This blog post introduces the concept of economic growth, the various factors that cause business cycles, and the key theories explaining them.
Economic growth refers to the sustained increase in Gross Domestic Product (GDP) from a long-term perspective. This signifies an improvement in the standard of living for citizens and an increase in the overall economic well-being of society. However, even in countries experiencing steady economic growth, the business cycle fluctuates between good and bad times. Business cycle fluctuations refer to the phenomenon where the trend line showing the long-term direction of real GDP deviates from that line in the short term, exhibiting periods of expansion and contraction. Various views exist regarding the primary causes triggering business cycles.
Until the 1970s, the prevailing view was that the main cause of business cycles lay in aggregate demand shocks stemming from changes in private corporate investment spending. It was believed that business cycles were triggered by fluctuations in investment spending based on private companies’ expectations about the future. Therefore, it was believed that the government could suppress economic fluctuations by implementing appropriate aggregate demand management policies in response to aggregate demand shocks. This was a period strongly influenced by Keynesian economics. However, after the 1970s, criticism arose that aggregate output might not change even if aggregate demand did. Consequently, the argument emerged that arbitrary monetary policy adjustments by financial authorities acted as a cause of economic fluctuations.
Subsequently, Lucas proposed the ‘monetary business cycle theory,’ positing that economic agents always hold ‘rational expectations’ and that economic fluctuations arise from their misjudgments due to imperfect information. Rational expectations mean that when new information arrives, economic agents appropriately use it to form expectations about the future. However, because the information available to economic agents is incomplete, they can make misjudgments, leading to business cycles. Lucas illustrates this with a hypothetical example.
Consider a firm that, for a certain period, knows only the price of its own product. If the price of this firm’s product rises, it could be due to an increase in the money supply causing a general rise in the price level, or it could be due to a change in consumer preferences for this product. If it is due to a general price increase, the firm has no reason to increase production. However, a firm that knows only the price of its own product for a certain period cannot accurately determine the cause of the price increase, no matter how rational its expectations are. Therefore, even when the general price level rises, the firm might interpret it as stemming from a change in preferences and increase its output. This would lead to higher wages for workers and an economic upturn. However, after a certain time, when the firm realizes the price increase was due to the general price level rise, it recognizes its misjudgment and reduces output.
Criticism arose that Lucas’s view struggles to fully explain large-scale business cycles. Consequently, some scholars began seeking the primary causes of business cycles in real factors like technological innovation and oil price increases, forming the ‘real business cycle theory’. According to them, when technological innovations occur that can enhance productivity within firms, companies will seek to hire more workers. Consequently, employment and output increase, leading to an economic expansion. Conversely, when oil prices rise, firms consume less energy in the production process, causing employment and output to decline.
Recently, some scholars have highlighted the external sector as a crucial factor explaining a country’s economic fluctuations. They observe that as economic cooperation among nations grows closer, the economic fluctuations of different countries exhibit a high correlation, suggesting that economic fluctuations can spread internationally. For instance, in situations like the global financial crisis, economic instability originating in one country can rapidly spread to others, potentially having a significant impact on the entire world economy.
Therefore, it is crucial to consider both international and domestic factors when understanding and forecasting economic fluctuations. Furthermore, governments and businesses must analyze these complex factors and prepare countermeasures to minimize the impact of economic fluctuations. In today’s complex and interdependent modern society, effectively managing economic fluctuations is essential for economic stability and sustainable growth.
