11. Instruments of Economic Policy, Foreign Relations of an Economy
11.5. Business Cycles
The above sections gave a brief overview of the notions of growth and development.
In reality it is very rare that the real GDP per capita of a country would grow at the same rate for several decades. Everyday experience tells us, that shorter or longer periods of fast growth of GDP per capita are followed by slower growth, then growth may stop completely in times
of crises, or even turn to decline, then the whole process starts anew. Such cyclical fluctuations of economic performance are called business cycles.
Expansion is a period of rapid economic growth, reflected in the increasing value of output (GDP), recession is a period of economic slowdown, reflected in decline of the GDP.
Phases of expansion and recession follow each other periodically, while the economic performance, i.e. total output grows continuously in the long run. This repeated regular pattern of upward or downward swings around a long-term trend is called cyclical behaviour, so the periodical repetition of expansion and recession is called business cycle. The fluctuations are characterised by two properties: the length, and the magnitude of the phases;
the business cycle itself is the period between two successive phases of expansions (or recessions).
expansion
recession upturn, recovery slowdown
trend of growth
0 2 4 6 8 10 12 14
0 4 8 12 16
time
output
Figure 11.4:The Business Cycle
Source: Author’s own construction based on Meyer-Solt (1997)
Figure 11.4 illustrates the phases of the business cycle. The line with positive slope illustrates the trend of long-term growth of the output, the waving curve illustrates the actual pattern of output. The part of the curve increasing above the trend line is called expansion, which, reaching the peak, turns to slowdown, a decreasing period above the trend line. The decline continues below the trend line, and it is called recession. Reaching the trough (the deepest point of recession), the curve turns back to increase, starting the phase of upturn or recovery. The phase of recovery ends when output reaches the level of long-term trend, and then the process continues with expansion again (Meyer-Solt, 1997). In a somewhat simplified classification the term of recession is often used for the successive phases of slowdown and recession, and the successive phases of recovery and expansion are called expansion (Samuelson-Nordhaus, 1987).
Business cycles are classified by several aspects. A classification is made by the area of the economy where the fluctuations are experienced, describing financial cycles, agricultural cycles, investment cycles and general economic cycles. According to the length of the cycle seasonal fluctuations, classical business cycles, Kuznets-cycles, Kondratyev-cycles and super- long Kondratyev-cycles are known:
Seasonal fluctuations are cycles of a length less than one year, typically occurring in the area of finance.
The classical business cycles are of a few years length, like the hog-cycle known in agricultural production, or the Kitchin-cycle of 3-5 years length (occurring in
the financial and banking sector, and in the inventories), and the 8-10 year long Juglar-cycle.
Kuznets-cycles are of the length of 15-20 years, experienced in fixed capital formation, in the buildings and construction industry and in ship-building.
Kondratyev-cycles last for 40-60 years, experienced in the total output level of the national economy, and empirically visible in economic history, although their theoretical explanation is still insufficient.
Super-long cycles are the cycles of more than 100 (or even 150-200 ) year length, found in agricultural production, and also in the process of scientific and technological development.
The explanation for the emergence of classical business cycles is the disequilibrium of aggregate demand and aggregate supply (Samuelson-Nordhaus, 1987). When either a supply-side disturbance or a demand-supply-side one occurs, the equilibrium turns to disequilibrium and this leads to a cyclical fluctuation (Meyer-Solt, 1997). Due to an external shock aggregate demand suddenly increases, therefore output inventories suddenly decrease. As a response, producers start to increase production, employing more factors of production than before, providing more income to the owners of these productive resources. increasing the flow of income. The increased income will further increase aggregate demand. As production increases, employment will also increase (unemployment falls), and investments will also grow. These processes increase production still further, so a cumulative process is started, an expansion is experienced in the economy. Eventually the process will stop, because reaching the level of full employment the number of workers cannot be increased any more (this is called the peak of the cycle).
Therefore the growth of production starts to slow down, as well as the growth of incomes. In response to that, consumption will not grow any further, output inventories start to accumulate, and producers start to decrease investments. Producers start to decrease their output, as well as the number of employed workers, which leads to rising unemployment.
Consequently incomes also decrease, which further decreases consumption, and that again leads to decreasing production, investment and employment, starting again a cumulative process of recession, or crisis in the economy. During this process sooner or later output inventories clear up, and production must be re-started, therefore replacement investments have to be done (this is called the trough of the cycle). The re-starting of production leads to a slow increase of employment and incomes, and that initiates the process of recovery (upturn).
The temporal relationships of the components of the cycle are described below:
The following components change together with production (i.e. increase in expansion and decrease in recession): investments, employment, intended inventories, price level.
