Characteristics of the Kondratiev waves

Kondratiev identified three phases in the cycle: expansion, stagnation, recession. More common today is the division into four periods with a turning point (collapse) between the first and second phases. Writing in the 1920s, Kondratiev proposed to apply the theory to the 19th century:

1790–1849 with a turning point in 1815.
1850–1896 with a turning point in 1873.
Kondratiev supposed that, in 1896, a new cycle had started.

The long cycle supposedly affects all sectors of an economy. Kondratiev focused on prices and interest rates, seeing the ascendant phase as characterized by an increase in prices and low interest rates, while the other phase consists of a decrease in prices and high interest rates. Subsequent analysis concentrated on output

Business Cycle Theory:

There are numerous theories about why business cycles occur. The book lumps them into two main categories: supply led and demand led. I break down the demand led into two different theories. The book does characterize two different types supply led recessions: one based on a long run AS shift and the other based only on the short run AS shift. I do only one type of supply shift, long run AS.

The AS/AD model: The Aggregate Supply and Aggregate Demand model is used to help explain business cycles. The basic model combines elements from the market for loanable funds (chapter 8), market for money (chapter 11 and 12), and theory of production (chapter 7). To understand the model, you need to understand the basic shapes of the curves and what would cause the curves to shift.

Aggregate Demand Curve

The AD curves slopes downward. The reason the AD curve slopes down is more complicated than why a typical microeconomic demand curve slopes down. In microeconomics, a demand curve slopes down showing that as price rises, people will want to buy less (or, as price falls, people will want to buy more). The microeconomic argument is that as a good gets expensive, consumers will switch, or substitute, to other goods. This theory won’t work in the macroeconomic world of AD. The problem is there is no “other goods” in the macro world. The AD curve is the demand for ALL goods. Also, in the micro world, as the price of a single rises, other prices are not changing. But in the macro world, we look at the price of all goods. So as prices rise in the macro economy, there is no other cheaper good to switch to.

So what is the more complicated theory about why the AD curve slopes down? The book offers three possible reasons, I use only one: interest rates. The interest rate is the hidden connector between the price level and demand for all goods:

When the real interest rate increases:

Aggregate demand falls because demand for C & I falls

Prices rise

When the real interest rate decreases:

Aggregate demand rises because demand for C & I rises

Prices fall

What would shift the AD curve?

The AD curve would increase or shift to the right if:

C increases: Consumers become more confident, consumers become less patient, disposable income increases (maybe), or the government changes its policy on savings

I increases: Investors sentiments improve, increase in technology, government changes its policy on investment

G increases: government spends more

NX increases: exports increase or imports decrease

The AD curve would decrease or shift to the left if the opposite of the above happened

Aggregate Supply Curve (Long Run):

The long run AS curve is vertical. This shows that as prices change, it has no effect on supply goods (production). In the microeconomic world, typically the supply curve slopes up. This means as the price of a good increases, businesses have an increased incentive to produce more of the good and they respond by producing more. This theory will not work in the macroeconomic world. In macroeconomic theory, it’s not just a single good price rising, it’s the price of all goods rising. This includes the price of all productive resources (for example, land, labor, capital).

As prices of all goods and resources increase, businesses have no reason to produce more (or less). So, as the price level increases, quantity of production stays the same. This makes the AS curve vertical. Higher prices don’t encourage additional production because there are also higher costs.

What determines where the AS curve is located, and what would cause the AS curve to shift? AS is determined by the quantity of resources (land, labor, capital, technology, quality of institutions). If the quantity of resources increase, the AS curve shifts right. As to the quantity of labor, the AS curve is drawn for the natural rate of unemployment (or “full employment”). If the natural rate of unemployment were to increase (fewer people working), the AS curve would decrease or shift left. This would be an example of a decrease in the quantity of a resource (labor).

Aggregate Supply Short Run:

The book also generates a short run AS curve. This is how the economy behaves in the short run. I describe how recessions occur without using this curve.

Demand Led Recessions

One type of theorized recessions begins with a decrease in AD. However, using the AS/AD model above, a shift in demand should result in a change of prices and interest rates, but no change in income or unemployment. That is, long run equilibrium doesn’t generate a recession. To get a recession, an additional assumption must be made. Two different additional assumptions are presented. One is the Keynesian model. The other is the misperception model.

