Endogenous Business Cycle Theory

Introduction

Business cycles refer to the recurrent expansions and contractions in aggregate economic activity. The economies of capitalist countries experience alterations in the trend of economic activities that are associated with upward and downward movements in production, employment, prices and other economic variables around their long-term growth trend. This paper examines the theory of endogenous business cycles. It begins with an overview of the endogenous business cycle theory; followed by a discussion of the features that are common in endogenous business cycle models; and finally, concluding remarks on the implications of the endogenous business cycle.

Overview

Endogenous business cycles are a sub-type of economic cycles of fluctuations in economic activity. Endogenous business cycles are theorized to be generated internally by economic agents, such as firms and households, as opposed to being driven by exogenous shocks (external forces such as wars, sudden drops in oil prices, etc.). Endogenous business cycle theory postulates that endogenous fluctuations in the levels of output, employment, and prices are generated by market imperfections and/or shocks to the economy. According to the theory, exogenous shocks do have an impact on the economy but they are not the main drivers of endogenous business cycles.

The fundamental difference between exogenous and endogenous business cycles is that the former arise outside the economic system, while the latter originate within the economic system itself. Moreover, the causes of endogenous business cycles are thought to be more limited and localized than those of exogenous business cycles. As opposed to exogenous business cycles where the cause of the cyclical fluctuations is external, for the endogenous business cycle, there is no single source of the fluctuations; rather, the fluctuations are a collective result of numerous interactions among economic agents and the economic structure. Another distinction between the two types of economic cycles is that the sources of endogenous business cycles do not need to be persistent or recurrent in order to explain the economic cycles.

Features of Endogenous Business Cycle Models

Endogenous business cycle models contain certain common features. These include:

1. Production: Endogenous business cycle models typically contain a production function that specifies how inputs of labor (L) and capital (K) generate output (Y). It is assumed that production is subject to diminishing returns due to resource constraints. That is, K and L are not sufficient to produce all of the output that the economy demands, so the production function reflects this scarcity.

2. Capital and Labor Markets: Endogenous business cycle models assume that markets for capital and labor exist, and that the prices of these inputs will adjust to maintain equilibrium in each market.

3. Consumption and Investment: The models also assume that consumption and investment decisions are driven by the marginal propensity to consume (MPC) and the marginal efficiency of capital (MEC).

4. Monetary and Fiscal Policy: Endogenous business cycles models account for how monetary and fiscal policies affect aggregate economic activity.

5. Non-Rationality: Endogenous business cycle models assume agents in the economy act in an non-rational manner and make decisions based on information that is incorrect, incomplete, or both.

Conclusion

The endogenous business cycle is a sub-type of economic cycle of fluctuations in economic activity that is theorized to be generated internally by economic agents, as opposed to being driven by exogenous shocks to the economy. Endogenous business cycles are generated by market imperfections and/or shocks to the economy. This paper has examined the theory and common features of endogenous business cycle models. It is important to recognize that agents in the economy do not always act rationally, and that their decisions are based on the information that they have, which is often incomplete or incorrect. Endogenous business cycle models account for these factors, as well as for the impact of monetary and fiscal policies, when modeling economic fluctuations.

Economic cycles describe the expansion, peak and contraction of short term economic activity. It is believed that the eceonomy of a nation follows a cycle of prosperity, recession, recovery and renewal.

The theory of economic cycles suggests that the economy varies over a series of shorter-term and longer-term cycles ranging from several days to several years. It is generally accepted that there are several basic shapes or types of economic cycles with each economy or market having its own cycle. This commonly accepted cycle is referred to as the business cycle. The business cycle has four distinct stages, expansion, peak, contraction and trough.

During the expansion stage, the economic cycle moves from recession to economic growth with levels of employment, wages, industrial activity, production and consumption increasing simultaneously. In the peak stage the economy reaches maximum production levels with full employment, strong price increases and robust economic activity.

The contraction stage of the business cycle occurs due to a fall in aggregate demand as consumers, businesses and governments decide to spend less than they did during the peak. This fall in spending causes a decrease in production levels and leads to a rise in unemployment.

Finally, in the trough stage, the economy is at its lowest point with production, employment, wages and prices all at their lowest. In this stage businesses and consumers alike have reduced their spending and the economy is in a state of recession.

The length and severity of the economic cycle vary from economy to economy and from market to market. Each economic cycle typically lasts from 1-7 years and has its own distinct pattern. In general, the shorter the cycle, the larger the impact on the economy and the harder the recovery. As such, understanding the economic cycle is important for business owners and policy makers alike in order to make informed decisions.