Real, Not Monetary Shocks Drive Business Cycles – Business Essay

Real, Not Monetary Shocks Drive Business Cycles – Business Essay
A business, or trade cycle, is the term used to describe the tendency for recurring fluctuations in economic activity characterized by alternating periods of upward

and downward movements in the aggregate level of output and employment, relative to their long-term trends. The initial concept of business cycles is generally attributed to French physician Clement Juglar, who described the economic cycle in 1860 as ‘a recurring, if not necessarily uniform pattern.’ Since that time, a four-phase scheme has been used to describe fluctuations in business cycles: an upturn ends at an upper turning point (boom), followed by a downturn which leads to a lower turning point (recession) which is, in turn, followed by the next upturn (Fig. 1.1). Theories on the causes of business cycles have considered an array of possible factors yet neither theoretical nor empirical work has conclusively delineated the underlying causes for fluctuations. I intend to expound the theories and assess relevant evidence on behalf of both real and monetary shocks. I turn, I shall also comment on how the two schools of thought are implicitly tied to political policy and finally offer an answer as to which really drives business cycles.

Mainstream macroeconomists view recessions as a case of market failure. There are workers who would like to work but cannot because no one is willing to hire them. Their lack of income creates consumers who would like to spend but who cannot because they do not have the funds to do so. As a result, there are businesses that would like to produce and hire more workers, but cannot because there is not enough demand for final output. The circle is complete, and there is something not working properly. The traditional explanation for this situation was a failure of wages and prices to adjust quickly enough. A change in spending drives the economy away from equilibrium, but sticky wages and/or prices prevent rapid adjustment to a new equilibrium.

Real-business cycle theorists reject the above explanation based on the assumption that markets always clear. Hence wages and prices should not be sticky, but should adjust quickly. In essence, the central idea is that technical change is the most important kind of economic disturbance behind business fluctuations. This approach builds on the ideas of Joseph Schumpeter who held that capitalism is characterised by waves of “creative destruction” in which the continuous introduction of new technologies constantly drives existing firms our of business. When there is a temporary improvement in technology, this temporarily raises productivity. It follows that the real wage is also temporarily higher given that workers are paid their marginal product, which is equal to the real wage. Workers respond to the temporarily high wage rate by deciding to work harder while the real wage is high, and as a consequence, output rises.

Suppose that in some weeks you get paid $15 per hour, and in other weeks you only get paid $5 per hour. If one could choose how many hours a week to work, what kind of pattern would be expected? Though some people may choose to work the same in all weeks, most people would work longer in the higher-pay weeks and less in the lower-pay weeks. They will take their leisure in the lower-pay periods, and move their work to the higher pay periods. The real-business cycle suggests that this same pattern holds over longer periods. When there is a technological shock raising real wage, people will work more causing output to surge, and when there is a technological shock lowering real wage, people will withdraw from work, causing output to fall. This pattern is what we observe as booms and recessions. Clearly, real business cycle theory depends heavily on the ability of workers to alter the amount of labour and leisure time they choose at each point in time. This is called the inter-temporal substitution of labour, and it is one of the most controversial assumptions of real business cycles.

Many economists find the real-business cycle theory totally unbelievable. No one can observe the technological shocks that are at the heart of this explanation, and it strikes many as simply ridiculous to argue that the unemployment during a recession is voluntary. However, the evidence for the argument that real shocks drive business cycles may be found in cases of natural and artificial disasters. Natural disasters such as the tsunami in Asia and artificial disasters such as the terrorists attacks on September 11th 2001. The evidence that September 11th caused an immediate and continued downturn in the economy of the United States (and as a direct result the strength of the dollar) is undeniable. Likewise the economic effects on the affected areas in Asia are possibly even more extreme. Entire villages and towns have been entirely destroyed and consequently the economy is defunct. Herein lies the problem of talking about business cycles in general. It is clear from the examples above that a business cycle in the developed world means a very different thing to those countries in the early stages of economic advancement. However, both cases support the argument that real shocks are the primary force behind business cycles. In terms of policy implications real business cycle theorists are inclined to deny the powers of governments, through monetary and fiscal policy, to control the rate of economic growth.

