Download Zarnowitz, Victor. Business Cycles Observed and Assessed

Omar Saucedo
4/16/08
Business Cycles
Business cycles are a product of capitalism and have been around since before the economic crisis
of 1825. The early explanations to business cycles began to form back in the 1800’s, but many of these
early explanations were unjustified and did foresee to the real problem at hand. Inevitably, the early
accounts of the phenomenon were crude and superficial. The problem, however, did not vanish. Each
reoccurring crisis commanded more and more attention, which gave rise to a new crop of ill-considered
explanations.
One of the earliest explanations of crises was the theory of “inflation”. The basis for this theory is
that an increase in coin or paper money issued by the government causes an increase in prices, that later
stimulates the business activity in the economy. This activity can cause extreme recklessness, which can
prompt it to produce feverish speculation, potentially leading to a crash in credit and widespread
bankruptcy. One of the first economists to argue the importance of inflation was David Ricardo. He
advanced the policy that money should be backed by gold, so the reckless printing of money by
governments would not occur. This policy was successful in many countries in the 1900 th century when
countries adhered to a gold standard.
Afterwards came the “overproduction” and “under-consumption” theories proposed by Karl Marx.
These theories explain that the efficiency of modern machinery, the power of society to produce has
outstripped its power to consume. Thus, we have the occurrence of what Malthus called a “general glut”.
Employers are unable to sell their increasing output of goods at remunerative prices, therefore they are
forced to close down and turn away their labor, who then have even less power to purchase the goods at
hand. These activities lead to crisis, which would eventually lead to the fall of capitalism.
The classical economists believed the theory of overproduction to be heresy. They believed
strongly in the principle of Say’s Law, which contented that there would never be overproduction, since the
supply of goods constituted its own demand. Their theories for explaining cycles were on the views of
sinking of capital in unprofitable investments. These unprofitable investments would impede the
accumulation of capital and the reinvestment that would occur with it. This would result in the loss of
confidence in the short run, and a crisis that would extend into the economy as a whole.
Moving on from the classical economists to the modern era, there are two points on which are
generally agreed upon. No longer are crises treated as sudden catastrophic events that interrupt the normal
course of business. On the contrary, they are treated as the most dramatic and briefest of three phases:
prosperity, crisis, and depression. The theory of crisis is what has grown into the theory of business cycles.
Recent models stress outside factors and random shocks. In an ideal world under assumptions of perfect
competition, flexible prices, rational expectations, money neutrality, real business cycles due to shocks to
technology are possible and perhaps also shocks to tastes, relative prices, and fiscal variables. Thus we
have the core of the Real Business Cycle Theory proposed by Prescott and Kydland, in which shock are
manifested and introduced to the economy.
In the real world, there is evidence that many sticky prices and wages coexist with many flexible
prices and wages. “Movements in levels of prices can be stabilizing even while movements in expected
changes of prices are destabilizing. Cyclical movements in nominal aggregates point to the role of money.
The premise of passive money clashes with the view that monetary policy is very important” (Zarnowitz).
This is the basis in which Milton Friedman built his engine that challenged historical viewpoints.
History shows us that monetary policies play a role in economic activity, as well with real and
expectational variables. Of these variables, profits, investment, interest rates, money and credit have
proven to be important variables throughout history. “Leads and lags, nonlinearities and asymmetries also
had demonstrably eminent roles, which they retain” (Zarnowitz). What we can derive from this is that
recessions have high social costs in terms of unemployment and depressed growth. On the other hand,
expansions can also be costly by causing imbalances and excesses. Structural and policy problems may
seem to be separable from these cyclical problems but often are not. Thus, we have the question in whether
the government should intervene or should it stay neutral and let the economy sort out itself.
