Business Cycle Causes

1. Business Cycle Causes A Robinson Crusoe Parable

2. Robinson Crusoe on an island.

3. Crusoe loves fish, so he spends half of each day fishing so he can enjoy fish in the evenings.

4. Additionally, Crusoe spends Friday mornings maintaining his fishing dinghy and nets.

5. 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.

6. Crusoe doesn’t have a fridge, so he preserves his catch by throwing it in a small, dark pond.

7. 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.

8. Suppose that Crusoe shares the island with some mischievous monkeys, who see Crusoe adding rocks to his pile.

9. They decide to imitate him, so every time Crusoe ads a rock, they sneak in and add one as well.

10. The monkeys are inflating the money supply by injecting currency into Crusoe’s investment fund.

11. Yay! I’m rich with food! One day, Crusoe suddenly notices that his “savings rate” of fish is double the usual.

12. This is the consumption-side of the boom phase of the business cycle. He decides to compensate by eating some of the fish he catches during the “savings hour.”

13. This is the investment-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.

14. 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.

15. 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.

16. 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.

17. He is forced to cut his investment rate (he has less time to fix ?) just to have some fish for Friday’s dinner.

18. The abandoned hut is an extravagant expenditure that represents a loss of capital. This is the bust phase of the business cycle. He must also abandon his incomplete hut because he does not have the time to finish it.

19. Now, since he has to fish on Friday what else doesn’t he do on Friday?

20. What screwed Crusoe up? • If the stones represent money, who monkeys with the money supply in real life? Sum it up!

21. 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!

22. Did the monkey’s trickery make Crusoe a better or worse saver? Sum it up!

23. 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. Gov’t Monkey’s Around

24. 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 of Low Interest Rates

25. 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

26. Also, consumers cut back and start saving which means spending less. • They stop buying things from companies. Consequences & Resolutions of an Inflated Economy

27. Stopping their unfinished projects • Cutting their budgets • Laying off workers • Sell • Go bankrupt - People out of work Company Response

28. 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 #1

29. 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. Scenario #2

30. The business cycle (boom/bust) is caused when government artificially lowers interest rates and inflates the money supply. Overall Lesson

31. Interference causes the bust to become slower and more painful. • Examples: • propping up banks and businesses, • protecting people who are foreclosing homes, • stimulus bill, • job bill, • etc. Government Response

32. 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. Bad government reactions when economy declines:

33. Lower tax rates • Cut government spending • Stabilize money supply As was done in the 1921 depression This was not done in 1921 Good government reactions: