A Keynesian Understanding of the Business Cycles

All of us have come across words like ‘recession’, ‘upswing’, ‘boom’, etc. in the newspapers at some point of time. All these words speak about how the economy is moving—whether it’s expanding or contracting. These terms together form the cyclical patterns which are called the business cycles or the trade cycles. They refer to the inherent tendency of economies to undergo ups and downs in regular patterns.

There are 4 phases to business cycles. They are—expansion, peak, contraction and trough. An expanding economy continues to move upwards until it reaches the maximum, which is called the peak. Once the peak is reached, the economy cannot expand any further and starts to contract. This contraction or recession continues until the economy reaches its trough or the lowest point, beyond which it cannot fall further. It therefore, begins to revive and expand. This cyclical pattern can take up to 2 to 12 years for each stage, meaning that one cycle is spread across long periods of time and does not have a fixed time period.

These cyclical patterns are bound to create disruptions in the economy. It can create wide-scale unemployment, inflation and disruption in the growth of the economy in such a way that it can lead to severe problems for the economy. One such recession was the 2008 global recession that affected most parts of the world, and many economies still experience some of the effects that it had created for them. This makes it important to understand why these cycles occur and how one can manage them.

A widely discussed theory is that which is given by J.M.Keynes, a prominent economist who made his theoretical advances during the Great Depression of 1929.The most important element of Keynesian theory is the Marginal Efficiency of Capital (MEC). It basically refers to the expectations of potential returns from the investment. This expectation depends on 2 factors. Firstly, it depends on the amount of capital available in the economy, and as the amount increases, the potential returns begin to fall. The second factor is the business expectations. When businessmen are optimistic of the returns, then their marginal efficiency of capital is seen to be higher. Therefore, irrespective of the level of capital in the economy, the marginal efficiency of capital tends to be higher when the expectations of the investor are optimistic. This is the central idea of Keynesian theory.

When an economy undergoes an expansionary phase, marginal efficiency of capital is high which pushes the investment levels in the economy. Investors continue to invest, as they carry with themselves an expectation that the level of profit will increase. However, once the economy shifts towards its peak, the cost of capital goods also increase, reducing the marginal returns from the capital. This is because when more and more capital goods are in demand, the cost of capital also increases. When it increases, the returns diminish as more cost has to be invested in to get the same amount of returns. Therefore, after reaching the peak, the economy just cannot expand any further and pessimistic business expectations begin to set in.

The falling MEC and the pessimistic business expectations bring down the amount of investment in the economy. As investment begins to fall, the economy also undergoes a contraction in production, income, employment and price levels. However, it also has to reach its trough. So, the most important factor explaining the ‘trough’ is that all capital goods get obsolete. Thus, the scarcity of capital increases the MEC thereby, pushing the investment and bringing the economy back to track. Another way to explain the trough is a technological breakthrough that may increase confidence and the marginal efficiency of capital.

The important element of Keynesian theory derived from this explanation of business cycles is the advocation for government intervention. Keynes argues that the entire process of revival (of the economy by itself) takes a long time and can take a heavy toll on the economy. It is the role of the government to restore the confidence of investors in the economy by intervening and making investments. This would positively affect the economy because more than any other factor, business confidence is an important element determining the level of investment. Therefore, government investment would encourage optimism in the economy.

There are several other theories that explain the reasons behind the operation of business cycles. The Keynesian theory is relevant because of the fact that it takes psychological factors (such as business expectations) into account to explain the economic phenomena. His theory was also propounded to give an explanation for the Great Depression of 1929. This theory also well explains the reasons as to why and when the government needs to intervene in the economy. All these factors make this theory a suitable one in the context of business cycles in the economy.

Picture Courtesy- financialdirections

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