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Fluctuations in economic activity: there is only one cause

29 August, 2016John Hearn

For a whole economy to trend upward or downward, it is necessary to look at the aggregate demand side of the economy and that means looking at what is happening to the rate of growth of monetary demand.

For a hundred years or more there has been an unresolved debate over what causes fluctuations in economic activity. These fluctuations have been given different names often associated with the length and amplitude of the cycle. Some of the more quoted are:

• Trade cycle
• Business cycle
• Stop-go cycle
• Kondratiev cycle

Because these cycles are often observed in capitalist economies there is a mistaken belief that capitalism is the cause, or at least that these cycles are inevitable in a capitalist economy. I will suggest that the step from capitalism to cycles is a non-sequitur as all the individual participants in a capitalist system are much too small and insignificant to have anything other than a minimal effect on the overall level of economic activity.

Early theories related cyclical momentum to agricultural surpluses and shortages and more recently to a wider range of commodities that impose a supply shock on the economy. Psychological theories looked at business optimism and pessimism as a driver, while excessive investment, malinvestment and the volatility of invention, innovation and economic growth have all been considered. The cumulative nature of expansionary and contractionary forces were given further voice with the multiplier and accelerator effects described by Keynes. Political or voting cycles in democratic societies tended to mean that monetary and fiscal policies were overdone in the run-up to an election and these explanations are probably closer to the real cause of fluctuations in economic activity.

As has already been hinted, the cause of these fluctuations has to be something that drives the whole economy rather than just being a small component of that economy. Over the last few centuries trade has taken place using money. In the first instance this money had value in use and value in exchange. It was something that was generally acceptable, held its value and was portable, durable, divisible and relatively stable over time. Monetary metals like gold and silver fulfilled these characteristics and became acceptable as money across nations and between countries.

If we remove exceptional years, the real economy tends to grow at a relatively slow and steady rate so if we are looking for a source for instability in trade we need look no further than changes in the supply of money and its effect on aggregate monetary demand and the level of economic activity. Ideally the money supply and monetary demand need to grow at the same rate as the growth in output. This keeps prices stable and gives prices the opportunity to act as signals in the market place as relative prices change in response to consumer demand and resources are reallocated to reflect what consumers want.

Given this information, we need to analyse what happens if the money supply and monetary demand grow faster or slower than the rate of growth of output. Answer this and you have the peacetime source of disruption in economic activity. If the rate of monetary demand grows faster than the rate of growth of output, then all firms see an opportunity to raise price. This in turn increases profits and encourages firms to think about expanding production. The boom conditions are underway. But the condition is temporary as all firms start to compete for productive factors and costs start to rise, eroding the profits. This temporary distortion caused by a boost in aggregate demand is then reversed into recession conditions. Alternatively if aggregate monetary demand grows too slowly then prices fall, profits are squeezed and unemployment may start to rise as the recession takes hold. To grasp this fully it is necessary to understand the difference between changes in relative prices and changes in the average level of prices as well as how money illusion causes people to perceive nominal changes in price as real changes in price. This is best illustrated where the price of labour rises more slowly than the rate of inflation, meaning that real wages have fallen when people see a rise in their nominal wage.

In the nineteenth century the gold standard produced fluctuations in economic activity which coincided with significant discoveries of gold. Around the middle of the century gold was discovered in California and Australia and, as the name describes, gold rushes occurred causing the price of gold to fall and other prices to rise along with profits and output. Once these mines were exhausted then gold money grew more slowly than output and the boom conditions turned to recession as gold prices rose and other prices fell. These were, however, the ideal circumstances to go in search of more gold, and at the end of the century it was discovered in South Africa and boom conditions ensued once more.

The picture is different in the twentieth and twenty first century as fluctuations are no longer regular. Governments and central banks have taken control over the supply of money and monetary demand. Two large recessions, one in the UK after the 1st World War and one in the US after the Wall Street crash, were caused by monetary contractions. After the 2nd World War, fluctuations in the UK became a stop-go cycle which can be closely linked to Keynesian attempts to boost aggregate demand and the government`s need to maintain a fixed exchange rate. More precisely we had a go-stop cycle which fitted quite neatly into the election cycle: a boost to demand as we ran up to an election and a subsequent contraction as we tried to maintain the fixed rate of exchange. We did have to devalue from one fixed point to another in 1967 and gave up completely in 1972 when the currency was floated or, more precisely, sunk.

From 1972 until now there has been a disconnect between boom conditions and rising prices and slump conditions and falling prices. Rather we have seen boom conditions when inflation has not been anticipated and slump conditions when it has been anticipated and this has been made worse if the inflation has been ratcheted up to higher levels in a mistaken belief by Keynesians that aggregate demand was deficient.
The financial crisis of 2006/7 turned into a recession prolonged by a failure to manage monetary demand efficiently to achieve target inflation. With the failure of Lehman Bros, interbank markets froze and banks stopped commercial lending. Since then a mixture of quantitative easing and distortingly low interest rates has only managed to create the illusion of a boom as bubbles have developed in property and other asset prices.

In conclusion, supply side explanations of fluctuations in economic activity may have had some relevance to individual sectors of the economy like a region or an industry, but they do not explain what is happening to the economy as a whole. For a whole economy to trend upward or downward, it is necessary to look at the aggregate demand side of the economy and that means looking at what is happening to the rate of growth of monetary demand. When it is growing significantly quicker or slower than the rate of growth required to maintain stable prices, then fluctuations in economic activity will be initiated.

John Hearn is an author and lecturer at The London Institute of Banking & Finance. Learn more about out our undergraduate, postgraduate and professional qualifications.