Marshall Keynes And Lucas Theories Of Business Cycles Economics Essay

Introduction

Business cycles are widely known economic phenomena, it is also one of the most controversial topics in macro economics, and this is due to the absence of one clear definition and applicable theory that explains it. Many economists have discussed the topic and formulated theories about business cycles, some said that business cycles were periodic others said that they were a direct result to a specific event (war, drought, etc). Among those economists are Joseph Schumpeter, Simon Kuznets, Nicolai Kondratieff and many others. However, in this paper we will focus on John Maynard Keynes, Robert Emerson Lucas and Alfred Marshal and their theories and views on the subject.

The business cycle is widely understood as being a series of expansions or constant growth followed by a decline in the economy, this means that an economy will experience increase in output, productivity, employment, and wages up to the point where the equilibrium is lost and the decline begins. Opinions differ on how the restoration of the economy is undertaken, some say that a free market will automatically adjust itself to the path of growth, others agree that government intervention is required to adjust aggregate demand which will help the economy return to its natural equilibrium.

Keynes argues that business cycles occurred due to fluctuations in aggregate demand which in turn affect output and lead of a period of reduced growth or maybe even recession.

The objective of the paper is to provide a comparison between Marshall, Keynes, and Lucas concerning their definition of a business cycle and what are its causes and in the light of this comparison we try to figure out which theory is more applicable to the recent financial crisis.

Marshall’s business cycle

Marshall Biography:

Alfred Marshall was one of the economists that had a great influence on economic thought, in addition, he was one of the main founders of the Neo – Classical school of thought. Alfred Marshall was influenced largely by John Stuart Mill, David Ricardo, Adam Smith and Malthus where some of his followers described his economic analysis as an extension of their work with one main difference that their focus was on the market economy and how it function rather than focusing on the human behavior.

Alfred Marshall was born on 1842 in England and died on 1924 where he lived and educated at Cambridge. He was affected widely by the social science where the economic tools and analysis had limited role; in other words, Marshall believed that economics is one of the most important sciences in the world will should be used as a way to raise the standard conditions of the human beings through more income equality and eradicating poverty. This also could be achieved through the help of the political forces. (Henry, 1994)

Supply and demand: Marshall uses the theory of the supply and demand as a way of determining price. So he analyzes the effect of each one separately. The most important contribution to the theory of demand was the formulation of the concept of price elasticity of demand. Concerning the supply his most important contribution was to the theory of supply was the concept of time specifically the short run and long run analysis where he changed the shape of the supply curve according to the time period.

Marginal utility theory: Marshall was one of the earlier economists that talked about the marginal utility or satisfaction where he said that a consumer tends to purchase a good up to a point where the Marginal utility is equal to the price. If the consumer is facing a situation where his Marginal Utility is greater than the price the consumer is facing what is known as consumer surplus – which is defined as the difference between what consumer is willing to pay and what he actually paid. (Colander, 2006, pp: 283-291)

Another contribution done by Marshall was the Quasi – rent theory and the effect of the taxes on the welfare. All these ideas and theories were published in his book “The Principle of Economics” in 1890 after nine years of writings where it was considered as one of the leading books in the century. Inside it he spoke about the supply and demand, the price elasticity of demand, the supply curve, the supply curve in the short and the long run, the marginal utility theory, the consumer surplus, the theory of value, and the stable Vs. the unstable equilibrium.

Marshall Business cycle:

Although Marshall was widely concerned with the micro analysis rather than the macro analysis, he did not totally ignore it as he spoke about the effect of the monetary forces on the price level. In addition, Marshall spoke briefly on the fluctuations of the economy with no deep analysis his work was based on the analysis of John Stuart Mill.

Marshall Saw that the main cause and may be the only one is the degree of confidence or what he called “the influence of business confidence”.

Marshall saw that an upswing in the economy or what is known as “the peak” of the economy is achieved when the credits is largely grown due to high degree of confidence on the other hand, a downswing in the economy or what is known as “the trough” is happened when there is a contraction in the credits due to lack of confidence and in this case the country is facing a recession that could be turned to depression if it lasts for a long time that will mainly affect the unemployment level of the economy.

