Business Cycle

Basic to all theories of business-cycle fluctuations and their causes is the relationship between investment and consumption. New investments have what is called a multiplier effect: that is, investment money paid to wage earners and suppliers becomes income to them and then, in turn, becomes income to others as the wage earners or suppliers spend most of their earnings. An expanding ripple effect is thus set into motion.

Similarly, an increasing level of income spent by consumers has an accelerating influence on investment. Higher demand creates greater incentive to increase investment in production, in order to meet that demand. Both of these factors also can work in a negative way, with reduced investment greatly diminishing aggregate income, and reduced consumer demand reducing the amount of investment spending.

Since the Great Depression, devices have been built into most economies to help prevent severe business declines. For instance, unemployment insurance provides most workers with some income when they are laid off. Social security and pensions paid by many organizations furnish some income to the increasing number of retired people. Although not as powerful as they once were, trade unions remain an obstacle against the cumulative wage drop that aggravated previous depressions. Schemes to support crop prices (such as the European Common Agricultural Policy) shield farmers from disastrous loss of income.

The government can also attempt direct intervention to counter a recession. There are three major techniques available: monetary policy, fiscal policy, and incomes policy. Economists differ sharply in their choice of technique.

Monetary policy is preferred by some economists, including the American Milton Friedman and other advocates of monetarism, and is followed by most conservative governments. Monetary policy involves controlling, via the central bank, the money supply and interest rates. These determine the availability and costs of loans to businesses. Tightening the money supply theoretically helps to counteract inflation; loosening the supply helps recovery from a recession. When inflation and recession occur simultaneously—a phenomenon often called stagflation—it is difficult to know which monetary policy to apply.

Considered more effective by American economist John Kenneth Galbraith are fiscal measures, such as increased taxation of the wealthy, and an incomes policy, which seeks to hold wages and prices down to a level that reflects productivity growth. This latter policy has not had much success in the post-World War II period.