There have been many economists who came before John Maynard Keynes who felt that
government involvement in commerce only impeded what would happen naturally, but the wisdom and
revelation of Keynes and the occurrence of the Great Depression would change the opinions of economics
as a whole. The General Theory views of given prices and wages income determine demand to form his
core argument, that prices and wages are sticky and establish the interaction of "aggregate demand" and
"aggregate supply" may lead to unemployment. The General Theory also suggested that inflation creeps
only near a state of "full employment". This was observed in the U.S. right before the bubble bursted and
Omar Saucedo
4/16/08
the stock market crashed in 1929. It was also Keynes who suggested that in order to get the economy
moving again, government intervention was necessary. He believed that it was the role of the government
to step in where the private sector had failed. This can be seen to be manifestation of the public work
projects that were imposed by Franklin Roosevelt.
To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem that
encouraged recession or even depression. . Excessive saving results if investment falls, this could be due to
falling consumer demand, over-investment in earlier years, or pessimistic business expectations. Keynes
believed that saving and investment are not the main determinants of interest rates, especially in the short
run. Instead, the supply of and the demand for the stock of money determine interest rates in the short run.
Keynes suggests saving involves not spending all of one's income. Also, a fall in income may end
excessive saving, allowing markets to attain equilibrium. However, instead of interest-rate adjustment
solving the problem, a recession does so. Keynes was also more concerned with problems in the short run
rather than waiting for market forces to do it in the long run, because "in the long run, we are all dead”.
On the other side of the spectrum is Milton Friedman, who opposed the Keynesian view of
government intervention of being instrumental to correct business cycles. Many times government
intervention was more destructive than beneficial. There is also the issue that there is usually a lag between
government policy and a reaction from the economic sector, so many times an over anxious
government/policy might not have the desired effect and more adjustments will be made. When the policy
finally does have the effect that it was originally intended, the over-adjusted fiscal policies might reek
havoc on the economy. Friedman has stated numerous times that calling the business cycle a "cycle" is a
false representation because of its non-cyclical nature. He believes that for the most business declines are
more of a monetary phenomenon. While the Keynesian approach to explain cycles dealt with investment,
Friedman took the monetarist approach for his search of an explanation.
The curious fact about the stock of money is that it is tends to rise during both expansions and
contraction. Due do the fact of the strong upward trend of the stock of money, it tends to dominate its
cyclical nature. A close look at the trends of money during a cycle reveals to us that there is a fairly close
connection between the magnitude of monetary changes during the course of a cycle, and the magnitude of
cyclical movement in business. In addition, velocity can also play an important role in the cyclical nature
of the economy. The (MV=PY) velocity of money rises during expansion and falls during contraction. By
understanding how velocity mitigates the actions of the Fed in the long run and in the short run, we can
gain a better understanding of the value of money and inflation. Friedman was correct in that there is a
stable link between inflation and the money supply, and that the stock of money displays a systematic
cyclical behavior. Money is much more closely correlated with cycles than investment and the Keynesian
explanation for cycles was surpassed.
We have gone through time to try to understand the evolution of the explanation of the
phenomenon known as business cycles. We can conclude from the research above that cycles will happen
and that money is a determinant of cyclical behavior. We also know that in times of extreme shocks, the
Fed must step in and mitigate the situation before it turns into a devastating event such as the Great
Depression of the 1920s.We also know that over anxious policies will have a devastating effect just as
much as no policies at all. Shocks are bound to happen and even though Friedman proposed eliminating
cyclical monetary mischief eliminates cycles, this has not happened. The real business cycle theory, which
was proposed by Prescott and Kydland, does take into account production shocks, and thus they have the
last word. Shocks are due to innovation and other externalities that occur naturally such as bad weather.
Now, these shocks may be temporary or long term but it cannot be denied that they do occur. All in all,
cycles are a product of capitalism and cannot be eliminated.
References
Friedman, Milton and Schwartz, Anna J. Money and Business Cycles. University of
Chicago and
National Bureau of Economic Research. The Review of Economics and Statistics, Vol. 45, No. 1,
Part 2, Supplement (Feb., 1963)
Mitchell, Wesley C. Business Cycles. Burt Franklin Publishers, New York (1970)
Zarnowitz, Victor. Business Cycles Observed and Assessed: Why and How They Matter.
Omar Saucedo
4/16/08