Transcript Business Cycle Causes

Business Cycle Causes
A Robinson Crusoe Parable
Robinson Crusoe on an island.
Crusoe loves fish, so he spends
half of each day fishing so he can
enjoy fish in the evenings.
Additionally, Crusoe spends Friday
mornings maintaining his fishing
dinghy and nets.
In order to have fish on Friday, he
must fish for an extra hour every
other day of the week.
This is his savings rate: one hour per day. It’s also his
investment rate because the savings is investing for Friday.
Crusoe doesn’t have a fridge, so he
preserves his catch by throwing it
in a small, dark pond.
He can’t see how many fish are in
the pond, so he keeps a stack of
small rocks near it. Every time he
adds a fish, he adds a rock, and
every time he eats one, he removes
one.
The rocks are his money supply.
Suppose that Crusoe shares the island
with some mischievous monkeys, who
see Crusoe adding rocks to his pile.
They decide to imitate him, so
every time Crusoe ads a rock, they
sneak in and add one as well.
The monkeys are inflating the money
supply by injecting currency into Crusoe’s
investment fund.
One day, Crusoe suddenly notices
that his “savings rate” of fish is
double the usual.
Yay! I’m
rich with
food!
He decides to compensate by
eating some of the fish he catches
during the “savings hour.”
This is the consumption-side
of the boom phase of the
business cycle.
Crusoe also decides to take some
extra time each day to start
building himself a new hut.
This is the investmentside of the boom phase
of the business cycle.
Crusoe now believes that the cost of
saving fish is half the usual, while in
fact his savings rate is too low for
the investments he is planning.
Before long, Friday comes around.
When it comes time to eat his midday
meal, Crusoe suddenly realizes that
he’s out of fish – despite having a
surplus of rocks.
He’s exhausted his investment capital
because the additional currency snuck
into his money supply did not represent
a real increase in his productivity or
savings rate. He doesn’t have the
capital (fish) to maintain his previous
consumption rate, much less increase
it.
He is forced to cut his investment
rate (he has less time to fix ?) just
to have some fish for Friday’s
dinner.
He must also abandon his
incomplete hut because he does
not have the time to finish it.
The abandoned hut is an extravagant
expenditure that represents a loss of
capital. This is the bust phase of the
business cycle.
Now, since he has to fish on Friday
what else doesn’t he do on Friday?
Sum it up!

What screwed Crusoe up?

If the stones represent money, who
monkeys with the money supply in real
life?
Sum it up!

What happens to Crusoe if he doesn’t fix
his nets?

What happens if you don’t save your
money and keep spending?
Sum it up!

Did the monkey’s trickery make Crusoe a
better or worse saver?
Gov’t Monkey’s Around

Government sets interest rates artificially
low to “help” the economy.

Artificially low interest rates does not have
enough money backing it up.

Government & banks creates (inflates)
money to cover the deficient money
supply.
Consequences of Low Interest
Rates

false signal of a lower interest rate people
buy more on credit and save less.

false signal of a lower interest rate
businesses buy more machines or start
more projects falsely believing it will be
profitable later.

People don’t want to save but want to
spend.
Consequences & Resolutions of an
Inflated Economy

Consumers spend to their credit &
money-making limit.

Prices for everything go up because
of inflation. They can’t afford more.

Because consumers begin spending
less, companies are not making
enough money to pay their loans or
complete their projects.
Consequences & Resolutions of an
Inflated Economy

Also, consumers cut back
and start saving which
means spending less.

They stop buying things
from companies.
Company Response

Stopping their unfinished projects

Cutting their budgets

Laying off workers

Sell

Go bankrupt - People out of work
Scenario #1

Person borrows money and purchases six
properties and will purchase building
materials. He lays six foundations and
starts building houses. Inflation causes
prices of bricks to go up and now he only
has enough money for four.

What does he do with the 5th & 6th
property and the workers?
Scenario #2
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20 page paper due tomorrow,
At 10 pm: taking hits of caffeine to keep
working,
At 12 am. More coffee!!
2 a.m. Red Bull!
4 a.m. More Red Bull
5 a.m. More Red Bull
6 a.m. THREE Red Bulls!
The caffeine hits keep getting less effective.
Like lower interest rates, the caffeine hits
don’t do enough anymore.
Overall Lesson

The business cycle
(boom/bust) is caused
when government
artificially lowers interest
rates and inflates the
money supply.
Government Response
Interference causes the bust to become
slower and more painful.
 Examples:
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propping up banks and businesses,
protecting people who are foreclosing homes,
stimulus bill,
job bill,
etc.
Bad government reactions when
economy declines:

Class warfare: yell at bad rich people, make
new laws regulations

Lower interest rates & continuously lower
them.

Tax/borrow/inflate & spend

Take more control → socialism

Combination of all the above.
Good government reactions:
Lower tax rates
 Cut government spending

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Stabilize money supply
As was done
in the 1921
depression
This was not
done in 1921