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While economic fluctuations are an endemic feature of industrial economies, their causes, timing and length are still a matter of debate and research.  This chapter focuses on the effects of cycles on economic growth and business activity. Consequences are different depending on whether we consider the whole economy or an individual firm. Firms can be hit differently by a recession according to their own characteristics (size, industry and type of capitalisation); in general terms, an investment decision has a different outcome depending on whether the economy is leading towards a trough or a peak. This problem leads to the importance of having accurate forecasts of economic activity that might affect the future yield of the firm. But forecasting is a very difficult and complex process and economics still has to make its own way through it.  We should keep in mind Lawrence J. Peter's definition of an economist as "an expert who will know tomorrow why the things that were predicted yesterday didn't happen today"!


Q1 Why do economic cycles (or business fluctuations) occur? What are the implications of these fluctuations for business?

There is no unique cause for cycles and a mixture of different factors can be traced behind each fluctuation. These factors are not elusive but they reinforce themselves and some economists give more emphasis to particular aspects than others.

i) Some theories of the business cycle focus on the intrinsic instability of the free market.  Investment is highly volatile and depends on future expectations of sales and aggregate demand. If they change, upward and downward spirals might be set in motion. When forecasts are positive, firms expect better turnouts and profits; they decide to increase production and stocks. Their increased demand for inputs improves prospects for other firms, stimulating employment, aggregate demand and further investment.  The multiplier-accelerator model is a way to formalise these considerations.

ii) Other theories focus on external supply shocks due to economic (oil crisis) and non economic reasons (wars or earthquakes).

iii) Shifts in the aggregate demand can also cause fluctuations.

iv) There can be policy induced shocks. As we have seen in chapter 15, management of fiscal and monetary policy can be driven by political more than economic considerations, thus leading to possible pro-cyclical policies, a likely eventuality when government decisions are influenced by the approach of general elections.

v) Others try to find a meeting point between the previous theories by explaining cycles with wage and price rigidity. Fluctuations occur, they say, because prices are not fully flexible. If prices were not rigid, an external shock could be overtaken by a downward movement of wages. Also a downward shift of aggregate demand would cause prices to decline and real money balances to


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