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and people experienced a welfare improvement. This issue is considered again in Chapter 9. (See exercise 5 at the end of this chapter to draw a conclusion regarding the welfare effects of growth.)

5.3.1EXPLANATIONS/CAUSES OF BUSINESS CYCLES

The question of what causes business cycles is of interest to economists since one of their challenges is to advise on how to increase real output. Because of the interdependent nature of the economic system, an economic shock could have adverse consequences on elements in the system that lead to the cyclical pattern observed in real output.

An economic shock is an unexpected event that affects the economy.

Some economic shocks affect one economy or a part of one economy more than other economies or other parts of an economy. Such shocks would be described as asymmetric shocks. For example, oil price shocks affect countries dependent on imported oil more than others and affect manufacturing firms more than services firms.

Central to the pattern of business cycles are people’s perceptions of what is happening in their local, domestic and international environments and their expectations of what will happen in the future. In terms of trying to identify specific causes of business cycles economists have put forward a number of possibilities but no single source can be identified. In fact some economists view business cycles as the efficient reaction of markets to new information or events somewhere in the economic system while others view them as a signal that markets are not operating efficiently.

Contractions and recessions may be caused by consumers, who fear a future downturn where unemployment will become a problem and who prefer to hold on to more of their income rather than to spend. In such circumstances a recession could arguably be caused by a change in demand or consumer expenditure. However, the ultimate cause would be the information that led to the initial change in demand. This could be because firms’ output becomes difficult to sell as it is too expensive and not competitive either at home or abroad (for export goods) and so firms cut back on production. Or maybe firms cut back on their investment expenditure because they are pessimistic about the demand for goods and services in the future (and hence their future profits) or because the loans they need to take out for investment are too expensive. Booms could be explained by opposite economic effects.

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Particular features of the nature of investment might serve to exacerbate business cycles. There is much evidence to indicate that much of the investment undertaken by individual firms is ‘lumpy’, meaning it is discrete and takes place occasionally rather than steadily. If different firms make their investments at the same time as others, investment activity will be decidedly cyclical. Rising productivity levels in firms may also drive investment since increases in current output will put upward pressure on the amount of capital equipment required to produce the output and on capital requiring replacement or renewal. As mentioned in Chapter 4, investment is the most volatile component of national income.

The explanation of cycles may also have some relationship to cycles in governments, which change regularly – every five years or so if no early elections are called – and often patterns of political business cycles are observed. Before elections there is a lot of evidence to indicate that incumbent governments try to present themselves in the best possible light with their electorate by announcing extra government spending, or tax cuts, or both which would boost economic activity. The new government must then deal with any pre-election spending, which might require cutbacks later, contributing to a cycle of economic activity.

Variation in the money supply in an economy represents another potential cause of business cycles. While the money market is discussed in detail in Chapter 7, what we can say here is that central banks’ decisions about how much money to supply to an economy has an effect on an economy’s interest rate (which is the price of money); and the interest rate, in turn, is assumed to feed into firms’ decisions about production and employment. An alternative view (of proponents of real business cycle theory) is that changes in money supply and interest rates are reactions to changes in output and/or employment. Real business cycle (RBC) theory is quite a recent approach to explaining business cycles.

Real business cycle theory is based on the view that changes in technology, long considered to provide an explanation for long-run economic growth (and expansion of the PPF), also explain business cycles.

The deterioration in technology that followed the oil price shocks of the 1970s meant that the standard production technology became substantially and unexpectedly more expensive over a short period of time due to increased energy costs.

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Such unexpected and adverse technology shocks change the decisions of

•firms that wish to cut back on costly production and attempt to pass on the price increases to customers;

•consumers who demand higher wages to compensate them for price increases and who plan to spend less when faced with such price increases;

•investors who reduce planned investment since they are pessimistic about a future of high energy prices.

Under such circumstances the market signals lead to reductions in employment, low wage increases (if any), and reduced investment. A positive technological change would have quite the opposite effects. Because of its technology-based approach, RBC theory offers a supply-side explanation for business cycles.

There are many similarities between the relatively new RBC theories and the creative destruction explanation of the economic system put forward by the Austrian economist Joseph Schumpeter (e.g. in 1911 and 1939). Schumpeter’s view of economic development centred on the role of the entrepreneur whose function in the economic system involved spontaneous and persistent (but irregular) introductions of innovations. Schumpeter linked the business cycle to the process of innovation in an economy. When inventors or entrepreneurs try to launch new products they often meet resistance but if a profitable opportunity is exploited imitation is likely with new variants of successful products being launched in imitation of successful first-movers. Production rises until the market becomes saturated and an economic downturn is experienced until the next wave of innovation and new products come along and the process repeats itself again. To fund such innovation requires the supply of credit to entrepreneurs, which highlights the role of the financial system in innovation and economic development. Entrepreneurs relying on bank loans are found in clusters within the economic system and as successful innovations emerge economies experience booms, while recession phases occur as the economy deals with creative destruction as described by Schumpeter (1975).

As we have seen in the preceding chapter, the contents of the labourer’s budget, say from 1760 to 1940, did not simply grow on unchanging lines but they underwent a process of qualitative change. Similarly, the history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening to the mechanized thing of today – linking up with elevators and railroads – is a history of revolutions. So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace to our own type of furnace, or the history of

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the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mailcoach to the airplane. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation – if I may use that biological term – that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. (Schumpeter, 1975, pp. 82–85)

An alternative view – that business cycles are indicative of markets failing to work–is attributed to John Maynard Keynes who wrote The General Theory of Employment Interest and Money (1936). Writing in the aftermath of the Great Depression of 1929–1932, the focus of Keynes’s work was on explaining how economies might in some circumstances be unable to prevent themselves from addressing the joint problems of low output and high unemployment and might need some intervention by governments to help them proceed and grow. Economists argue regarding which, if any, markets should be aided by government – goods markets where there may be insufficient competition, examined later in Chapter 6, or labour markets if wages are too high, examined in Chapter 8. There are also arguments that the financial sector through providing insufficient credit represents another example of market failure and any one or all three markets failing to operate as they should could provide an explanation for business cycles.

Economists have come a long way from the sunspot theory expounded in the nineteenth century by Jevons, who believed that storms on the sun, observed through telescopes as sunspots, caused crop failures. Since the nineteenth century economy was heavily organized around agricultural production, sunspots were considered an explanation for low production and recessions. Better harvests were associated with booms. This sunspot theory of business cycles had no basis in fact but since it was the initial focus on the question of what causes business cycles, it still receives economists’ attention. As Benjamin Franklin said, ‘A question is halfway to wisdom.’

To date, economists have come up with many theories, some of them competing, that provide explanations for business cycles. Despite the lack of agreement on any single cause, what economists appear to agree on is that people’s expectations of what will happen in the future (firms, consumers, government) underlie the pattern displayed in real output.