The Business Cycle: Challenging Classical Economic Equilibrium

FROM THE LECTURE SERIES: REDEFINING REALITY: THE INTELLECTUAL IMPLICATIONS OF MODERN SCIENCE

By Steven Gimbel, Ph.D.Gettysburg College

The 20th century would see advances that undermined both the beliefs of classical economics. The old foundation for economics as a science would be replaced scientifically. The first of these intellectual pillars challenged that the small-scale interactions gave rise to a predictable large-scale behavior. But how did this happen?

An illustration of a business cycle.
The idea of the business cycle is that interactions in the market are predictable and cyclical. (Image: ImageFlow/Shutterstock)

What is the Business Cycle?

The predictable behavior of the economy is what’s known as the business cycle. According to this idea, the economy has an equilibrium point. Much like a pendulum, the idea is that the large-scale economy would alternatingly grow and contract around a fixed point.

Business owners are always looking to maximize profit, and, when possible, they will seek to grow. When times are good, they’ll take advantage of them by ramping up production as much as they can. This means hiring more workers which leads to lower unemployment. With more people employed, there’s more money available in the economy, and sellers looking to maximize profits can raise their prices. This generates inflation.

This is a transcript from the video series Redefining Reality: The Intellectual Implications of Modern ScienceWatch it now, on The Great Courses Plus.

The Inflationary Phase

With businesses everywhere expanding, there’s the need for loans. So we need banks to supply the loans. Since lots of businesses are looking to expand, there’s competition for the loans and the interest rates the bank can charge rises.

Eventually, this inflation makes the products less desirable, and demand cools. But production has been ramped up to meet the demand of the high-flying days, so there’s now left-over supply piling up in the warehouses as goods are produced at a rate that’s greater than they’re being sold. The result is that prices go down. Sellers try to entice buyers with more attractive deals.

The image is showing a financial collapse.
In classical economics, the inflationary cycle is followed by a deflation. (Image: SewCream/ Shutterstock)

But this brings in less money, and there are still the loans to be paid off. Further, much less product is needed, so less production is required, and thus fewer employees. This means fewer people with money which further cools demand. The economy slows and the downturn begins. The downturn feeds on itself. When things are going badly, business owners stop expansion. The economy contracts—this is a recession.

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The Deflationary Phase

But one result of high unemployment is that employers can pay less. Workers know that there aren’t easy jobs to be had. The glut of supply keeps the price down and, as a result, the cost of doing business is low.

This means that the percentage of profit is actually fairly high. Further, with business owners playing it safe, banks are sitting on lots of money. The bankers drop the interest rate. There’s cheap money now available.

At the same time, the backlogs of goods will be eventually eliminated. The demand may be low, but it’s not zero. Conservative owners will eventually find that even the lesser demand outruns the decreasing supply on-hand. As a result, there’s more demand than supply and prices start to rise. Rising prices signals the need for more supply, and production slowly starts to get ramped up again, beginning the cycle again.

The Wobble of Equilibrium

People are rational and self-interested, and because their decisions take time to implement, the actions of those in the market will lag behind the timeframe of the actual changes of the market itself. As a result, there’s never a fixed arrival at the equilibrium.

Economists say that wages and prices are sticky. Workers are given contracts over a period of time and even if the going market wage is lower, the bosses are now locked into that wage. Similarly, prices tend to adjust slowly.

The result of this stickiness of labor costs and prices is that there’s a lag between what’s happening on the ground and the reaction by the rational agents in the market. As a result there is a boom-bust cycle that occurs around the equilibrium point.

The Great Depression and Keynes

Crowd gathering at the intersection of Wall Street and Broad Street after the 1929 crash.
The crash of 1929 led to the Great Depression all over the world. (Image: US-gov/Public domain)

There was the crash of Black Tuesday, October 29, 1929. A bubble in the stock market from the roaring ’20s caused an overvaluation of stock prices. The result was the Great Depression. There was very high unemployment and very low interest rates. The classical model held that this ought to spur on a period of growth, but it did not.

The British economist John Maynard Keynes argued that there are multiple possible equilibrium points and it’s possible for the economy to become stuck around one of these undesirable points. He suggested that as a result of the crash, the economy had become stuck around one of these undesirable points.

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A Keynesian Solution

The economy could be restored to its usual cycle around the usual equilibrium if it were given a push. Aggregate demand can’t accelerate the economy when it’s stuck around an undesirable equilibrium point. Keynes contended that aggregate demand needed a boost. If the government increased spending, that extra demand added to the economy, if big enough, could pump enough life into the economy to restore it to its former healthy state.

What Keynes did was to change our understanding of what the nature of reality is when it came to fiscal matters. Keynes suggested the need to talk about macroeconomic phenomena in a macroeconomic language, which cannot be reduced to microeconomic happenings. Money supply, interest rates, unemployment, inflation all occur on a level that influences the micro-level and is influenced by it but remains non-reducible.

A Dynamic View of Business

Economics is not like physics, it’s more like biology. We need to study the molecular level to understand why an organism is the way it is, but the importance of molecular biology doesn’t mean that ecology is pointless.

If we want to understand the full evolutionary history of a species, the genetic map will only get us so far. There’s another level that works above the molecular. We need to understand how the species interact with their large-scale environment to see why certain traits are selected instead of others.

In the same way, microeconomics is important, but macroeconomics necessarily remains a study to itself in order to augment the more focused view. So, the middle of the 20th century forced us to re-evaluate the presupposition that the working of the small could account for the workings of the large in the economy.

Common Questions about the Business Cycle

Q: What happened on October 29, 1929?

There was the crash of Black Tuesday, October 29, 1929. A bubble in the stock market from the roaring ’20s caused an overvaluation of stock prices. The result was the Great Depression.

Q: How is the inflationary phase generated?

When times are good, businesses take advantage by ramping up production as much as they can. They hire more workers which leads to lower unemployment. With more people employed, there’s more money available in the economy, and sellers maximize profits by raising their prices. This generates inflation.

Q: What was Keynes’ explanation for the Great Depression?

The British economist John Maynard Keynes argued that there are multiple possible equilibrium points and it’s possible for the economy to become stuck around one of these undesirable points. He suggested that as a result of the crash, the economy had become stuck around one of these undesirable points, and that was the cause of the Great Depression.

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