Keynesian Business Cycle Theory

The Keynesian Business Cycle Theory, or KBCT, is central to the Keynesian school of economic thought. The KBCT was John Maynard Keynes’ lens through which he analyzed economic volatility and offered prescriptions on how to correct market failures and deficiencies. An understanding of the KBCT is essential to an understanding of Keynes’ methodology and theories and how they apply to historical events and the future to come. 

Keynes mainly developed his business cycle theory in his principal work The General Theory of Employment, Interest, and Money that was published in 1936 at the height of the Great Depression. After finishing the first draft of General Theory, Keynes wrote playwright and political commentator George Bernard Shaw and said “I believe myself to be writing a book on economic theory which will largely revolutionize—not I suppose, at once but in the course of the next ten years—the way the world thinks about its economic problems.” Keynes’ prediction was largely correct, and his theories took major prevalence over the next few decades and retained an important position in all economic considerations from that point on.

The KBCT is rooted in the idea that economic output is dictated by aggregate demand. Aggregate demand is the total amount of spending in the economy which is calculated by adding consumer spending (C), total investment (I), and government spending (G). When aggregate demand is high, businesses’ revenue will also be higher than when aggregate demand is low because aggregate demand must be equal to total revenue because all spending is revenue for the entity at the receiving end of a transaction. Periods of high aggregate demand will coincide with periods of high profits, which means that high aggregate demand also coincides with high employment and production. The reverse is also true, low aggregate demand will generate periods of low income, employment, and production levels (in that order).

Keynes acknowledged this influence that aggregate demand and spending has on the economy and suggested that shifts aggregate demand are responsible for fluctuations in the business cycle. Periods of high aggregate demand are considered economic booms, and when aggregate demand recedes after a boom period, a recession begins.

Aggregate demand can recede for a variety of reasons, but Keynes contended that recession-inducing shifts are generally the result of a negative change in investment demand. This is because consumer demand tends to not be very volatile in the short-run, but investment demand is extremely volatile in both the short and long runs. Thus, investment demand is more likely to experience a large shock that transfers throughout the economy and generates a recessionary period.

During a growth period during which aggregate and investment demand are high, the prices of financial resources like capital products are pushed up as a result of their high demand. This is where the Keynesian concept of the marginal efficiency of capital (MEC) comes into play.

The MEC is the expected return on an investment project. If fewer returns are expected from an investment, investors will be more wary of making that investment. A blanket increase in investment demand across many sectors of the economy will coincide with a gradual blanket decrease in the marginal efficiency of capital. This inverse correlation between spending and MEC lays at the center of the Keynesian interpretation of what fuels the fluctuations in the business cycle. The MEC keys investors in on the actual usefulness or potential value of their investments in the future and this measure offers them one method of determining whether or not to invest.

MEC (1)

(Figure 1)

As Figure 1 shows, a contraction from MEC 1 to MEC 2 also entails a drop in the level of investment (I₁ to I₂) at any given interest rate (R₂). This contraction in investment produces a capital shortage which can induce employee layoffs and an ensuing lack of consumer demand that is characteristic of a recession.

An adjustment in the MEC can negatively or positively influence investor confidence. Confidence is widely considered to be one of the principal constituents of Keynes’ idea of animal spirits. Animal spirits are the least readily understandable part of the business cycle from an empirical perspective. Keynes defined animal spirits as “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” Essentially, they are actions taken by economic actors that are not weighed rationally. They can be the product of a number of outside social and economic forces that urge the actor towards the decision. George Akerlof, professor of economics at UC Berkeley and Nobel laureate, and Robert Shiller, professor of behavioral economics at Yale and Nobel laureate, attempted to define and categorize animal spirits in their (cleverly titled) novel Animal Spirits. They outlined five types of Animal Spirits: confidence, fairness, corruption and bad faith, money illusion, and stories.

Confidence, Akerlof and Shiller argue, is the single most important animal spirit of all. High confidence fuels investment booms and downturns in confidence coincide with downturns in the economy. They make a very simple contention: if investors feel confident in the markets, they will invest, and if they do not feel confident in the markets they will not invest.

