Effects of Business Cycles

Topics: Keynesian economics, Monetary policy, Macroeconomics Pages: 6 (1731 words) Published: October 20, 2008
In general the economy tends to experience different trends. These trends can be grouped as the business/trade cycle and may contain a boom, recession, depression and recovery. A business/trade cycle (see figure 1) is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real Gross Domestic Product (GDP) and other macroeconomic variables. Samuelson and Nordhaus (1998), defined it as ‘a swing in total national input, income and employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy’. These fluctuations in economic activity usually have implications on employment, consumption, business confidence, investment and output.

Theories and the nature and causes of business cycle fluctuations

The Keynesian Approach
This theory shows how the collaboration of multiplier and accelerator can lead to regular cycles in aggregate demand. The Keynesians believe that economic activity is generally unstable and is subject to inconsistent shocks, usually causing the economic fluctuations and are attributed to the changes in autonomous expenditures especially investment.

The Keynesian approach is pretty simple; higher investment will lead to a larger rise in income and output in the short run. This means that consumers will spend some of their income on consumption goods. This will give rise to further increase in expenditure. Ceteris paribus an initial rise in autonomous investment produces a more than proportionate rise in income. The rise in income will increase investment to meet the increase demand for output. The Keynesian also points out that as the economy is inconsistently unstable there is the need for government to intercede to make the economy stable when necessary.

The Monetarist Approach
This approach was developed by M. Friedman and A. J. Schwartz in their classic study A Monetary History of the United States, 1867-1960 (1963). The monetarist approach acclaims economic instability to fluctuations in the money supply swayed by the authorities. In such a situation the economy will return moderately back to the normal level of output and employment. They made it clear that the changes in the rate of monetary growth give rise to short term fluctuations in output and employment. Therefore in the long run, the trend rate of monetary growth only cause movements in the price level and other normal variables.

They also attributed business cycle to the expansion and contraction of money and credit. Their views were that monetary factors are the primary source of fluctuations in aggregate demand. They claimed to have established a strong correlation between changes in the money supply and changes in economic activity. However, major recessions have been associated with absolute declines in the money supply and minor recessions with the slowing of the rate of increase in the money supply below its long-term trend.

The New Classical Approach
Developed by Robert Lucas (1975), this theory points out unforeseen monetary shocks are the cause of business cycles. Lucas (1975) defined business cycles as ‘the serially correlated movements about trend of real output that are not explainable by movements in the availability of factors of production’. The equilibrium theory of this approach illustrate that economic agents react ideally to the prices they observe and markets continue to clear.

The approach is of the view that changes in monetary or fiscal policy can have effect on output and employment if they are unforeseen, for instance if the money supply is determined by the authorities according to a standard and the general public knows that the standard may base its behaviour and decisions making on the anticipated growth of the money supply.

Stages of the Business Cycle
Boom - This is the stage in the economy where there is high consumer spending and output...
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