In our dynamic framework (recall Figure 6.1), if investment remains stant from one period to the next, then aggregate demand will also stay con-stant, but aggregate supply will rise because investment adds capacity.
Hence, a constant level of investment leads to excess capacity. However, since a change in investment has a bigger effect on demand than on supply, up until a certain point an increase in investment reduces the excess of capacity; beyond that point an increase in investment leads to lack of capacity.
In this setting, iffirms expect only a smallincrease in demand (gegr), investment will not increase enough. It will generate an increase in effective demand smaller than initially expected, and smaller than the actual increase in capacity. As a result, the rate of capacity utilization will fall and the expected increase in demand will become even smaller. This will lead, in turn, to a rapid fall in the types of investment that are influenced by short-run changes in demand, and to corresponding falls in output: an economic crises.
By contrast, if firms expect a bigincrease in demand (gegr), invest-ment will rise too much. It will generate an increase in effective demand bigger than initially expected, and bigger than the actual increase in cap-acity. Hence, the level of capacity utilization will rise and the expected increase in demand will become even bigger. This will lead again to a big increase in investment, so that a self-sustained process of expansion will ensue.
NOTES
1. This is the main contribution of the chapter. We shall argue that Harrod’s dynamic system, which has been usually applied to the theory of growth, should instead be used as the basic frameworkin the analysis of the business cycle.
2. The accelerator essentially says that, iffirms are producing at the normal rate of cap-acity utilization, then an expected increase in aggregate demand will be met by additions in capital (net investment):
(3)
where INis net investment and v, the accelerator coefficient, is the amount of new capital required to produce one extra unit of output.
As is well known, the fact that net investment is a function of the changerather than the levelof demand has the following implication.An increase in demand does not neces-sarily imply an increase in net investment: (i) If demand rises but by less than it had risen in previous periods, then net investment falls off; (ii) There will only be an increase in net investment if demand growth accelerates; and (iii) Note finally that positive net invest-ment presupposes demand growth: a stagnant demand requires no additional capital and thus leads to zero net investment.
3. For an application of this argument to the profit squeeze and underconsumption models of the cycle, see Sherman (1991, 203, 256–57).
4. The latter implies that the money stock and/or its velocity of circulation adjust endoge-nously to changes in aggregate demand and output. For reasons why these endogenous adjustments are likely to occur see Kaldor (1986), in the case of money, and Pollin (1991) and Leão (2005), in the case of velocity. Evidence on the variability of velocity along the cycle is presented in Table 6.1.
5. By contrast, if a change in investment had a greater effect on supply than on demand (that is, 1/v1/s) this instability would not exist. In that case, iffirms lacked capacity and tried to suppress it by raising investment, supply would rise more than demand and the lack of capacity would sooner or later disappear.
INv(Yd)e
6. Joan Robinson (1969, 92) also arrived at this result:the tragedy of investment is that it can never remain at a constant level. For . . . the level of demand for goods will be the same. But all the time capital is accumulating . . . the rate of profit consequently falls off . . . and new investment will appear less attractive to entrepreneurs’.
7. In the remainder of the paper, we will assume that aggregate supply corresponds to the level of output obtained with a certain desired rate of capacity utilization (for example, 80% of full capacity), not with full capacity.
Note also that our model uses the accelerator as the central explanation of the level of investment. However, we are aware that the investment process is very complex and that the accelerator has many limitations (for a detailed discussion, see Sherman 1991, 141–42). In particular, the accelerator is more incomplete than a function that makes investment dependent on changes in profit rates, as proposed by Sherman (1991, 251).
This is because the accelerator ignores the effects on investment of changes in costs of raw materials,finance, taxes and labour. Hence, we will use the accelerator carefully, and complete it whenever changes in costs are not fully incorporated into prices and lead to changes in profits and investment.
8. Why do we have this surprising result? The reason is that too optimisticexpectations about demand growth (gegr) lead to an increase in investment such that – since its effect on capacity is lower than on demand (1/v1/s) – firms end up with supply adjusting to expected demand, but lagging behind actual demand.
9. For empirical evidence on rates of capacity utilization along booms, see Tables 6.2 and 6.3.
10. The decline of the propensity to consume along booms is often attributed to the fall in the share of wages in national income that usually takes place in these periods. For empirical evidence, see Tables 6.2 and 6.3.
11. Note that this argument is different from that of the simple multiplier–accelerator model. Without fully endorsing it, Sherman (1991, 141) summarizes the multiplier–accelerator explanation for the upper turning-point:Suppose that demand grows rapidly which causes a certain level of investment. If the rate of growth of demand slows, then the level of investment must decline. But an actual decline in investment will cause a recession . . . Thus a theory may explain business cycle down-turns . . .merely by showing why aggregate demand will slow its growth, and it is not nec-essary to prove that aggregate demand will decline before investment declines (emphasis added).’
The difference is that, according to our argument, the explanation of downturns requires not merely a slowing down of demand growth – but a slowing down of demand growth to a level below the required rate.
12. In this setting, we may speculate that the unusually long US expansion of the 1990s may have been permitted by the fact that technological innovations and population growth have created a natural rate of output growth as high as the actual rate (gn g) – thereby preventing output from ever reaching the full-employment ceiling.
13. The referred movements of nominal wages, productivity, raw materials prices, prices of finished goods and interest rates occurred frequently during the expansions of the 20th century (see Tables 6.2 and 6.3).
A notable exception was the behaviour of raw materials prices during the expansions of the 1950s and 1960s when they remained unchanged (Sherman 1991, 211).
14. This argument is especially relevant because, towards the end of expansions,firms’ costs become particularly sensitive to increases in interest rates, – especially in short term rates.
This happens because along booms (i) firms’ debt/equity ratio rises; (ii) the periods allowed for debt repayment become shorter; and (iii) the ratio of liquid assets to short-run debt falls (see Wolfson 1986).
15. The effect of profits is (partly) distinct from the effect of demand on investment.
Indeed, ‘profits influence investment not only by providing the motive for it [like demand] but also through providing the means. An important part of invest-ment is financed out of retained profits. Moreover, the amount that a company puts up of its own finance influences the amount it can borrow from outside’. (Robinson 1962, 86).
16. For evidence on these movements of raw materials prices, interest rates, the share of wages and the propensity to consume along the contractions of the 20th century, see Tables 6.2 and 6.3.
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