The following components change opposite to production (decrease in expansion and increase in recession): not intended inventories, unemployment.
Investments and aggregate demand change before the change in production.
Inventories and employment change after the change in production.
Cyclical behaviour may be induced by external and internal causes (Meyer-Solt, 1997; Samuelson-Nordhaus, 1987). External causes include social and political events, as wars, revolutions, or changes in the natural environment, as natural disasters, or exhaustion of some natural resources, while the most typical internal cause is the change in investments.
Economists disagree about the need and possibility of intervention in the business cycle. Unpredictable, irregular shock-like fluctuations are harmful for the economy, because the uncertain economic environment makes business decisions very hard, eventually leading
to slower economic growth. Other economists say, that a certain level of fluctuation is necessary in the economy, and trying to prevent it will cause a disturbance in the nature of economic processes, which is more harmful than beneficial.
The actual economic policy usually tries to diminish these fluctuations, thus the government often intervenes in the economy. The chapter on economic policy explained the instruments available for intervention, including fiscal and monetary policy, and other tools.
A crucial requirement for the success of intervention is the ability to predict the cyclical pattern in advance. The most popular method for such predictions is the analysis of economic time series that change before the change in production. The other option is the regular surveying of economic agents, and computing business confidence indices. However, the discussion of these tools go beyond the scope of the present textbook.
Review Questions
1) Describe the main tasks and functions of the state in the national economy, explain the concept of economic policy, and list the main policy approaches. Explain the meaning of fiscal and monetary policy.
2) Explain the structure of the government budget, and the meaning of budget surplus and budget deficit.
3) Describe the structure of the foreign balance of payments.
4) What indicators are used to measure the level of indebtedness of a country? What is the debt service ratio, and how can a country find itself in a debt trap?
5) What does the notion of economic growth mean, how can we measure it? What is development and how does it differ from growth?
6) What indicators are used to measure the welfare of a country, the quality of life of its inhabitants?
7) Describe the properties of business cycles, and classify them by their length.
8) Describe the process of the business cycle, explain its phases.
Problems and Questions to Develop Competence
1. Illustrate by the IS-LM model the impacts of the following events on the values of the interest rate, national income, consumption and investment:
a. The central bank increases the money supply.
b. The government increases its expenditures.
c. The government raises taxes.
d. The government increases its expenditure and the taxes by the same amount.
2. Assume that the government intends to increase investments, while keeping the level of output the same. Show in the IS-LM model the possible measures of monetary and fiscal policy that attain this aim.
3. Look for historical examples when the government decreased taxes and, as a result, run a high budget deficit.
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Glossary
Accounting costs: the annual costs of production that are legally allowed to account for in a profit-and-loss account. These include all the explicit costs and the accountable part of the implicit cost. Currently the only accountable implicit cost is depreciation.
Accounting profit: the difference of total sales revenoue and accounting costs.
Activity rate = number of the labour force /the number of the working-age population (%), it measures the proportion of adult propulation that is included in the labour supply.
Aggregate demand: the quantity of goods, that the economic agents (households, firms, and the government) desire to purchase at given prices. The aggregate demand curve (AD) is the aggregate demand plotted as the function of the price level.
Aggregate supply: the total quantity of output that the economic agents intend to produce and sell at given prices, productive capacities and costs. The aggregate supply curve (AS) is the aggregate supply plotted as a function of the price level.
Average Cost (AC): total cost per unit of output, AC=TC/Q.
Average fixed costs (AFC): total fixed cost per unit of output, AFC=FC/Q.
Average Product: The average product of labour, APL shows the average amount of output produced by each unit of labour: APL = Q/L. The average product of capital, APK shows the average amount of output produced by each unit of capital: APK = Q/K.
Average total costs (ATC ): ATC =TC/Q, the same as AC, average cost..
Average Variable Cost (AVC): total variable cost per unit of output, AVC=VC/Q.
Balanced budget of the government: the revenues and expenditures of the government are equal, no savings or deficit exist (i.e. the tax receipts are exactly equal to the sum of government expenditure and transfers).
Basic questions of economics: what to produce, how to produce, for whom to produce?
Bond: a (long-term) debt security that promises to pay fixed yield to maturity, making pre-defined payments periodically for a specified period of time.
Budget constraint (budget line): the set of all bundles of two goods that the consumer is able to purchase at given prices and income, assuming all the income is spent on these goods The formula for the budget constraint is: I = px × x + py × y, where I denotes the consumer’s income, x and y the amounts of the two purchased goods, px is the unit price of product x,, py is the unit price of y.
