One generic reason is the pace at which investment accelerates in response to upward trends in sales. This linkage, which is called the acceleration principle by economists, can be briefly explained as follows. Suppose a firm is operating at full capacity.
When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. As a result, changes in sales result in magnified percentage changes in investment expenditures. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates.
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In more concrete terms, the response of the investment spending is related to the rate at which sales are increasing. In general, if an increase in sales is expanding, investment spending rises, and if an increase in sales has peaked and is beginning to slow, investment spending falls. Thus, the pace of investment spending is influenced by changes in the rate of sales. Many economists cite a certain "follow-the-leader" mentality in consumer spending. In situations where consumer confidence is high and people adopt more free-spending habits, other customers are deemed to be more likely to increase their spending as well.
Conversely, downturns in spending tend to be imitated as well. Technological innovations can have an acute impact on business cycles. Indeed, technological breakthroughs in communication, transportation, manufacturing, and other operational areas can have a ripple effect throughout an industry or an economy. Technological innovations may relate to production and use of a new product or production of an existing product using a new process. The video imaging and personal computer industries, for instance, have undergone immense technological innovations in recent years, and the latter industry in particular has had a pronounced impact on the business operations of countless organizations.
However, technological innovations—and consequent increases in investment—take place at irregular intervals. Fluctuating investments, due to variations in the pace of technological innovations, lead to business fluctuations in the economy.
There are many reasons why the pace of technological innovation varies. Major innovations do not occur every day.
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Nor do they take place at a constant rate. Chance factors greatly influence the timing of major innovations, as well as the number of innovations in a particular year. Economists consider the variations in technological innovation as random with no systematic pattern.
Thus, irregularity in the pace of innovations in new products or processes becomes a source of business fluctuations. Variations in inventories—expansion and contraction in the level of inventories of goods kept by businesses—also contribute to business cycles. Inventories are the stocks of goods firms keep on hand to meet demand for their products.
How do variations in the level of inventories trigger changes in a business cycle? Usually, during a business downturn, firms let their inventories decline. As inventories dwindle, businesses eventually use down their inventories to the point where they are short. This, in turn, starts an increase in inventory levels as companies begin to produce more than is sold, leading to an economic expansion.
This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate. However, as the rate of increase in sales slows, firms begin to cut back on their inventory accumulation. The subsequent reduction in inventory investment dampens the economic expansion, and eventually causes an economic downturn. The process then repeats itself all over again. It should be noted that while variations in inventory levels impact overall rates of economic growth, the resulting business cycles are not really long.
The business cycles generated by fluctuations in inventories are called minor or short business cycles. These periods, which usually last about two to four years, are sometimes also called inventory cycles. Variations in government spending are yet another source of business fluctuations.
This may appear to be an unlikely source, as the government is widely considered to be a stabilizing force in the economy rather than a source of economic fluctuations or instability.
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Nevertheless, government spending has been a major destabilizing force on several occasions, especially during and after wars. Government spending increased by an enormous amount during World War II, leading to an economic expansion that continued for several years after the war. These also led to economic expansions. However, government spending not only contributes to economic expansions, but economic contractions as well.
In fact, the recession of —54 was caused by the reduction in government spending after the Korean War ended. More recently, the end of the Cold War resulted in a reduction in defense spending by the United States that had a pronounced impact on certain defense-dependent industries and geographic regions. Many economists have hypothesized that business cycles are the result of the politically motivated use of macroeconomic policies monetary and fiscal policies that are designed to serve the interest of politicians running for re-election.
The theory of political business cycles is predicated on the belief that elected officials the president, members of Congress, governors, etc. Variations in the nation's monetary policies, independent of changes induced by political pressures, are an important influence in business cycles as well.
The Central Bank, in the case of the United States, the Federal Reserve Bank, has two legislated goals—price stability and full employment. Its role in monetary policy is a key to managing business cycles and has an important impact on consumer and investor confidence as well. The difference between exports and imports is the net foreign demand for goods and services, also called net exports.
Because net exports are a component of the aggregate demand in the economy, variations in exports and imports can lead to business fluctuations as well. There are many reasons for variations in exports and imports over time. Growth in the gross domestic product of an economy is the most important determinant of its demand for imported goods—as people's incomes grow, their appetite for additional goods and services, including goods produced abroad, increases. The opposite holds when foreign economies are growing—growth in incomes in foreign countries also leads to an increased demand for imported goods by the residents of these countries.
This, in turn, causes U. Currency exchange rates can also have a dramatic impact on international trade—and hence, domestic business cycles—as well. Business cycles are difficult to anticipate accurately, in part because of the number of variables involved in large economic systems.
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Nonetheless, the importance of tracking and understanding business cycles has lead to a great deal of study of the subject and knowledge about the subject. It was as a result somewhat surprising when, in the s, the nation found itself stuck in a period of seemingly contradictory economic conditions, slow economic growth and rising inflation. The condition was named stagflation and paralyzed the U. Another somewhat unexpected business cycle phenomenon has occurred in the early s.
It is what has come to be known as the "jobless recovery. The most recent trough occurred in November , inaugurating an expansion. The reasons for the jobless recovery are not fully understood but are the cause of much debate within the economic and political circles.
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Within this debate there are four leading explanations that analysts have given for the jobless recovery. But the real-business cycle model shows that the neoclassical model implies anything but smooth growth. A purely neoclassical model, devoid of anything resembling a business cycle in the sense of transitory departures from neoclassical equilibrium, nevertheless explains most of the volatility of GDP growth at all frequencies.
Monetary policymakers looking to a neoclassical model to provide the neutral levels of key variables-potential GDP, the natural rate of unemployment, and the equilibrium real interest rate, need to solve a complicated and controversial model to find these constructs. They cannot take average or smoothed values of actual data to find them. Further, low-frequency movements of unemployment suggest a failure of the basic idea that departures from the neoclassical equilibrium are transitory.
I discuss new theories of the labor market capable of explaining the low-frequency movements of unemployment. I conclude that monetary policymakers should not try to discern neutral values of real variables. Some branches of modem theory do not support the concepts of potential GDP, the natural rate of unemployment, and the equilibrium real interest rate.
Even the theories that do support the concepts suggest that measurement in real time is impractical. Robert E. Hall, Development of the American Economy. Economic Fluctuations and Growth.