Marshall says that to avoid the fluctuations of the business cycle the economy need not to reach its peak through overexpansion of the credits because once a peak is reached the economy will move through a period of contractions until it reaches the trough that cause the depression that may last for many years before the economy starts to go through expansion of the economy until it reaches the peak once again and so on. In other words the main solution from Marshall`s point of view is that the economy should not reach the stage of trough or depression by preventing the economy from overexpansion through market control. However, if recession occurs the government should intervene to solve it through raising the degree of confidence of the economy by attempting to guarantee firms from high risk which will succeed in restoring the confidence of the business. (economictheories.org, 2008)

This weak analysis did not give any satisfaction to Marshall so he searched for another explanation of the economic fluctuations rather than this explanation that was an extended analysis to the work of John Stuart Mill. This new analysis of the fluctuation of the economy was explained by Marshall through the quantity theory of money.

The quantity theory of money was the main contribution of Marshall in the Macroeconomic analysis. In this theory he saw that both the supply of money and the demand of money create fluctuations in the price level “inflation rate” that in turn cause serious fluctuations in the aggregate demand and supply of goods and services that Marshall called it “the credit cycle” or what is known as “the business cycle”. (laidler, 2003,p:12)

According to Marshall economic fluctuations happen when the economy is in the expansion stage where the demand and the supply of money increase causing the prices to increase and the profits made by the businessmen “the money borrowers” to increase. This expansion will continue until the lenders begin to be unconfident of the ability of the borrowers to repay the money; in this case the lenders will refuse to give any more credits or “tight the credits” this in turn will cause some business men to resell their products and a collapse of prices will occur in a series of panic actions that derive the economy to the stage of recession. (laidler, 2003,p:13)

Keynesian business cycle:

Keynes Biography:

Considered to be the father of Macro Economics, John Maynard Keynes, a British economist who developed his own school of economic thought known as the Keynesian school of economics. The Keynesian school of economics had arrived and overthrown the neoclassical school of economics. The Keynesian school had a firm belief in the use of both monetary and fiscal policies to help an economy come out of a depression or recession. (Peter Clarke, 2009)

Keynes Business cycle:

Unlike the neoclassical school that believed that a free market would adjust itself in the short and medium run, and that supply creates its own demand, Keynes believed that government intervention was necessary, whereby using an expansionary monetary policy, a sufficient level of aggregate demand can be attained and with wages flexibility, it would help the economy surpass a depression or recession and reach full employment. (Peter Clarke, 2009)

In Keynes book “The General Theory” that he wrote in 1929 which is the period where the great depression hit Britain severely causing poverty, and misery. This depression cause stagnation, long – term dependence of people on the government, and high unemployment.

The main thing that was confusing Keynes how to go out of this economic downturn and what cause it in the beginning, Keynes came out with the concept of business cycle where each economy in the world has ups and downs in its economic activity involving occasional periods of widespread unemployment. These Ups are known as “Peaks” which happens when the economy expand while the downs are known as the “trough” which happens when the economy is contracting. These are called business fluctuations. (Friedman, p: 2, 1997)

How to go out of a period of down turn is what keep the mind of Keynes busy in the following years he found out two main reasons: the first one is the increasing rate of unemployment while the second one is the laissez faire economy which was supported by Adam Smith. So without government intervention, a private-enterprise capitalist system using non-commodity money would tend toward a position characterized by a high level of involuntary unemployment of persons who would willingly be employed at the current wage rate but could not find job. (Friedman, p: 3, 1997)

So the ideal solution from Keynesian point of view is that the employers need to decrease real wages given to their employees this will decrease the percent of people who are looking for jobs, als

.o the capitalists cost should be reduced and this could not achieve unless the real interest rate decreased. (Friedman, p: 3, 1997)

However, this analysis had proved to Keynes after a while that it is not efficient with respect to the economy, because the nominal wages had decreased accomplished with fall in nominal prices so that there is no big change did happen to the real wages this change was not decrease in the level of real wages actually what happen is slight increase in the real wages. In other words, Keynes said that by cutting expenses and wages the economy will return to its natural equilibrium. But as we all know that would directly result in a decrease in consumption and in turn a decrease in output which will only amplify the depression and make it worse.

Keynes ends up with a concluding remark that the changes in prices and interest rates could not be counted on. As a result he searches for another tool to explain the ups and downs of the economy these tools were the aggregate demand and aggregate supply of employment. (Friedman, pp: 5-6, 1997)

Aggregate demand as defined by Keynes is the sum of expenditures on both consumption and investment goods where the expenditures on consumption goods depends on the personal income and from he came out with the concept of MPC – Marginal propensity to consume. On the other hand, investment is the addition to the capital where the investment is depending on “marginal efficiency of capital,” where it relates the amount of investment needed to the economy by the rate of interest.

