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Business Cycle

rose above the “bank” rate of interest, the level of eco- and savings preferences and in businesses’ confidence are
nomic activity would begin to increase. In contemporary a substantial source of instability.
terms, the natural rate of interest is what businesses expect There is a whole body of literature on political busi-
to earn on real investment. The bank rate is the return on ness cycles. As economist William D. Nordhaus noted:
financial assets in general and commercial bank loans in “The theory of the political business cycle, which analyzes
particular. The boom begins when, for whatever reason, the interaction of political and economic systems, arose
the cost of borrowing falls significantly below expected from the obvious facts of life that voters care about the
returns on investment. This difference between the rate of economy while politicians care about power” (1989, p. 1).
return on real and financial assets generates a demand for The idea is that politicians in power will tend to follow
bank loans by investors seeking to exploit the opportunity policies to promote short-term prosperity around election
for profit. The economy booms. time and allow recessions to occur at other times. The evi-
At some point the bank rate will start to rise and/or dence that the state of the economy influences voting pat-
terns is strong, as is the apparent desire of incumbent
the real rate will start to fall. When the expected rate of
politicians to influence the economy; but it is difficult to
return on investment falls below the rate at which funds
can be borrowed, the process will begin to reverse itself make a case that the overwhelming determinant of the
and the recession is on. As bank loans are paid off (or level and timing of business fluctuations is politically
determined. At some points in modern history, politically
defaulted on), bank credit is reduced, and the economy
determined policies were apparently a determining factor
slows accordingly.
and at other times not.
Since the late twentieth century, business cycle theory
With respect to the impact of governmental policies,
has centered on the argument about the source of cyclical
there is a dispute as to the relative importance of mone-
instability. The question of the root causes of ups and tary policy (controlling the money supply) and fiscal pol-
downs in the level of economic activity received a lot of
icy (government expenditures and taxes). Those who
attention in the 1980s and 1990s.
believe that monetary policies have had a generally desta-
Figure 1 shows how the parties to the debate are bilizing effect on the economy are known as monetarists.
divided up. First, there is the question of whether the pri- Most economists accept that fiscal policy, especially in
vate sector of the economy is inherently stable or unsta- wartime, has been a source of cyclical instability.
ble—which is to say, do the observed fluctuations As noted above, it is the so-called Keynesian econo-
originate in the government or private sector? On one side mists who believe that the private sector is inherently
are what might be called classical economists, who are unstable. While noting the historical instability of invest-
convinced that the economy is inherently stable. They ment in tangible assets, they have also emphasized shifts in
contend that, historically, government policy has destabi- liquidity preference (demand for money) as an independ-
lized it in a perverse fashion. On the other side are what ent source of instability. As a counter to the standard Key-
might be called Keynesians, named after the British econ- nesian position, there has arisen a school of thought
omist John Maynard Keynes (1883–1946). Keynesians emphasizing real business cycles. This school contends
believe that psychological shifts in consumers’ purchasing that nonmonetary variables in the private sector are a

Current arguments in business cycle theory

Source of Fluctuations

Government Private

Monetary Fiscal Monetary Nonmonetary
(Monetarists) (Keynesian) (Keynesian (Real Business Cycles)
[Political Business Cycle] Liquidity
Preference)

Figure 1

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 65