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Demand Theories of the Business Cycle

May 30, 2011

There are many explanations of the business cycle, but they can be categorized into two groups:

1. Supply Side – Theories that explain why production can become more difficult in certain periods.

2. Demand Side – Theories that explain why the rate of spending varies, and how to stabilize it.

Some, such as the Austrian Business Cycle Theory attempt to bridge the gap between the two.  The two most popular, Monetarism and Keynesianism are squarely in the “Demand Side” school of thought.  The Real Business Cycle Theory is an example of a supply side theory.

All demand theories of the business cycle have one thing in common: they all state that reductions in the total amount of spending in the economy are harmful.  They all focus on sticky prices, meaning some prices change more slowly than others.  If all prices, savings, wages and currency doubled overnight, nothing real in the economy would change.  Everyone could buy the same goods they could before, since they could pay for the higher prices with their higher wages and savings.  Since relative prices determine economic activity, sticky prices result in disequilibrium and potentially may cause recessions.  One example of a sticky price is wages.  People do not like it when their wages are cut.  They lose morale, which may lower productivity.  Firms frequently give their worker small raises, but almost never give them small wage cuts.  If firms face a decline in spending, they will lay workers off rather than cut everyone’s wage.  On the other hand, commodity prices are extremely flexible.  The price of iron or oil, for example, respond instantaneously to changes in supply and demand.

Because of the sticky price, quantities adjust more:

E = equilibrium, S = Sticky, 1 = Starting demand, 2 = ending demand
If demand decreases from Demand1 to Demand2, the price will fall to Pe and quanitity will fall to Qe. If prices are sticky, the price cannot change, so quantity will adjust to Qs.

A firm cannot easily estimate overall economic activity.  Early in a recession, they can only observe the demand for their own goods.  Imagine you are manager at a sporting goods store, and you notice that fewer people are buying bicycles, baseball gloves and other products you sell.  There could be many possibilities.  It could be a general recession, and all other businesses are also suffering or it could just be a relative demand shift, like if people decide they don’t like sports as much and just want to watch TV all day.   In a general recession, the correct response is to lower your prices.  Prices of inputs in equilibrium will fall in tandem and you will be able to maintain both employment and sales.  However, if the reason for the decline is industry specific and the reduction in demand is only relative, the correct response is to scale down your business.  Perhaps get a smaller store, scale down hours worked, fire employees and even declare bankruptcy and exit the industry altogether.

Graph: The Reduction in Spending in the 2008 Recession in the U.S.

Source: St. Louis Federal Reserve Bank

Another major cost of sticky prices is debt.  When a person or firm takes out a loan, they typically need to pay back a fixed nominal amount.  Their ability to repay the loan is based on their nominal income.  In any transaction, the buyer’s spending is the seller’s income.  If spending drops, so too does income and thus the overall ability of everyone in the economy to pay back their loans.  If their loans are not paid back, firms must enter bankruptcy, which is costly.  If a bank goes bankrupt, they must sell off their assets to pay back their creditors, which drives asset values down.  When the asset prices fall, people lower their spending even more in an attempt to rebuild their balance sheets.  While one person can do this, everyone cannot, since by lowering spending, they are lowering income.  Income then spirals down even further, causing deflation.   With asset prices dropping and the value of cash increasing, people then attempt to shift more of their savings into government currency and debt, which lowers investment spending.  One of the most important stylized facts of business cycles is that investment drops much further than day-to-day expenditures during recessions.

Sectoral Shifts

If the central bank does not accommodate  desire to increase their net savings, more deflation will occur.  Eventually, prices adjust enough to accomedate people’s desire to save in the form of currency and the economy can get back on its feet, but the process can be long and painful.

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