The investors will have an incentive to invest so long as the yield exceeded the interest rate at which they could borrow the funds to ¬nance the investment.(Friedman, p:9,1997)

The Keynesian theory for business cycles revolved around aggregate demand levels, where by having flexible factors in the economy such as prices and inflation an economy can reach and maintain its natural level of equilibrium, Keynes strongly believed in government intervention to restore and maintain natural equilibrium.

Keynes argued that this is not true; he said that since the aim of any business is to attain profit, and by working to achieve its goal, it will make the appropriate decisions which in turn will maximize profit and there for output will return to its optimal level.

In order for income and employment to raise then consumption must rise so that the investment opportunity seems financially viable. However, as we mentioned earlier Keynes recommended cutting the wages which means reducing income. He found that the solution for this paradox is to peg interest rates at extremely low levels.

Keynes strongly believed that the interest rate should be kept at a very low level to encourage investment. By keeping the interest rate low people will be forced to invest their money hoping for a higher rate of return. By heavily investing it will help the economy reach full employment and come out of a depression.

The Keynesian model for the business cycle assumes a completely closed market with no import or export for simplification. This means that all of the GDP consists of consumption & investment. Hence any increase or decrease in output is a result of fluctuations of consumption & investment.

Therefore the Keynesian book “The General Theory” that he had published in 1963 gives a detailed analysis about the economy, interest rate, unemployment, and business cycle theory; this theory could be summarized in three points:

The main factor that leads to fluctuations in the business cycle is the marginal efficiency of capital”. It describes the rate of discount marginal which would make the present value of expected income from fixed capital assets equal to the present supply price of the asset.

Therefore as the level of investment increases, a decrease in the rate of return will take place As investment increases, this happens because early investment was directed at the most lucrative possibilities; subsequent investment is channeled into less promising areas and the returns diminish. (Tanaka, pp:2 -3, 2008)

The ups in the economy “Booms” caused by increasing level of investment driven by marginal efficiency of capital.

The stock of capital that is accumulated over years during the economic expansions at the ends depreciates and returns back to its normal level.

Lucas’ business cycle

Lucas Biography:

The American economist Robert Emerson Lucas, jr. was born in 15th of September 1937 in Yakima, Washington. He went to the University of Chicago where he received his B.A in history in 1959 and his PhD in economics in 1964 from the same university. Since the 1970`s he was one of the best and important economists which he confronts the basics of the macroeconomics theory that was subjugated by the Keynesian economics. He was in conflict that the macroeconomic model should be built as a collective version of microeconomic models. (Frangsmyr, 1995)

He was the one who developed the Lucas critique which is the policymaking of economics. In 1995 Robert Lucas was awarded a noble prize in economics for having developed and applied the hypothesis of rational expectations and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy. (Encyclopedia Britannica, 2010)

The Lucas critique is a really important application that critiques the insinuation that there is a negative correlation between unemployment and inflation which is basically known as the Phillips curve it could easily breaks down if the monetary establishment try to make use of it. This critique led to some other developments such as the new Keynesian economics of the neoclassical which lead towards microeconomic basics for microeconomics theory. In 1990 Robert Lucas discussed the classical economic theory forecast that the capital of the country should run from rich countries to poor of course under the assumption of the diminishing returns of capital and this was known as the Lucas paradox. (Encyclopedia Britannica, 2010)

Lucas Business Cycle:

Business cycles are now de¬ned as deviations of aggregate output from a trend, when there is a movement in these deviations for different aggregate time series.

(Albanesi, 2010)

Lucas analysis these fluctuations in the aggregate output using the Aggregate demand and supply tools which 2was known as the IS – LM model where he found out that the relation between the demand of output and the production is defined by the IS model while the relation between the savings and investment is explained within the LM model and the equilibrium between the IS – LM model determines the real interst rate and GDP, he added that this model used to explain the adjustments in the economy that manage the fluctuations in the economy.

In other words, Lucas analysis the business cycle as an equilibrium phenomenon, where he founded his theory on four factors: the first one is that markets will always clears – reaches the equilibrium – at all time, the second factor is that each agent in the market is self acting in a way that each agent targeting his own interest regardless of the public interest, the third factor agents are expected to be rational. The fourth factor is that information is imperfect. (Lucas, 2001)

Also Lucas added that one of the main reasons that cause fluctuation to the economy is that agents are acting in lack of information in a way that they took economic decisions with no clear information available at their hand. (Laidler, 2009)

Another reason for the business cycle is that the agents acts with no differentiation between the relative price and aggregate prices changes which in turn with any monetary disturbance the economy face severe fluctuations represented by contraction and expansion to the economic activities in all markets. In other words, if the change in the aggregate prices lead to change in the relative prices a disturbance in the economy will took place. This will cause a shock in the economy and contraction in the economic level will occur. (Karni, 2009)

Another point added by Lucas is that we should not look at the overall economy at once rather each problem or each model should be discussed and analyzed separately.