Keynesian Recession:

Keynes suggested that the economy in the short run is different than the long run because in the short run, the economy may not be able to reach equilibrium. The original version of Keynes suggested that wages may not adjust to reach equilibrium. Now, some economists suggest that prices might not be able to adjust possibly due to menu costs. The ideas that wages or prices can’t adjust to equilibrium is called “sticky wages” and “sticky prices” theory.

Generating a recession: start with a drop in AD (a drop in C, or I, or G, or NX). Prices and interest rates should drop. But the Keynesian assumption says prices are sticky and won’t fully adjust downward. Since prices don’t fully adjust, this leaves the market out of balance: supply is greater than demand and there’s a surplus of goods in the economy. Company inventories will start to build up. What will companies do? They won’t lower price (prices are sticky). Since they aren’t selling everything they produce, they cut production back. They do that by laying off workers. So in the short run, production (or income) falls as companies cut production. And unemployment rises as workers are laid off. In the short run, income is down and unemployment is up: that’s a recession. In the long run, prices (and interest rates) will eventually drift downward and bring demand back up to match long run supply. Companies’ sales will go back to normal, so they’ll increase their production and employment back to normal, long run equilibrium, full employment, natural rate.

Misperception Theory:

The misperception theory doesn’t use disequilibrium like the Keynesian theory does. Instead, it uses the idea that businesses get fooled into reducing production and employment.

Generating a recession: start, again, with a drop in AD (a drop in C, or I, or G, or NX). Prices begin to fall. As prices fall, businesses don’t realize that prices across the entire economy are falling. Instead, businesses fear that the price of their product is falling because there’s a lack of demand for their specific product. That is, businesses confuse the macroeconomic event (the fall of AD and all prices) with a microeconomic event (fall of demand for their product and the price of their product). When companies fear that demand for their product is falling, what do they do? They cut production and lay workers off. In the short run, income is down and unemployment is up: that’s a recession. In the long run, companies will realize that demand for their product did not fall. It was just prices across the entire economy and their resource costs are falling to match. Companies will return production and employment back to normal, long run equilibrium, full employment, natural rate.

Real Business Cycles: Supply Led Theory

The last business cycle theory covered is caused by shift in AS, not AD. Temporary changes in the availability of resources and the cost of production is called a “supply shock”. Examples of supply shocks could be sudden drop in oil production, bad weather destroying crops, or natural disasters. Supply shocks can also be good which would cause an expansion, not a recession.

Generating a recession: a bad supply shock hits the economy. The AS curve shifts the left. The new equilibrium has higher prices, lower income, and higher unemployment. That’s a recession. In the long run, the supply shock goes away or is dealt with so production returns to the previous level.

This recession is different than the Demand Led recessions because as income falls, prices rise. With demand led recessions, prices fall during the recession. Prices rising during a recession became known as “stagflation” meaning a stagnation of production + inflation.

The book also talks about a supply led recession being cause by businesses just expecting higher production costs. This would cause the short run AS curve to decrease. The resulting recession would appear identical to the above described supply led recession. The only difference is instead of an actual decrease in resources, companies only anticipate higher resource costs.

Unemployment: essence and types

Unemployment is surplus of labour supply on demand for labour . Interactions between supply of and demand for labour identify employment level. Unemployment rate. Unemployment rate(U.r.)=number unemployment people/general population x100%

• E.g U.r.= 500 000/10 000 000 x 100 %= 5% in Kazakhstan (2011)

Types of unemployment: Frictional, Structural, Cyclical. There are definitions of U:

• Frictional unemployment means voluntary giving up the job

• Structural unemployment is staying without job because of a new technology

• Cyclical unemployment is staying without job because of changes in economic cycle (low demand)

Inflation: essence, types

• Inflation is a process when purchasing ability of money is decreasing because of price increasing

According to price level changes inflation can be differentiated as: Steady (қалыпты) inflation, Galloping (қарқынды) inflation.

• Steady inflation is type of inflation when average price level changes till 10% per year.

• Galloping inflation is type of inflation when price level changes between 20% and 200% per year.

1.David Begg, Foundations of Economics, McGraw-Hill Higher Education, 2009.

2.Andrew Gillespie, Foundations of Economics, OUP Oxford, 2011.

3.Internet resources

http://www.oup.com/uk/orc/bin/9780199586547/

http://www.investorwords.com/1641/economic_cycle.html#ixzz2GQLPedZF