Budget deficit of the government: the sum of government expenditures and transfers is higher than the tax revenues of the government, the value of government saving is negative.
Budget surplus of the government: the revenues of the government (i.e. taxes) are higher than the sum of government expenditures and transfers, the value of government saving is positive.
Bureaucratic (centralised) coordination: the economy is directed by central plans and decisions, some economic agents are subordinate to others, the government directs the organisation of the economy by commands and prohibitions.
Business cycle: the periodic fluctuation of national output around its long-term trend, with phases of expansion and recession following each other; characterised by the length and the magnitude of the phases; the cycle itself is the period between two successive phases of expansions (or recessions).
Capital accumulation: the set of goods to be used for expanding productive resources. Capital accumulation is divided into two categories: investment goods and inventories.
Ceteris paribus: ‘assuming all else unchanged’ (Latin).
Common stock: represents a share of ownership in a corporation, with no maturity date, a claim on the earnings and assets of the corporation
Consumer Price Index (CPI): a price index, for which the basket of goods used in the calculation contains all the goods (products and services) that the people of the country purchase in the given year.
Consumption (C): the part of the income which the members of society spend on goods (products and services) to satisfy their wants.
Consumption Function: it is described as a linear function of the disposable income, by the formula:
C(Y) = C0 + Č×YDI , where C0 is called autonomous consumption, and, Č×YDI is consumption induced by increasing incomes, and Č is the marginal propensity to consume that shows the proportion of additional disposable income that is spent on consumption.
Cost-push inflation: a type of inflation that is related to the supply side, and is shown by the decrease of aggregate supply. Its main cause is the rising price of some factors of production
Costs of production: the money value of the resources utilised in the production process, equal to the sum of fixed and variable costs, TC=FC+VC.
Cross-price elasticity of demand: shows the percentage change of the demand for a commodity in response to a one percent change in the price of some other related commodity.
Current account: contains the current revenues and expenditures in the foreign balance of payments, consisting international flows of merchadise trade, trade in services, factor incomes and unilateral transfers..
Debt service ratio: the value of debt service compared to the receipts of the current account.
Debt service: interest payments on the loan, and the repayment of the principal itself.
Deflation: the decrease of the price level.
Demand function: it measures the demanded quantity of a product as a function of price, ceteris paribus, assuming that other factors remain constant. The demand curve is the graphical representation of the demand function, in the coordinate system of price and demanded quantity.
Demand side instruments: instruments of economic policy that affect aggregate demand, affecting either the goods market (the position of the IS curve) or the money market (the LM curve).
Demand: the buyers’ willingness and ability to purchase the goods, it shows the quantities of a particular good that the buyer is able and willing to buy at various prices.
Demand-pull inflation: caused by persistent rises in aggregate demand; the reason for it is a change in some factors affecting aggregate demand – either in the goods market, or in the money market.
Derived demand: it is a property of the demand for factors of production, the firm demands a quantity of some input if and only if consumers demand the output those resources are used to produce, so that the costs of the demanded resource and the revenues received by selling the output make profit for the producer
Development: a broader concept than growth, besides the increased capacity to produce consumption goods it also includes the opportunity to improve health care and education services, the level of infrastructure, cultural enrichment and extension of freedom widely available for the population.
Differential land rent: is the land rent that is defined by the quality differences of various lands. This land rent is further classified, defining fertility-related differential rent (because more fertile lands produce higher yields with the same costs) intensity-related differential rent (as additional resources will yield higher outputs in more fertile lands), and location-related differential rent (because location closer to markets decrease the costs of purchasing inputs and of selling the output).
Disposable income: the disposable income of the private sector is equal to the total macroeconomic income minus taxes plus transfers , YDI =Y - NTH+F =Y - TH+F + TRH+F .
Economic costs of production: are equal to accounting costs plus the opportunity costs..
Economic growth is an increase of the capacity of an economy to produce goods and services to satisfy the consumption demand of its population; it is measured by the annual growth of GDP as a percentage of GDP in the previous year.
Economic processes: movements of goods and money related to the production and consumption of goods, as well as the generation and distribution of incomes, during a year.
Economic profit is the total sales revenues minus economic costs, that is equal to the accounting profit minus opportunity costs (or normal profit).
Economy: the complexity of interactions and processes related to the production, distribution, exchange and consumption of material goods and services.
Employment rate = number of people employed/ number of adult (working age) population (%)
Engel curve: represents the relationship between the consumer’s income and the consumed amount of a
Engel curve: represents the relationship between the consumer’s income and the consumed amount of a