemployment, rates of exchange with other countries and inflation.

When the policy is termed contractionary it shrinks the size of the money supply or it increases it slowly it is also referred to contractionary if it raises interest rate. Expansionary policy decreases the interest rate or increase the money supply more rapidly. Monetary policies are described as , accommodative if the rate of interest set by the monetary authority is meant to create economic growth and neutral if it is intended neither to reduce inflation nor create growth or tight if it is meant to combat inflation

”The need for a framework that can help us understand the links between monetary policy and the aggregate performance on an economy seems self evidence. On the one hand, citizens of modern societies have a good reason to care about developments in inflation, employment and other economy wide variables, for those developments affect to an important degree people’s opportunities to maintain or improve their standard of living. On the other hand, monetary policy as conducted by central banks has an important role in shaping those macroeconomic developments, both at the national supranational levels. Changes in interest rates have a direct effect on the valuation of financial assets and their expected returns as well as on the consumption and investment decisions of households and firms. Those decisions can in turn have consequences for gross domestic product (GDP) growth, employment and inflation. It is thus not surprising that interest rate decisions made by the Federal Reserve System (Fed), the European Central Bank (ECB), or other prominent central banks around the world are given so much attention, not only by the market analysts and financial press but also by the general public. It would thus seem important to understand how those interest rate decisions ends up affecting the various measures of an economy s performance both nominal and real. A key goal of monetary theory is to provide us with an account of the mechanisms through which those effects arise. (Gali, 2008)

Aggregate demand and aggregate supply are some of the factors influencing the occurrence of business cycles (AD and AS).Aggregate demand is the total economic demand for services and goods produced at a particular time and level of their price. It is the demand for a country’s gross domestic product(GDP). The aggregate demand is usually represented by a downward sloping curve in a graph. Where the lower point represents lower prices and increasing demand. Aggregate supply is the total goods and services that companies are planning on selling during a given time. It is the total amount of goods and services that firms are willing to sell at a given price level in an economy. “We interpret fluctuations in GNP and unemployment as due to two types of disturbances: disturbances that have a permanent effect on output and disturbances that do not. We interpret the first as supply disturbances, the second as demand disturbances. We find that demand disturbances have a hump shaped effect on both output and unemployment; the effect peaks after a year and vanishes after two to five years. Up to a scale factor, the dynamic effect on unemployment of demand disturbances is a mirror image of that on output. The effect of supply disturbances on output increases steadily over time, to reach a peak after two years and a plateau after five years. ‘Favorab1e supply disturbances may initially increase unemployment. This is followed by a decline in unemployment, with a slow return over time to its original value. While this dynamic characterization is fairly sharp, the data are not as specific as to the relative contributions of demand and supply disturbances to output fluctuations. We find that the time series of demand-determined output fluctuations has peaks and troughs which coincide with most of the NBER troughs and peaks. But variance decompositions of output at various horizons giving the respective contributions of supply and demand disturbances are not precisely estimated. For instance, at a forecast horizon of four quarters, we find that, under alternative assumptions, the contribution of demand disturbances ranges from 40 to over 95 per cent” (Blanchard & Quah, 1990).

Dutt (2006) argues that aggregate demand and aggregate supply relate to establish the short run performance of the economy, but in the long run scrutiny of economic growth, aggregate demand normally make its exit and aggregate supply rules the branch. These theories imply that the rate of growth of per capita income in long run equilibrium mainly depends on supply side factors. They do not introduce aggregate demand into the analysis at all, assuming that the economy is always at full employment and that all saving is uniformly spent. Thus, for majority macroeconomists, aggregate demand is applicable only for the short run and in the study of cycles, but immaterial for the study of growth. The obvious reason for this is that the market system, in the form of flexible wages working all the way through assets markets, or government policies, solves the problems of unemployment and the variation of aggregate demand from aggregate supply in the longer run.

Traditional Keynesian description of the cyclical movements of inflation centred primarily on demand shocks .When the government increase spending it has always been believed to have a multiplier effects on consumption and output and enhanced aggregate demand will certainly generate inflation through the Phillips Curve and the increase in the rate of interest through the central bank’s monetary policy. “U.S. data appear to be consistent with this view: recent VAR studies suggest that consumption rises in response to a government spending shock, and that the Federal Funds Rate rises in response to the increase in output and inflation;1 moreover, the unconditional correlation between inflation and output is positive (0.33), and so is the correlation between nominal interest rates and output (0.35).2 Recent data from the Euro Area also appear to be consistent with the traditional Keynesian view: national inflation differentials are positively correlated with national growth differentials”. (Canzoneri, et al., 2006).The Real Business Cycle (RBC) model initially centres on productivity shocks. From the RBC s view productivity shocks compel fluctuations in output hence the cyclical actions of interest rates and inflation is the basic demonstration of a monetary policy that is irrelevant.The New Neoclassical Synthesis(NNS) challenged Keynesian theory, and stimulated the development of New Keynesian (NK) and Real Business Cycle (RBC) and it added monopolistic competition and actual inactivity to the RBC model to make a New Keynesian model in which both productivity shocks and demand shocks take part in a role in the cyclical movements of interest rates and inflation. In NNS models, demand shocks have a tendency to generate procyclical movements in interest rates and inflation, while productivity shocks have a tendency to generate countercyclical movements. The government policy targeting certain parts or individual parts of the economy especially markets, business and industries also known as microeconomic policy. When microeconomic policy is poorly planned or poorly implemented may cause business cycles to occur. The primary concern of microeconomic policy is promoting micro goals equity and efficiency.

To round it all up about business cycles, although they are called cycles they do not follow a particular trend or pattern as all the factors work independently from each other but their short comings have a significant impact on the economy. Fiscal policy plays an important part in keeping business cycles at check and in control as rapid economic growth needs to be slowed down. The economy that is sluggish needs boosting. Monetary policy plays a big part in the occurrence of business cycles, the control of money supply and interest rates to the economy. Aggregate supply and aggregate demand, production shocks have an impact on the gross domestic product which in turn will cause unpredictable occurrence in a business cycle.


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