Business cycle and growth policy


Chapter 1: Introduction continuation




01st Definitions

02nd Distinction of different economic phases

03rd Distinction of differently long economic cycles

04th Topicality of the economic concept

05th Definition "economic growth"

06th Main reasons for an economic policy

07th Differences and similarities

08th The development of the economic policy

09th The development of the growth policy



06th Main reasons for an economic policy



Two aims of economic policy are known mainly:


On one hand it is about eliminating macroeconomic unemployment: As unemployed is considered every employee who is firstly able to work and secondly willing to work but has not found a job and therefore does not have a work relationship.


On the other hand, it is about fighting inflation: it spoken of inflation always when the average of goods prices, including prices for services, increases. We measure the extent of inflation by the inflation rate, which indicates by what percentage the price level increases per period (e.g. year).


In both cases (combating unemployment as well as inflation), the real reason for the non-achievement of these two aims lies in the fact that in the context of a market economy the economic activities do not remain constant nor grow or contract steadily, but manifest themselves in cyclical movements.


Joseph Alois Schumpeter has compared this progression of the economy with the movements of a rocking chair. The rocking chair moves because it is pushed from the outside. The way in which these movements take place, however, is based on the construction of the rocking chair. In a similar way, it can be argued that the cyclical movements are also determined by the specific characteristics of a market economy system, although it must be assumed also that the impetus for changes in the results of a market economy always depends on the decision alterations of the individuals (households as well as enterprises).


But just because cyclical movements are a specific feature of a market-based order, we do not find economic cycles in other economic systems and therewith naturally no need to combat the deficiencies that are triggered by economic cycles. Economic cycle policy is thus a specific task which only becomes necessary if the prevailing economic system has been organised market economy oriented.


It has been pointed out, though, that in the framework of political economics cyclical movements are also taking place in representative democracies, even though they run somewhat different than the market-induced economic movements, they nevertheless can be compared with economic movements due to certain similarities.


These contexts are now becoming a problem in the framework of the economic policy, especially because at least by the supporters of a Keynesian theory just the state is attributed a crucial role in the fight against unemployment and inflation. Here, the question rises as to whether a system (the representative democracy) is at all in the position to influence the economy in the desired way, if the public expenditure itself is subjected to cyclical movements out of political contexts.


How can be expected that a fiscal policy of the state has a stabilising (dampening the cyclical fluctuations) effect on the lack of private demand by way of adapting government expenditure, if even government expenditure itself is subject to fluctuations in a representative democracy because of inner reasons? In fact, therefore it was doubted, in particular by Nordhaus, that the state could pursue an efficient economic policy in a representative democracy, and the thesis was established that, quite contrary to these expectations, the state itself gives impetus to the cyclical fluctuations of the economy which even aggravate and partly trigger these.


But if, despite all, economic cycles are ultimately responsible for the fact that mass unemployment and inflationary processes occur, then it must be pointed out that it is not only the cyclical fluctuations in economic activity that trigger unemployment and inflation. There are other causes of unemployment and inflation that have nothing to do with the economic cycle and for that very reason not each unemployment or inflation can be combated by the government trying to dampen economic fluctuations by fiscal policy measures. Other causes require a different therapy.


So we have to assume that e.g. that the rise in the raw material prices may cause enterprises to reduce their output due to too high costs and thereby trigger unemployment. Although just in this the way the economy is being influenced, an economic downturn takes place, nevertheless the causes of unemployment are here not a too low demand for goods, and therefore the Keynesian formula, which consists of a rise in the governmental demand, can neither reduce unemployment in this case. Here, it is the rise in the raw material prices that is causing both unemployment and economic activity to weaken.


Combating unemployment is thus only partially a problem of the economic policy and therefore also plays a decisive role in the scope of the structural policy. In the same manner, there are of course also non-cyclical causes for inflationary processes.


Thus, the classics of economic theory feared that if private banks were allowed to issue banknotes at their own discretion, an inflationary process would be triggered, since the goods value of a banknote generally exceeds the value of the banknote as financial resource, and therefore banks would strive to increase the amount of banknotes constantly - regardless of the trading volume. We will address this problem in more detail in further chapters of this lecture.



07th Differences and similarities



Now, let us ask to what extent economic policy and growth policy share common features, but also differ from one another.


The main difference between economic and growth policy lies in a different objective. The aim of growth policy is to influence the long-term trend, while the aim of economic policy is to dampen short-term fluctuations.


