Justification of Business Cycles - Essay Example

Is policy makers' concern relating to business cycles justified Give reasons for your answer. What policies have traditionally been used to damp downthese cycles Business cycles, also known as economic cycles, consist of periodic fluctuations in economic activity concerning its long-term growth trend. A typical business cycle involves periodical shifts between rapid growth of productivity, recovery and prosperity, and periods of stagnation or decline. These fluctuations are usually measured by the real gross domestic product (GDP). One of the policy makers' main roles is to smooth out the business cycle and to reduce its fluctuations by narrowing the margin between the stages of growth and decline. The term "cycle" can be rather misleading as business cycles don't tend to repeat regularly in time. Most observers find that the length of a business cycle from peak to peak, or from bottom to bottom vary, so that cycles are not systematic in their regularity. In fact, economic history shows that no two cycles are alike. Some economists dispute the existence of real "cycles" and use the term "fluctuations" instead. Others see enough similarities between shifts in economy and claim that studying business cycles in detail is a powerful tool which can serve us to determine the current state of the economy. The key question concerning business cycles is whether or not similar mechanisms that generate recessions and booms in capitalist economies exist. Periods of stagnation are a great burden for society. Being painful for large majorities of workers who lose their jobs, they produce pressure on policy makers to try to smooth out the oscillations. A very important goal of Western civilization since the Great Depression has been to limit the dips. However, government intervention in the economy can be a risky business. For example, some of Herbert Hoover's reforms (including tax increases) are widely believed to have deepened the depression. Managing economic policy in order to reduce the negative side effects of business cycle bottoms is not an easy job in a society with a complex economy, even when the theory of Keynes is applied. According to some nineteenth-century advocates of communism, this is an insurmountable difficulty. For instance, Karl Marx claimed that the business cycle crises of the capitalistic economy were inevitable results of its operations. From this point of view, all that governments can do is to delay the inevitable economic crises and to hope that they will not appear during their stay in power. Even then, crisis could emerge in a different form, for example as severe, unexpected inflation or an increasing government deficit. Worse, by delaying a crisis, western governments are seen as making it more painful for their successors and more dramatic for the whole society. In addition to the wide-spread left-wing criticism, Neoclassical economists question the ability of Keynesian policies to manage an economy. Challenging the Phillips Curve Nobel Laureates such as Milton Friedman and Edmund Phelps argue that inflationary expectations negate the Phillips Curve in the long run. Their theory was supported by the stagflation of the 70's. Friedman claimed that all the Fed can do is to avoid large mistakes. He believes that the rapid contracting of the money supply in the face of the Stock Market Crash of 1929 was such a big mistake. It turned what would have been a recession into a great depression (Rothbard, 1975). That is why, good forecasts of the cyclical movements of the economy and especially of the turning points of a business cycle are critical to improve policy decisions. The means of monetary and fiscal policy can also help to smooth the cycle out. The Austrian School of economics does not accept the suggestion that business cycles are inherent features of an unregulated economy and seeks for their origins in governmental intervention in the money supply. Austrian School economists underline the role of interest rates as the price of investment capital, which stays in the base of every investment decision (Mises, 1983). In a free-market, unregulated economy, the interest rate reflects the actual time preferences of lenders and borrowers. Some call this the "natural" interest rate. Government control over the money supply through central banks disturbs the equilibrium and the interest rate no longer reflects the real supply of investment capital and respectively, the demand for it. Austrian School economists conclude that artificially low interest rates raise the demand for loans higher than the actual supply by willing lenders. On the other hand, if the interest rate is artificially pulled up, the opposite situation will occur. This leads investors to borrowing and investing either too much or too little in their long-term projects (Hayek, 1967). Austrian scholars see periodic recessions as necessary corrections after periods of credit expansion, when unprofitable investments are terminated, thus freeing capital for new investment. The Austrian economists also predict that artificially low interest rates, resulting in an increase in the supply of fiat credit, generate inflation, which obliges central banks to increase the credit supply even further, in order to maintain the artificially low interest rate, thus prolonging the economic boom and worsening the inevitable correction that follows. In Austrian theory, depressions and recessions are regarded as positive forces. They are considered as the market's innate, natural mechanism of undoing the misallocation of capital during the boom. Austrian School economists use the dot-com investment frenzy as a modern example of artificially stimulated credit for unsustainable overinvestment. In the Keynesian view, this Austrian theory provides that the natural rate of interest is unique at any given time and that it cannot be affected by policy makers. To Keynesian economists, however, this rate is only unique if the economy is at full employment. If the economy operates with less than full employment, then monetary policy and fiscal policy can play a positive role rather than simply creating booms that collapse on themselves in a consecutive order. It is important to say that, in the Austrian School, unemployment is typically attributed to government interference in labor markets, based on minimum wage laws, employment regulations, and taxes working against employers, which prevent the labor market from fully clearing (Roger, 1997). Milton Friedman has a very different point of view concerning business cycles and the possible means of their regulation. On a number of occasions he has stated that calling the business cycle a "cycle" is wrong, because of its non-cyclical nature. He claims that for the most part business declines are more of a monetary phenomenon, excluding very large supply shocks. Economic theory has recently moved towards the study of economic fluctuations rather than cycles. Yet, some economists still use the phrase 'business cycle' as a convenient shorthand. The theory of rational expectations states that no deterministic cycle is able to persist since it would consistently create arbitrage opportunities. Much of the modern economic theory also considers the economy to usually be at or close to equilibrium. These widespread views led to the formulation of the idea that economic fluctuations observed in the economy can be regarded as shocks to a system. Some scientist argue that modern business cycle theories often mislead by measuring growth using the real gross domestic product, which does not reflect well-being and can also generate distortions in the perception of economic grow because of the disproportional price changes of the various products. According to them, a mismatch is created between the state of economic health as perceived by society and that perceived by bankers, which drives them further apart politically (Skousen, 1990). However, excluding the issues of long-term economic growth, economists may be right to use real gross domestic product when studying business cycles. After all, it is fluctuations in real GDP, not those of personal perception of well-being, that cause shifts in unemployment, interest rates, and inflation. In other words, economic issues are the main concern of business cycle experts. References: Hayek, F. A. (1967) Prices and Production, Second edition. New York: Augustus M. Kelley, Publishers. Mises, L. von et al. (1983). The Austrian Theory of the Trade Cycle and Other Essays. Auburn, AL: The Ludwig von Mises Institute. Roger W. G. (1997). The Austrian Theory of the Business Cycle. New York: Garland Publishing Co. Rothbard, M. N. (1975). America's Great Depression, Third edition. Kansas City: Sheed and Ward, Inc. Skousen, M. (1990). The Structure of Production. New York: New York University Press. Read More