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Economics: Theoretical Explanations for Cycles


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  • Type: Video Tutorial
  • Length: 10:10
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 108 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Fluctuations: Unemployment & Inflation (18 lessons, $22.77)
Economics: The Business Cycle (2 lessons, $2.97)

In this economics video tutorial, you will learn about theoretical explanations for Cycles. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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We are left with the task of explaining this animal. How does an economy manage to expand, peak, contract, trough, and do so over and over, snaking upwards over time? What causes the economy to cycle like it does? Why doesn't it grow smoothly, and in an orderly fashion? Well, this is a matter of explaining the business cycle. Why does a business cycle occur? And, you know, there are almost as many different explanations for the business cycle as there are schools of thought about the economy. Let's look at some of the ways in which different economists have explained this process of boom and contraction.
We can start with Karl Marx, who believed that a lot of what happened in the economy was about conflict between labor and capital - that is, the wealthy people who owned the machines and the factors of the production, and the un-empowered workers who were at their mercy. Marx believed that what happened with capital tended towards overproducing goods, creating glut, then having to put the products on sale in order to get anyone to buy them, and that there were these lurches in the economy as we had periods of oversupply, followed by periods of shortage. And then of course it was always the workers who ended up being taken advantage of, because they suffered the brunt of these gluts through unemployment and other consequences. So in Marx's view of things, it was really about class conflict between capital and labor; and, unfortunately, the fact that the economy is unplanned, and is a wild organism, instead of an orderly garden, caused these cycles to be relatively severe. So Marx's prescription for the business cycle was: more planning - control this animal, restrain it, and make it follow an orderly path.
A second explanation for the business cycle is due to Joseph Schumpeter. Schumpeter's view of the world focuses on technology; and Schumpeter believed that the economy was driven by a process of creative destruction. That is, people came along with a new way of doing things, better products, better production methods, and anytime a new technology developed, it changed everything, and there was a period of disorder and chaos at the economy got used to the new methods of production. So we're doing fine with horses and buggies; along come automobiles, and with automobiles, new methods of mass production, which everyone then begins to imitate, no matter what kinds of goods they're producing. So the whole economy has to re-gear itself to mass production and factories; and with that, there is dislocation - there are booms, the boom eventually hits some kind of peak, and then there's a period of recession. So in Schumpeter's view, the long story is driven by technology, and the short story is the lurches - the starts, the stops - that result when people are trying to incorporate new technology into their own businesses, expand their operations with the new technology, or create new products whose opportunity is created by the new technology. So Schumpeter's view is that the business cycle is really driven by innovation; it is the byproduct of people's innovative, creatively destructive impulses.
Another explanation is Keynes's. Keynes believed that the business cycle could be muted by government spending; that is, people tended to save too much whenever they got scared, and their fear led them to save and not spend, which caused the economy to slow down and tip into a depression, or a recession. And the antidote, Keynes said, was for the government to spend on public goods like roads and bridges and schools. And if government spending increased to countervail the decrease in consumer spending, the business cycle could be evened out. Keynes's ideas were very influential in this country until the 1970s, whenever we wound up with a situation in which we had unemployment and inflation occurring simultaneously. Keynes doesn't do a very good job of explaining so-called stagflation, because in Keynes's view of the world, there's almost a tradeoff between unemployment and inflation. That is, whenever all the resources in the economy are employed, prices tend to rise through competition. But whenever there's unemployment, at least we had the advantage, then, of inflation being relatively less severe, because there's less demand for goods and services, and their prices are not pushed up so rapidly. But the important thing about Keynes's view of the world is that the economy is driven by demand. And if consumers don't demand enough stuff, then the government should step in and meet the gap. And if the government will do so, then the business cycle can be smoothed out.
Another explanation is what we call the new classical version. The new classical economists believe that the business cycle really is no problem at all; it's just the natural interplay of supply and demand. Sometimes the economy is going to boom, sometimes the economy is going to bust, but, well, that's just the way it is, that's the economy doing it's own thing. And, therefore, there's no need to mess with it. The prescription of the new classical economist is: Let the economic business cycle happen the way it wants to; that is, let's let the law of the jungle rule" - that any effort to govern this mechanism usually creates more trouble than it solves. So the new classical version says, keep your hands off; let nature take its course; let the interplay of supply and demand determine interest rates and prices and employment. The economy is going to evolve on its own; and maybe the best thing for the government to do is to focus its effort on the market failures - that is, providing public goods, providing education, providing infrastructure - things that are going to make economic agents more productive. But don't get in and try to run the business of the economy, because no one is strong enough to rule the jungle.
Another view of the business cycle is what we call so-called "real business cycles." With real business cycles, the economy is being driven by certain real factors - like the price of oil, like technology - and as these things change, their effects feed through the economy like shock waves. So if oil prices go up, that raises producer prices, which eventually raises consumer prices, which creates inflation, which causes the Fed to tighten the money supply, which leads to a recession. But it's real business cycles that the real effect is not due to any kind of mistake that people are making, it's just the natural course of things in the economy that occasionally pebbles will drop into the water, and shock waves will propagate across it. Real business cycles are driven by the fundamentals of the economy, and this is probably a helpful way for us to understand the economy as kind of a tightly strung instrument, and anything that touches it is going to create a resonance throughout the economy.
The final explanation that we'll consider is the monetarist explanation. And the monetarist explanation says that business cycles are caused, or at least worsened, by problems with the money supply, that the government makes credit easy to get, or the Central Bank lowers the interest rate by pumping a bunch of money into the banking system. Now we've got a boom - everybody wants to start a business, everybody wants to start a stock portfolio. They bid up the price of assets; then the Fed gets scared, tightens the money supply, interest rates go up, people sell their stocks. And the next thing you know, you've got prices falling again - that the booms and busts in the economy are due in large measure to poor management of monetary policy. And the view of strict monetarists is that if money is allowed to grow smoothly and not used as a very active policy instrument, but if money is allowed to be used smoothly, or to grow only in line with increases in the demand of money, than the business cycle will be less severe. But any effort to use money to actively manage the economy ends up accumulating problems that result in more severe booms and busts.
So which one of these explanations is right? Class conflict? Technology drive? Government spending? The law of the jungle? Oil prices and other real shocks? Or the management of the money supply? Well, of course, the truth is that every one of these elements probably plays some role in the booms and busts in our economy. The more common sense version, the conventional wisdom version of the business cycle that you read in the business press, has elements of all of these. And as you think about the most recent boom in the U.S., some of the things that are cited are: Technology has improved, which is changing what we produce and how we produce it; that labor unions have been held at bay by the fact that capital is in ascendancy right now because of the importance of information technology; we have this reduction in the national debt because we are running a relatively small deficit, or in recent years even a surplus in the government budget; and the fact that the economy is growing very, very rapidly - we've got a kind of free-feeling entrepreneurial culture right now that encourages business development and new job creation. The money supply has been growing pretty rapidly if you actually look at the numbers, but economic activity has been increasing; so perhaps the increased money supply is justified by the increase in money demand. And finally, oil prices and other commodity prices have been low until recently. And now the increase in those commodity prices is causing some analysts to be concerned that we may be headed for the peak.
Who knows? Stay tuned, and find out what happens to the most recent expansion in the U.S. economy. But, in the meantime, understand that there are a lot of different explanations to account for the business cycle, and we'll hear elements of them in many of the studies that we do as we try to unpack the business and make predictions about what happens next.
Economic Fluctuations: Unemployment and Inflation
The Business Cycle
Theoretical Explainations for Cycles Page [2 of 2]

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