Business Cycle Theory

Ever since booms and depressions began, people have been trying to figure out why they occur. Professional economists have worked out a variety of theories. Businessmen, financiers, labor leaders, and the man in the street have their business-cycle theories too. The man who says, “The bigger the boom, the bigger the bust!” has an implicit theory about how booms and busts are related. The man who says, “What goes up must come down!” also has at least a partial theory about the relation of booms and depressions.

Different writers have emphasized everything from sun spots to Wall Street as the primary cause of booms and depressions. A theory that seems to explain all business cycles simply and neatly is heady stuff. But alas, no one has come up with one simple theory that does in fact explain all our fluctuations. However, there is widespread agreement on a central analytical framework for looking at the dynamically interacting variables.

This framework is provided by Chapters 5 to 8. It suggests that we should focus on changes in aggregate demand relative to the economy’s growing productive capacity. Aggregate demand is made up of consumption and investment spending (if we temporarily ignore government spending), and these in turn are influenced by the supply of money and interest rates. Booms are dynamic, cumulative, interacting processes in which increased investment stimulates more consumption, which in turn raises business sales and profits, and stimulates more investment. Similarly, recessions are cumulating downward processes in which the dynamic interaction between contracting consumption and contracting investment is the core of the contraction. In both, expansions and contractions of the money stock may play an important role.

We shall, therefore, focus on these three major variables (consumption, investment, and money) and on their dynamic interactions—both because this approach provides a relatively simple framework and because it is the way most economists themselves go about explaining complex real-world economic fluctuations. In essence, we shall use a simple theoretical model with three main relationships, temporarily omitting government.

1. The level of g.n.p. at any time is primarily determined by the level of private investment and a multiplier whose size depends on the total leakages (saving) in the system.

2. Investment in any period is partly a function of income and consumption in the preceding period; thus there is a “feedback” effect of consumption on investment as well as a causal link from investment to income and consumption.

3. Changes in the supply of and demand for money also affect the equilibrium toward which the system moves at any time. It is the dynamic interaction among these three, sometimes strongly affected by random shocks such as wars, that is the essence of “business cycles.”

THE CUMULATIVE UPSWING

Let us begin with an economy recovering from a recession. Assume that something happens to start an upswing. Then we shall trace through its progress. This stimulus leads to prosperity, and then to a downturn, which in turn is followed by a recession, possibly by a full-fledged depression. In examining the upswing, note how each expansive factor gradually develops self-limiting tendencies, which increasingly act to put a ceiling on the prosperity and to turn the economy down into recession.

Rising Consumption

Rising Consumption Through the Multiplier. To begin, assume that for some reason investment spending increases, perhaps because a new product or machine is invented. This new investment spending will generate a multiplied amount of income and consumer spending, through the multiplier. Just how much consumption rises for each dollar of new investment depends, of course, on the “leakages” through saving in each round of spending. Apparently a multiplier of 2 to 3 is approximately accurate for the American economy; remember, it’s the relation of consumption spending to g.n.p., not to disposable personal income, that provides the relevant multiplier for explaining g.n.p.

The consumption/disposable-income ratio tends to be high in bad times. At the bottom of a depression, consumption may be nearly 100 per cent of disposable income; if the marginal propensity to consume is similarly high, the multiplier will be large. As incomes rise into prosperity, though, the marginal propensity to save typically rises, reducing the multiplier on each additional investment dollar. Whatever the exact marginal propensity to consume, it is rising incomes that are the main foundation for rising consumption spending in the upswing. Consumption spending rises primarily because incomes rise; consumption plays a relatively passive role in the upswing.

Other Inducements to Rising Consumption. As the economy comes out of a depression, more spendable income is the only thing likely to give a major boost to consumption spending. But if the revival takes hold, there are three additional special factors that may increase the marginal propensity to consume, pushing towards a larger multiplier.

First, consumers may have a backlog demand for consumer durables refrigerators, stoves, autos, and radios—piled up from the depression. You can use the same refrigerator a long time if you’re good at minor repairs and don’t mind foregoing the latest improvements, but you’re not likely to be very happy about it. And try as you will to avoid it, the day will come when you have to buy another refrigerator or have the food spoil in hot weather. The postponement of purchases of durable goods is one reason depressions last. Catching up on these postponed purchases is one of the big lifts in revival. Second, as revival moves along and prices begin to rise, consumers may begin to expect still higher prices ahead. Expectations of rising prices generally speed consumer buying, but this is a boost we can’t count on with any confidence until the upswing is well under way.

Third, as times improve consumer credit may become more readily available to marginal borrowers. Such credit permits consumers to spend more in relation to current income than they otherwise might.

These three special boosts may come into play simultaneously, separately, or not at all in the upswing. The first is likely to be strongest early in revival and then gradually weaken as revival sweeps upward. The second is unpredictable, but it is most likely after the boom is in full swing and rising prices are widespeard. The third depends on the behavior of lenders, and ultimately of the monetary authorities. Easy~ loans to consumers are most likely to come with improving expectations and rosy hopes.

But remember: Rising consumption in the upswing depends largely on rising incomes, and thus indirectly on rising investment.