Theories of economic fluctuation

Some writers have ascribed economic fluctuations to the quantity of money in circulation. Changes in the money supply do not always conform to underlying economic changes, and it is not difficult to see how this lack of coordination could produce disturbances in the economic system. Thus, an increase in the total quantity of money could cause an increase in economic activity.

The banking system, with its ability to expand the supply of credit in an economic expansion and to contract the supply of credit in time of recession, may in this way amplify small economic fluctuations into major cycles of prosperity and depression. Theorists such as the Swedish economist Knut Wicksell emphasized the influence of the rate of interest: if the rate fixed by the banking system does not correspond to the “natural” interest rate dictated by the requirements of the economy, the disparity may of itself induce an expansion or contraction in economic activity.

In the early 1970s the American economist Robert Lucas developed what came to be known as the “Lucas critique” of both monetarist and Keynesian theories of the business cycle. Building on rational expectations concepts introduced by the American economist John Muth, Lucas observed that people tend to anticipate the consequences of any change in fiscal policy: they “behave rationally” by adjusting their actions to take advantage of new laws or regulations, inevitably weakening or undermining them. In some cases, these actions are significant enough to offset completely the outcome the government had hoped to achieve.

Although he was criticized for overstating the connection between human behaviour and economic rationalism, Lucas influenced other 20th-century economists who asserted that business fluctuations resulted from underlying changes in the economy. Historically, according to their view, economic fluctuations have been marked by periods of innovation followed by slower periods during which the innovations were absorbed. Business cycles, therefore, serve as adjustments to underlying conditions—adjustments that are necessary if economic growth is to continue.

Since the Great Depression, many governments have implemented anticyclical policies designed to offset regular business fluctuations. The increasing complexity and diversification of modern economies, however, have tended to reduce their dependence on any one sector, thereby limiting the possibility of boom-and-bust effects resulting from specific industries.

Good introductions to the study of business cycles include Erik Lundberg (ed.), The Business Cycle in the Post-War World (1955, reprinted 1986); R.C.O. Matthews, The Business Cycle (1959, reissued 1967); Robert Aaron Gordon, Business Fluctuations, 2nd ed. (1961); Alvin Harvey Hansen, Business Cycles and National Income, expanded ed. (1964); and Henri Guitton, Fluctuations et croissance économiques, 3rd ed. (1970). Famous surveys of business-cycle theories are Joseph A. Schumpeter, Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process, 2 vol. (1939, reissued 2006); and Gottfried Haberler, Prosperity and Depression, 5th ed. (1964, reissued 1968). J. Tinbergen, Statistical Testing of Business-Cycle Theories, 2 vol. (1939, reissued 2 vol. in 1, 1968), attempts to verify by econometric analysis the theories surveyed in Haberler’s work. The nontheoretical approach to business-cycle research is set forth in Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles (1946); and further developed in Geoffrey Hoyt Moore, Business Cycle Indicators, 2 vol. (1961). Important articles are collected in American Economic Association, Readings in Business Cycle Theory (1944, reprinted 1980), and Readings in Business Cycles (1965). History and politics are dealt with in Vivian Walsh and Harvey Gram, Classical and Neoclassical Theories of General Equilibrium; and James E. Alt and Kenneth A. Shepsle (eds.), Perspectives on Positive Political Economy (1990).

The basic principles of macroeconomics, which include cyclical analysis, may be found in any contemporary textbook of economics. Two good introductions to this subject are George T. McCandless, Jr., Macroeconomic Theory (1991), neoclassical in approach; and Joseph Stiglitz, Economics, 4th ed. (2005), Keynesian-oriented. At the intermediate level, two competing alternative theories of national income are presented in Robert J. Barro and Vittorio Grilli, European Macroeconomics (1994), which applies the intertemporal equilibrium approach to macroeconomic analysis; and Rudiger Dornbusch, Stanley Fischer, and Richard Startz, Macroeconomics, 9th ed. (2004), which follows an IS-LM (an economic equilibrium model measuring trade-offs between the market for goods and bonds and the market for money) approach.

More specialized or intensive treatments of macroeconomics are John Maynard Keynes, The General Theory of Employment, Interest, and Money, new ed. (2006), the classic theoretical work in the field; Seymour E. Harris (ed.), The New Economics: Keynes’ Influence on Theory and Public Policy (1947, reprinted 1973), a collection of early essays on Keynes and his ideas, representing the thinking of its time; and Gardner Ackley, Macroeconomic Theory (1961; also published as Macroeconomics: Theory and Policy, 1978), an introductory text. Later evaluations by leading economists of the significance and influence of Keynesian ideas may be found in Roy F. Harrod, The Life of John Maynard Keynes (1951, reprinted 1990), offering insight into the genesis of Keynes’s ideas; H.G. Johnson, “The General Theory After Twenty-five Years,” in The American Economic Review, 51:1-17 (1961), providing a retrospective survey from a monetarist point of view; Robert Lekachman (ed.), Keynes’ General Theory: Reports of Three Decades (1964); Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (1968, reissued 1973), an interesting but difficult appraisal of the development of Keynesian ideas; and Herbert Stein, The Fiscal Revolution in America, 2nd rev. ed. (1996), examining the relationship between Keynesian thinking and governmental policies in the United States.

Some important perspectives on economic strategies that have resulted in fluctuations are John Kenneth Galbraith, Economics and the Public Purpose (1973, reissued 1975), and Economics in Perspective: A Critical History (1987); Robert E. Lucas, Jr., “Understanding Business Cycles,” in Stabilization of the Domestic and International Economy, ed. by K. Brunner and A. Meltzer, vol. 5 of the Carnegie-Rochester Series on Public Policy, Amsterdam, North-Holland, 1977; and Douglass C. North, Institutions, Institutional Change, and Economic Performance (1990).