In contrast those who believe that monetary shocks drive business cycles argue that it is indeed the government (or central bank) policies that can control the rate of growth. The target of monetary policy may be the achievement of a desired level or rate of growth in real activity, the price level, the exchange rate, or the balance of payments. In both the UK and the US policies have included setting the interest rate charged by the central bank, sales or purchases of securities to control the money supply, and changes in the required reserve ratios of banks and other financial institutions. Monetarism was drafted as a ‘revolution’ against the then orthodox Keynesian theory. In the early and mid-1960s, monetarism and Keynesian economics were regarded as distinct and probably irreconcilable explanations for business cycles.
Monetarists distinguish themselves from other economists by stressing the existence of a stable money-demand function. One implication is that the best way to stabilise the economy is to stabilise the rate of growth of the money supply at a low level. Assuming that output is determined exogenously (by the microeconomic supply decisions of households and businesses) so that Q can be taken as given, then the definition of velocity implies:
P = (M .V)/Q

If V is fairly stable, and Q is exogenous, the equation implies that changes in M translate into changes in the price level. Thus, monetarists stress that changes in M are the key to controlling the price level. They hold that money should be allowed to rise at a constant rate per year. Thus, controlling inflation becomes merely a problem of controlling M.

Monetarism is much more sceptical than Keynesian economics with regard to the need for, and efficacy of, stabilization policies. In order not to distort price signals, the government should make the supply of money stable and predictable. An independent central bank is helpful in achieving this goal. Friedman and Schwartz brought money back to the fore with the publication of their Monetary History of the U.S (1963). In this influential book, Friedman and Schwartz show that money and real aggregate production move together closely over the business cycle. Laidler’s model shows that the interplay between a Friedmanian accelerationist Phillips curve and the quantity equation is sufficient to generate business cycles in R. Frisch’s sense. According to Friedman and Schwartz much the same mechanisms potentially give rise to business cycles in the open economy with international trade in commodities and securities. They also posit that incorporating structural unemployment into the monetarist model does not affect the main results. The supply side determines average aggregate output and the interplay between supply and demand determines the fluctuations around this average level.

The theoretical positions of these two schools of thought converged to a widely shared macroeconomic consensus in the early 1970s that the average output level is determined by supply-side factors, while the demand side is an important determinant of the fluctuations of aggregate production about the average level.
The issue of whether monetary policy can be used to control business cycles is at the heart of the economic debate with regard to the European Monetary Union (EMU). Many believe that Gordon Brown’s view that Britain would be adversely affected economically by joining the Euro is the single largest factor as to why Britain remains a sovereign state. The argument revolves around the fact that monetary policy, if it is to have a controlling effect on an economy, is most effective when it is used to counteract localised shocks. It follows then that a single monetary policy for all EMU nations (with well-documented fundamental differences in the foundations of their respective economic status) would be less effective than implementing one specific to the UK.

In conclusion, and I think most modern macroeconomists would agree, that business cycles are clearly influenced by both real and monetary shocks. As I have shown, real shocks, can offer a more identifiable force behind business cycles and yet it could simultaneously be argued that the government’s monetary policy is the more constant, driving, factor. I believe that the government should take an active role in moderating the business cycle through stabilization policies. This is because, as research has shown, short-term business cycle fluctuations may have long-term effects on the economy. The persistence of long-term unemployment in European economies is a good example of how short-term fluctuations in output and employment can create serious long-term problems for the economy. I am inclined to agree with Boehm who states ‘there are both endogenous and exogenous causes of cycles and concludes that, while each cycle is distinct, there are also common elements to all business cycles.’ The implication is that any theory suggesting random elements as the main source of cycles is suspect. Since new classical theory postulates that cycles are caused by random monetary shocks and real business cycle theory places blame on technology shocks, both theories fail by Boehm’s criteria. Boehm concludes that an eclectic theory of the cycle is necessary and that continual monitoring is needed for stabilisation purposes.

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