In Robert Lucas business cycle theory he first asked a question saying “Why is it that, in capitalist economies, aggregate variables undergo repeated fluctuations about trend, all of essentially the same character?” the answer to this question is due to Keynes general theory and also Lucas said that to answer the question was one of his greatest challenges in economics research and he tries to meet this challenge by what is called the business cycle theory. Among the economist there was a wide discussion to solve the problem.

Lucas explain the business cycle as a shock that happen to the economy mainly this shock is a monetary one where by the effect of the multiplier a series of economic contraction took place inside the economy cause a series of cyclical movements in the output. These cyclical movement in the real output cause cyclical movements in prices, interest rate, and investment rate. (lucas, 2001)

According to another point of view they seem rather modern, the inspection that macroeconomics is in need of a microeconomic basis has become usual, and though there is much uncertainty about the character of this Need and about what it would mean to convince it, it’s usually that many recent Economists would have no trouble accepting about what Hayeks said it’s the Haykes statement which was he integration of cyclical experience into the structure of economic equilibrium theory, with which they are in ‘apparent contradiction, remains the crucial problem of Trade Cycle Theory;’ By ‘equilibrium theory’ we see that above all understand the modern theory of the common interdependence of all economic measure, which has been most completely articulated by the Lausanne School of theoretical economics.

Lucas started to discuss and review the main qualitative features of economic time line which we call “the business cycle.” Theoretically, actions about tendency in GNP in any country can be well explained by a stochastically bothered difference equation of very small arrange. These actions do not reveal equality of either period or amplitude, which of course, they do not be similar to the deterministic wave action which sometimes arises in the natural sciences.

Those regularities which are experiential are considered in the co-movements amongst dissimilar aggregative time series. This means that the Output of a country move together while the creation of producer and consumer durables much better amplitude than does the creation of nondurables. In addition, Production and prices of agricultural goods and natural resources have lower than average conformity.

As far as Lucas knows there is no need to meet the criteria these observations by limiting them to exacting countries or time periods: they come into view to be regularities ordinary to all decentralized market economies. Though there is extremely no theoretical cause to anticipate it, one is led by the essentials to finish that, with admiration to the qualitative actions of co-movements among series, business cycles are all alike. To hypothetically inclined economists, this conclusion should be striking and challenging, for it propose the option of a united clarification of business cycles, grounded in the general laws governing market economies, quite than in political or institutional characteristics exact to particular countries or periods.

One of the critiques to the business cycle model explained by Lucas that there is no certainty or an accurate result from the other th-+eoretical models like Keynes Haykes and others they all gave great impression on the forces of monetary policy. Another critique is that the economist from Tinbergen they see that and discovered that monetary factors or a force doesn’t not seem very significantly empirically.

V. Conclusion

due to the large financial crisis that hit the world recently there are an increasing concern with the business cycle models, three major well known economist analysis why the economy may fluctuate between periods of expansion and periods of contractions. This paper analyzes the concept of business cycle for three main economists who are Marshall, Keynes, and Lucas.

Marshall provide very week analysis concerns the business cycle model this happens because he did not give any attention to the macro economic analysis he only concerned with the microeconomic analysis, however his contribution to the macro analysis was through depending upon the model analyzed by the John Stuart Mill. He refer to the economic fluctuations as a reason to monetary shocks which called “the credit theory” which is the same theory as Mill but with more depth analysis.

Lucas came and provide us with strong explanation why do we have fluctuations in the economy he has the same opinion as Marshall that the business cycles caused by monetary shock to the economy. Although they give same reason to the business cycle the analysis of Lucas was much deeper and strong.

On the contrast Keynes provide different reasons behind the cause of the business cycle he said that a business cycle happen due to decreasing wages, disposable income will result in decrease in the output level and a recessionary period will occur as the aggregate demand shift to the left.

In my opinion the most significant analysis for the business cycle is that provided by Lucas most of the recent papers are dating the USA recent financial crisis to a recession that result because of a monetary shock that hit the economy in the US that results in declining output, income and increasing the rate of unemployment and trade deficit in addition to a widespread contractions in many sectors of the economy.”