As we have discussed in other tutorials, the government is constantly working to keep the
economy growing. However, economies often unpredictably shrink. While there are booms,
there are also busts. We call this a business cycle, or a period of macroeconomic expansion
followed by a period of contraction. At times, the business cycle can feel like
a rollercoaster due to how unpredictable it is. In this tutorial, we will look at what
drives business cycles and how economists try to prevent economies from shrinking.
When things are going well in life, we often don’t seem to notice, and this is also the case with
the economy. In fact, we don’t have many terms for when things are going right in an economy.
“Stable,” “growing,” and “secure” are perhaps three adjectives that could describe a “good”
economy. On the other hand, we have many terms for when things go wrong. Although definitions vary,
a recession is an economic contraction that lasts at least six months. In other words,
for six consecutive months, even as the population continues to increase, the economy
is smaller than it was before. A depression, on the other hand, is a really long and really
bad recession. The most famous depression in world history is the Great Depression,
which lasted from 1929 to around 1939, and had devastating effects. International trade went down
by more than 65%. One third of all banks failed. Unemployment in the United States got as high as
25%. And inflation increased substantially. One of the worst things that can happen in a
business cycle is stagflation. Stagflation is a recession combined with inflation. So people are
unable to find work or make higher wages while prices continue to steadily rise. Economists
first recognized stagflation during the 1970s when the Organization of Petroleum Exporting Countries,
or OPEC, issued an embargo against European and North American countries. This caused the global
price of oil to skyrocket, which then led to the increasing costs of other goods, and a rise in
unemployment. Governments greatly struggle with knowing how to properly respond to stagflation.
Economists use many tools in trying to predict business cycles, even though they are very
difficult to predict. The leading indicators are a set of important economic variables that yield
specific data. While we will go over many of these indicators in a future tutorial,
examples include gross domestic product, employment figures, the inflation rate,
and consumer spending. In the meantime, let’s focus on four main variables economists
have identified which drive business cycles: business investment, interest rates and credit,
consumer expectations, and external shocks. If businesses are not investing in their own growth,
economies tend to suffer. If they are, economies tend to thrive. If banks make it more difficult to
borrow money, economies tend to suffer. If they make it easier to borrow money, economies tend
to thrive. Consumer expectations can be the most difficult variable to interpret for economists.
While some things are more certain, like knowing that consumers are more likely to buy goods around
the holidays, other consumer expectations seem to come out of nowhere. Similarly,
an external shock is an unexpected event that dramatically changes an economy. A recent example
of an external shock is the COVID-19 pandemic. During the Great Depression, two prominent
economists arose who had sharply different views regarding how to interpret and respond
to business cycles. Those were Friedrich Hayek and John Maynard Keynes. While both feared the
boom and bust cycle, they developed different solutions. Hayek had more of a long-term focus,
while Keynes had more of a short-term focus. Hayek feared high inflation more than high unemployment,
and generally thought that government regulation of the economy did more harm than good. Hayek
believed that markets should be kept free, presuming that consumers are rational and act
in their own best interest. In this way, Hayek’s views were more in line with Adam Smith, a pioneer
in the field of economics who helped develop our current understanding. Most importantly,
Hayek believed an economy would be more stable if both production and savings increased.
Keynes, on the other hand, wanted governments to be much more proactive in their economies. Keynes
feared high unemployment more than high inflation, and generally thought that economic regulation is
good. He believed that the economy could be and should be steered by governments. Not only that,
he thought private businesses should be assisted by governments during recessions. Most
importantly, Keynes believed an economy would be more stable if demand increased. He thought fears
of both inflation and savings were overrated. Even today, there are two main schools of thought
when it comes to business cycles, tracing back to Hayek and Keynes. On Hayek’s side, we currently
have what’s known as supply-side economics, which is based on the idea that the supply
of goods drives the economy. On the other side, “Keynesian” economics argues that it is better
to encourage economic growth by increasinging aggregate demand. It’s worth emphasizing, however,
that the predominant school of thought today is the “Keynesian” perspective. In other words, most
economists are more preoccupied with increasing demand and getting consumers to spend their money
to keep the business cycle booming. However, as seen by prominent economists like Arthur Laffer,
supply-side economics is still influential. And that concludes an introduction to business cycles.