The authors explain fairness as the social and moral influences upon an economic actor that drive them to loosen their own position in favor of someone else’s, or to irrationally push against someone else’s position in favor of bettering one’s own apparently inadequate position. For example, they argue that considerations of fairness are present in wage considerations that don’t meet equilibrium rates (consistent with efficiency wage theory).

Corruption and bad faith is a relatively self-explanatory category, which involves the increase in anti-social behavior that occurs during economic booms. Akerlof and Shiller describe what they call the “corruption multiplier”, which describes how acts of corruption become normalized and transmit through financial systems and businesses more and more as the practices become more commonplace.

Money illusion is the failure to take the real value of money into account when drawing up contracts or making transactions. Money illusion is one proposal as a reasoning behind price stickiness. When inflation or deflation occurs and changes the real value of money, price adjustment generally lags mildly behind, and money illusion could be one reason why this occurs. If people are not taking the real value of goods into account, then long-term agreements will not be tied to inflation and the real effects of inflation become less predictable.

The final piece of animal spirits that the authors describe is stories. Stories, essentially, are the media narratives that surround an economic period and have a profound impact on market psychology. For instance, in the period of growth in housing prices preceding the Great Recession, Akerlof and Shiller noted that most articles took a very optimistic view on the continued growth of housing prices despite the fact that housing prices would eventually collapse (culminating in the Great Recession itself). They make a strong case for the role of media narratives and overall sentiments fueling irrational economic growth, and that growth fueling positive media narratives in a destructive self-fulfilling cycle.

Keynes contended that a reduction in investment induces a reduction in income that generates a drop in consumption, which closes the cycle by lowering profits and the incentive to invest. A reduction in investment is the result of an observable drop in the MEC and investor confidence, and thus the animal spirits of investors in general. This is called the Keynesian multiplier, which details the fact that any drop in investment (∆I) equals ∆I * 1/1-MPC where the MPC is the average marginal propensity to consume of a populace.

The multiplier is Keynes’ framework for comprehending the things that happen during a recession. As the multiplier effect progresses, income, employment, and production all fall as the product of an initial decline in investment. Keynes also contended that prices and wages are sticky during recessions, meaning that they do not have the tendency to adjust proportionally in order to ensure the market naturally restores full employment.

In the Keynesian view, economic recovery occurs naturally as the MEC rises due to the depletion of the availability of capital stock that occurs during a recession and the natural deterioration of capital that would eventually necessitate an investment in new capital equipment. However, Keynes noted that recessions bring about mass human suffering and that natural recovery takes an excessively long amount of time, and that government has the responsibility to dampen the length of a recession by enacting fiscal policies through deficit spending to boost aggregate demand and normalize the economy with intervention.

The Keynesian interpretation and analysis of the business cycle differs from its classical predecessors by rejecting the idea that prices and wages adjust to ensure full employment after contraction. This idea was quite radical, as classical economics was the prevailing school of thought at the time of Keynes’ writings; challenging classical economic thought was challenging our understanding of capitalism and markets themselves.

Since Keynes’ time, many economic theories have utilized his framework and expanded upon it in order to solidify his work and the world’s understanding of the business cycle. For instance, the theory of debt deflation, proposed initially by Irving Fischer and expanded on by Hyman Minsky and many others, proposes that the real value of debt rises as a product of deflation, which causes loan defaults and delinquency to rise. Another example would be the extensive work that has been and is being carried out by the New Keynesian economic tendency to provide microeconomic foundations for sticky wages and prices and other phenomenon commented on by Keynes in his writings.

Regardless of one’s views towards Keynesian thought, its influence is remarkably vast and an understanding of its theory is necessary to an effective understanding of modern economic policy. Approaching the study of Keynesian economics should be done without pre-existing dogmatism, as empiricism is paramount to the study of economics. Ideas cannot be evaluated effectively with an uneven hand.


  5. The New Keynesian Synthesis by David Romer

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