The phases of the business-cycle-slump, recovery, boom and deflation — are illustrated in Fig. An economy in a slump is experiencing high demand- deficient unemployment of both labour and capital. A low level of both investment and consumption demand leads firms to cut back on their production, lay off workers and leave capital goods idle. Although money may be available for firms to borrow and interest rates may be low, investment will not increase because of pessimistic expectations. None the less, even in this period, the economy has been subjected to fairly regular cycles of minor expansions and recessions.
One of the random disturbances mentioned was a change in the money supply. We now consider to what extent changes in monetary variables may be responsible for cyclical variations in real output.
They concluded that the monetary changes were not associated with changes in national income, but the change in the money supply that causes the change in national income. No sooner has one cycle started to diminish in amplitude than another disturbance occurs, starting off a new cycle. The types of disturbances which could do this are changes in investment, balance of payment, crisis, changes in money supply, rapid inflation and policies designed to curb it, industrial disputes, and so on. A possible explanation is that the cycle is inherently explosive, but is constrained within a band determined by an upper limit, called a ceiling and lower limit, called a floor.
The cycle thus generated will tend to have a constant amplitude determined by ceiling and floor. Such a cyclical movement in real output is illustrated in Fig. So far in the analysis, the single increase in autonomous investment of £10 has caused income to rise from £1, 000 to £1, 025 in the first four time periods and then start to fall in the fifth. Taking the little time-path to period t + 10, we obtained a clearly damped cyclical variation in real national income.
In the recovery phase the level of aggregate demand is rising and, thus, businessmen become more optimistic. Generally, this is a period of rising consumer demand, investment demand, expanding output levels and a falling rate of unemployment. This is a time of low unemployment, a high level of demand, high level of output and profits, an increasing rate of inflation and rising interest rates.
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If the money supply does not fall, interest rates will fall and, thus, encouraging new investment. However, its effectiveness depends on the interest-elasticity of investment which is like to be very low in the boom and slump periods of the cycle.