The similarities between the economic and the growth policy arise from the following connection: The long-term movements of the growth trend are overlaid by short-term economic movements. Therefore, let us firstly look at the actual development in the domestic product.




We now draw the trend line in this graphic by calculating the average long-term incline of the domestic product and plotting it as a straight line in our diagram.

We can now determine the ideal-typical course of the economic movement, by subtracting the trend of the development.


However, the cyclical characteristics and the characteristics determined by trend are by no means two variables that are independent of each other in their emergence. Rather, the growth rate itself depends on the extent of the fluctuations: growth namely requires a certain degree of stability. Growth is mainly triggered thereby that entrepreneurs invest and are innovatively active. However, both actions are associated with uncertainty, generally speaking, no entrepreneur can be absolutely sure that investment and innovation lead to the hoped-for success in any case. The entrepreneurs expect a certain success and only therefore they carry out these activities, but they can not be absolutely sure.


The dependence of investment and innovation on uncertainty also entails that entrepreneurs are willing to take risks only up to a critical limit. If the extent of uncertainty increases, then the willingness for investment and innovation decreases, whereat the individual entrepreneurs differ very well on the question of at what level of uncertainty they are not willing anymore to invest and introduce renewals despite uncertainty.


But a mutual dependence on growth and the economic activity results also from the fact that economic policy serves as a means of growth policy: By reduction of free resources and thus reducing unemployment the level of growth can be increased.


Thirdly, there is a commonality between economic and growth policy because in both parts of the economic policy the influence on growth and economic activity takes place via the investment volume: Especially within the scope of Keynesianism, both the economy as well as the growth are controlled primarily by the investment volume. This connection seems to indicate a harmonious relation between economic and growth policy.


But there are also conflicts of aims between growth and stability: A Keynesian growth policy can lead to inflation; a stability policy can trigger short-term growth losses. A Keynesian policy focuses on an increase in government spending. These are usually financed thereby that the central bank increases the volume of the banknotes.


This increase in the aggregate demand for goods should and also can under certain conditions help to increase the volume of goods produced. But this is, according to Fisher's equation of exchange, only one possibility out of several, which way this extra money supply will go in detail. According to this formula:


G * U = P * X


Firstly, an increase in the money supply can be reflected in a decline in the velocity of money, the money is temporarily hoarded. Secondly, it must be reckoned with the possibility that goods prices will increase. Thirdly, the growth in money supply by an increase in the goods demand can also lead to an increased production.


Of course, in times of non-utilisation of the production capacities it can be expected that a certain part of this additional money supply will actually lead to an increased production, but always only a certain part. The fact, that in reality it can not be expected generally that the overall increase in the supply of money leads to an equal expansion of production, depends on one hand on the fact that the entrepreneurs need time to boost production so that the increased demand initially leads to price increases which in the first place induce the entrepreneurs to produce more goods.


On the other hand, we can not assume that an economic upswing is reflected therein that a recovery in all sectors occurs simultaneously and to the same extent. Rather, some industries will rush ahead, others will follow only after a certain time, others are not even able to expand production e.g. for lack of sufficient raw materials.


But this asynchronous business cycle entails inevitably that bottlenecks appear in those industries that have taken the lead, leading to price increases while other sectors still have high surplus capacity and, above all, not all workers have found an employment yet.


Now, if the aim of full employment is pursued, then this means at the same time that measures to achieve full employment can lead to a neglect of the aim of monetary stability.



08th The development of the economic policy


Economic movements are limited to market economies.


Before the global economic crisis, no economic policy took place in a narrower sense. Only the already occurred crises have been combated. Here, the discount rate policy played an outstanding role, further the state confined itself largely to the granting of unemployment benefits as well as the implementation of public relief works, in order to enable the unemployed people to find employment in this way.


A fundamental change in this question took place during the global economic crisis: Both Heinrich Brüning (Chancellor in the Weimar Republic, 1930-32) and Herbert Clark Hoover (President of the USA, 1929-33) tried to combat the global economic crisis with a deflationary policy.


In contrast, Franklin Delano Roosevelt (President of the United States, 1933-45) and the National Socialists in Germany tried to stimulate the economy by expansive measures.


Furthermore, the minimum reserve policy was introduced in the Weimar Republic, initially in order to prevent bank crises and in the post-war period also as a control instrument of the central bank.


