QUESTIONS AND ANSWERS

BARRY HARRISON

1. Using the information in Figure 1 explain the conventional view of the business cycle.
2. What are the assumptions on which the conventional view of the business cycle is based and why might these assumptions be weak?
3. Explain the real business cycle theory and its implications for stabilisation policy.
4. What are the harmful effects of the business cycle implied in the conventional view and the beneficial effects of the business cycle implied in the real business cycle view?

1. Figure 1 shows changes in Gross Domestic Product (£m) at constant 1995 prices. In other words it shows the real changes in output that have occurred over the period using resources located within the borders of the UK. Until the early 1970s, periods of recession and expansion were hardly discernible from the general rise in output. There were relatively mild recessions in the early and late 1950s and in the mid 1960s. However, in the early 1970s there was a marked expansion of output and it is from this point that cyclical changes in output become more apparent. The conventional view of the trade cycle is that output expands or contracts as a result of autonomous changes in demand. In this view, usually referred to as the Keynesian view, output is demand driven and supply responds passively.
2. A major assumption of the conventional, or Keynesian, view of the business cycle is that deviations from trend changes in output persist because wages and prices are 'sticky'. This implies that wages and prices move upwards when demand is rising, but fail to fall when demand declines below trend. This is important because if wages and prices were flexible downwards they would fall so that any excess supply of labour would be eliminated and unemployment would disappear. However, there is growing evidence of real wage flexibility and in particular that, faced with job losses, workers are often prepared to accept a cut in nominal wages so as to preserve their jobs. The sticky price assumption of the Keynesian model might therefore be questionable, although many economists argue that it remains realistic and most certainly cannot be rejected.

   A second problem with the conventional view is its failure to adequately explain the emergence of stagflation, i.e. the coexistence of rising inflation and rising unemployment, towards the end of the 1960s and into the 1970s. Neither could the conventional view, with its emphasis on aggregate demand, adequately explain why inflation increased as a result of supply-side shocks such as the dramatic increases in the price of oil imposed by OPEC in the 1970s. Both of these events cast serious doubt on the conventional view as an explanation of the business cycle and led economists to question the assumptions on which this view is based and to search for alternative explanations of the business cycle.

3. As explained earlier, the conventional view of the business cycle is that it represents temporary movements around a long-term trend. This view of the business cycle cannot be rejected from the data we are given. However, neither can we reject the real business cycle view. The most striking feature of the real business cycle view is that fluctuations in GDP represent permanent adjustments rather than temporary fluctuations. The different views stem from differences in the causes of changes in economic activity.

   The Keynesian view is that the primary causes of changes in economic activity stem largely from changes in aggregate demand. In particular, random, temporary fluctuations in private sector investment and consumption spending are viewed as the primary cause of the business cycle. These demand-side fluctuations can be offset (or, through error, augmented) by temporary adjustments in demand-side policies and in particular by fiscal actions. Real business cycle theorists, on the other hand, emphasise the importance of supply-side factors as the cause of fluctuations in economic activity. They argue that there is no reason why such changes are necessarily temporary and instead argue that, by their very nature, they represent permanent adjustments to the economy. Major supply-side influences are changes in the skills possessed by the labour force and changes in technology. For example, in recent years the IT revolution has had a profound impact on production. Neither improvements in the skills possessed by the labour force nor improvements in technology are reversible and so there is no reason to believe that the impact of such changes is temporary. Similarly, the privatisation process has profoundly changed the productive potential of the supply side of the economy. Deregulation, in particular, by sweeping away many of the barriers to entry and other restrictions on competition, has had a major impact on the efficiency with which economies utilise their resources. Supply-side shocks, such as changes in the price of oil, might also have permanent effects on the supply side of the economy because of the changes in the techniques of production they induce.

   The real business cycle view seems simple enough. There is, nevertheless, a possible paradox. Changes in GDP are correlated with changes in investment and consumption, which is exactly what the conventional view suggests. The rationale is that an autonomous change in consumption and/or investment would generate an increase in real GDP. However, real business cycle theorists, with their roots in classical economics, argue that causation is from supply to demand, rather than from demand to supply. They suggest that upswings in the cycle are the result of an improvement in supply-side conditions that create profitable opportunities. In order to exploit these opportunities, entrepreneurs need to hire additional workers and invest in additional plant and capacity. As incomes rise, consumption rises, and so we observe an increase in output, employment, consumption and investment. However, increases in these aggregates are motivated by an improvement in supply-side conditions - not by an autonomous shift in aggregate demand. Similarly, downswings in the cycle are motivated by unfavourable changes in supply side conditions. One such change might be a rise in the price of oil, but relatively high rates of direct taxation might also stifle risk taking and initiative.

   Central to real business cycle view is the importance attached to changes in the real wage in inducing changes in employment which result in changes in production. In particular, a rise in the real wage persuades additional workers to accept offers of employment and a reduction in the real wage has exactly the opposite effect. One implication of real business cycle theory is that government stabilisation policies are unnecessary because the causes of the cycle have nothing to do with changes in aggregate demand. They further allege that, to the extent that markets allocate resources most efficiently, any government intervention to reallocate resources and so smooth the cycle must, by definition, result in a less efficient allocation of resources. Whether such a reallocation is desirable or not is, of course, a value judgement but from a resource allocation point of view, intervention creates waste.

4. The view that the business cycle is harmful for the economy has never been quantified and so it is difficult to be precise about the magnitude of the implied economic loss. However, losses might arise in two ways. In the first place unemployment represents a situation when the economy is operating below its productive potential. Output, which could have been produced from idle resources, has no opportunity cost and is lost forever. Furthermore, it is alleged that reducing the severity of the cycles might allow the economy to grow at a faster rate. One way in which this might happen is that stability might encourage confidence among entrepreneurs that returns on their investments will be more certain because unemployment will be lower and demand higher. To the extent that investment is encouraged, growth will be increased.