Interest Rates and the Business Cycle

What economists term the business cycle has been the subject of much study since its emergence during the industrial revolution. The roller coaster behavior of growth in the economy has eluded full explanation and led to the development of a variety of schools of thought on the issue. While traditional economists focussed on money as the key cause of cyclical activity, more recent analysis has turned to technological shocks as the driving force behind the business cycle (Christiano and Fitzgerald, 1998). Despite the tendency of these most recent studies (referred to as real business cycle theory) to discount the causal relationship between interest rates and the cycle, empirical data suggests that some relationship does exist between the two (Sill 1996). Thus, this paper will attempt to first define the business cycle and then to discuss the theorized and empirical relationships between interest rates and the cycle.

Generally, the business cycle is the defined in terms of expansion and contraction of the economy. It is the tendency of the economy to move from recession to growth and back again over time. This up and down characteristic of the economy is a fairly simple concept when thought of in the abstract. However, a more precise definition is required in order to develop a model that will explain the phenomenon. Unfortunately, without a full understanding of the business cycle

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S S1 r r1 D Money supply Firms borrow, increase production, prices fall/real wages increase; demand increases Prices S P S1 p1 D output As demand increases, firms increase output further; more borrowing leads to strain on bank reserves/ higher interest rates Interest rates S1 S r1 r D Money supply While this view was widely accepted, traditional theoretical models failed to adequately explain the inter-relationships between sectors of the economy. As Christiano and Fitzgerald (1998) point out, expansion and contraction across all or most sectors of the economy are inherent in the definition of business cycle. Their argument is based on the NBER's definition of recession as ". . . a persistent period of decline on total output, income, employment and trade usually lasting from six months to a year and marked by widespread contractions in many sectors of the economy."
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Approximate Word count = 2540
Approximate Pages = 10 (250 words per page)

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