Finally, an influence on the economy occurs mainly by a state fiscal policy.


The stability policy after World War II was characterised by a new monetary policy instrument: the open market policy. Furthermore, the Keynesian fiscal policy was also used to combat inflation.


In the 1960s, a concerted action was introduced in order to prevent inflationary effects of the wage policy.


New difficulties arose, though, both by the appearance of stagflation phenomena and the phenomenon of hysteresis. Stagflation is understood as the simultaneous occurrence of stagnation phenomena and inflation phenomena. This phenomenon is explained in particular by the fact that the share of fixed costs in the post-war period has risen strongly, that therefore the unit costs rise with a decrease in production and the entrepreneurs attempt to capture this cost increase by price increases. Thus at the same time, occurs a decline in employment and an increase of the prices.


The phenomenon of hysteresis is expressed by the fact that the labour market reacts only delayed to the cyclical turnabouts on the goods markets. A slow-down in the economy is therefore not immediately reflected in an increase in unemployment since the entrepreneurs have to comply with notice periods.


Sometimes, particularly professionals are not made redundant at a decline in production since employers fear that they will not be able to recruit skilled workers in time for the next economic upturn and that new workers will have to be trained for their work first. Thereby result costs that are sometimes higher than if they had continued to employ these workers despite a lack of demand.


But precisely because entrepreneurs partly at the beginning of a cyclical upturn already have the workforce they need to increase production, they do not need to recruit additional labour force at that time yet. This tendency is then intensified by the fact that at the beginning of an economic upturn the entrepreneurs are still unsure whether the new orders are of unique nature or already announce a sustainable upturn. Precisely because the entrepreneurs cannot make workers redundant immediately in case of a lack of demand, the entrepreneurs tend to carry out the additional orders with overtime of the existing workforce during this initial, still uncertain time.


Finally, the system of fixed exchange rates that existed until the creation of the euro zone forced an international coordination of the economic policy. If e.g. in the USA the interest rate is lowered by the central bank in order to stimulate the economy, then sooner or later this will lead to interest rate reductions in Europe. These states then follow the trend in the USA.


If, on the other hand, an attempt had been made in the USA to stimulate the economy in line with the Keynesian policy on government expenditure increases and an increase in the budget deficit, then this policy might even have a deflationary effect on European countries. If namely the US Federal Reserve was unwilling to support the government policy by expanding the money supply, then the increased demand caused by the increase in the state budget would lead to interest rate increases, which would then lead to a slow-down of the economic situation in Europe.


In view of these connections, the individual states strive to coordinate their economic stimulus programmes in such a way that negative effects in the concerned countries are avoided most possibly.



09th The development of the growth policy


Growth policy is found predominantly in planned economies. But also the states which pursue a Keynesian policy endeavour to influence their economic growth. A growth policy s. s. can only be seen since the post-war period, though.


A growth policy became necessary in the aftermath of World War II particularly in the context of the competition of the systems. The USA and the Soviet Union competed for supremacy in the world. First and foremost, economic growth became necessary because the military equilibrium was only maintained if both world powers (USA and Soviet Union) provided about the same amount of armaments.


But on the other hand, this competition was also carried out by the endeavour that the average level of consumption of the citizens of both systems did not differ too much.


The lower the growth rate of one state was compared to the growth rate of the other state, the less could this state have its two aims (equal armaments level in order to not be inferior in a fight and equal consumption level in order to bind its own citizens per se) achieved.


The economic theory shows now that the market economy is generally superior to a state planned economy in terms of productivity. It is also well known that US President Ronald Reagan deliberately attempted to increase the growth rate of the USA in order to force the Soviet Union to its knees. And indeed the Soviet empire finally collapsed due to its economic shortcomings.


With the growth policy after the end of World War II it was initially intended to primarily raise the general level of welfare. But after the American economist Okun put the thesis according to empirical research - in my opinion, wrongly - that the aim of full employment could only be attained if an annual growth rate of about 3% was guaranteed, growth policy had now been given predominantly the aim of achieving full employment.


Recently, there are approaches to a qualitative growth policy which is less concerned with volume growth than with environmental improvements. Precisely because the environment was damaged by industrialisation for a long time, slowly the aim developed, not to simply achieve the highest possible growth rate, but to design economic growth in such a way that the environment is not damaged and that the following generations also have sufficient material resources (requirement of sustainability).