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Hicks' Theory of Business Cycles

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

Business cycles are an important part of economics and have been shown to occur, surprisingly regularly, on a 8-10 year cycle. A number of economists have theories why this is the case. In this lesson, learn about John Hick's theory.

The Basic Business Cycle

Economies expand and contract - sometimes things are good, sometimes not so much. The idea of this happening in a cycle is called a business cycle.

This concept dates back to economists from the 1800s like Adam Smith and David Ricardo. They identified the general growth and decline of goods and services over the course of years. They would see economic growth, with signs such as individuals accumulating more wealth and goods, saving more money, and unemployment dropping near to the point of full employment.

Then, after some time, things would change, and there would be fewer jobs, meaning fewer people with extra money to buy things, meaning less output and production, which would lead to an economic slowdown, or recession.

While there weren't any conflicts with this basic understanding of business cycles, it did leave some questions unanswered. For example, while it explained growth and decline in the economy, it didn't address the time the economy was stable.

This basic explanation also assumed little or no lag time between a change in employment and a change in savings rate (the percentage of average income a household would save), nor demand for certain items.

The absence of this information didn't invalidate the existence of business cycles, it simply left more questions for future economists, like John Hicks, to figure out.

Hicks' Theory of Business Cycles

John Hicks was an economist early in the 1900s that took the work of Adams and Ricardo and joined it with the work of many of his contemporaries to answer some remaining questions. Hicks thought about how the multiplier effect and accelerator effect interact with one another.

The Multiplier Effect and Accelerator Effect

  • The multiplier effect is the total impact an incremental dollar in income could have throughout the economy. You might think, ''Well, it's $1.00.'' But think of the flow of money through the economy. If you earn that extra dollar, you'll probably spend it on something. The producer of that good will get the money, and it will end up - at least partially - as income for someone else.

That person will then buy something, providing income for someone else. If, by the time that dollar is 'done' being spent, it has turned into $4 in wages for you and other people down the supply chain, then the economy has a multiplier of four.

  • The accelerator effect is a little easier to articulate. It's the expected increase in investment as the economy grows. This doesn't happen at exactly the same time, but as the economy grows and people's income increases, this also increases investments - either in savings accounts or more aggressive investments.

Answered Questions

First, by talking about the idea of a lag period, Hicks was able to suggest why the economy can be stable and not in a constant state of booms and busts.

Think about how this would play out in your own life. If you had been unemployed and then got a job, would you start spending and investing more on your first paycheck? Probably not. You would want to replenish your savings account and repay any debt you may have incurred.

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