Stock Markets in Islamic Countries pdf

STOCK MARKETS IN ISLAMIC COUNTRIES – Book Sample

2.2 THE DIFFERENT TYPES OF CYCLES

This section briefly distinguishes between the different types of cycles used to explicate economic fluctuations. First, we have business cycles as discussed above. Second, the Kondratieff cycle is used to explain long cycles. Kondratieff (1935) identified economic long waves in Western countries of approximately 50–60 years. In his theory, each cycle consists of three phases: expansion, stagnation and recession.

Later economists divided these three phases or waves into four seasons, whereby spring represented improvement, summer showed acceleration and prosperity, fall was indicative of a plateau and winter was decline and depression.

Entrepreneurs bringing about social shifts of expansion and growth led the first season. Summer represented escalating prosperity that changes the general attitude towards work leading to inefficiency and complacency. The plateau period represented by fall comes next as social attitude shifts towards stability and normalcy.

It is at this period that unemployment rises. Lastly, winter is the stage of severe depression, where the economy suffers significantly. However, modern economists do not accept this long wave theory, with much of the criticism pointing towards undecided start and end periods of the waves.

Third, the technology cycle, as discussed by the Real Business Cycle (RBC) theory, suggests that there is a high positive correlation between labour productivity and employments.

2.3 THEORIES OF BUSINESS CYCLES

One of the earliest theories linked fluctuations to that of harvest, and since harvest is depended on nature, it was considered a biological cycle. However, this theory was not without its critics and it did not last long at the turn of the twenty-first century when the contribution of agriculture had fallen significantly. The best-known sector cycle in economics is the agricultural commodity cycle, which followed the cobweb pattern. Kaldor (1938) explained that regular fluctuations occur in agricultural production because (1) the following period’s production is dependent on current or past prices, and (2) the current prices are also determined by current production.

With the introduction of the Industrial Revolution at the end of the eighteenth century, technology and technological revolutions have spurred many economists to conclude that technological innovation

10 STOCK MARKETS IN ISLAMIC COUNTRIES

had brought about a wave of change in the economy without end but rather with pauses in between. Hence, these rhythmic changes in technological innovations could be responsible for corresponding movements in the economy. The most popular and well-established theory in this aspect is the RBC theory, which is discussed in detail below.

Another popular theory lies in the imbalance between output and sales in an expanding economy. This has led economics to believe that busi-ness cycles are caused by either overproduction or underconsumption. The Keynesians are strong proponents of this theory.

Similarly, other theories hold that changes in supply of savings and investments that come along with it cause waves in the economy. Lastly, monetary theorist are of the opinion that changes in money supply cause economic fluctuations; in such an increase, the total quantity of money could cause an increase in economic activity. One such theory, the Austrian Business Cycle (ABC) theory is explored in detail below.

Below the RBC theory is discussed in detail owing to its relevance to this book and other theories are mentioned briefly.

2.3.1 Real Business Cycle Theory

A key theory that is relevant to this book is the RBC theory. According to the standard RBC approach, the competitive equilibrium of the market economy achieves resource allocation that maximizes the representative household’s expected utility given the constraints on resources. Although the RBC approach has often been criticized for its abstraction from firm and household heterogeneity.

According to the theory, changes in technology in the business sector are what cause the booms and bust of a business cycle. It argues that macroeconomic variables are largely responsible for shifts in busi-ness cycles. The RBC theory demonstrates that changes in economic activity are compatible with competitive general equilibrium environ-ments. Therefore, factors such as coordination failures, price stickiness, waves of optimism or pessimism or monetary or fiscal policy are not needed to explain business cycles.

Proponents of the RBC theory believe that only the forces that can change the Walrasian equilibrium can cause fluctuations in economy. The Walrasian equilibrium is described as the set of quantities and relative prices that brings together supply and demand in all markets of theeconomyat thesame time.

On the other hand, opponents of the RBC theory argue against the viability of the RBC theory saying that there is a lack of rigorous economic testing to test the practicality of how it explains business cycles. Similarly, the theory does not account for recessions, as it would require economy-wide reduction in productivity.

It is argued further that the RBC model does not account for monetary shocks, while much evidence is available to suggest that monetary conditions stimulate business cycle fluxes. New Keynesians have considered this limitation and worked upon a better fitting theory on business cycles.

Another interesting critique on the RBC Models is its use of the Hodrick–Prescott (HP) filter to decompose series into growth and busi-ness cycle components, as it removes valuable information associated with business cycles and can cause spurious data patterns.

2.3.2 Keynesian Theory of Business Cycles

Keynesians commented on the classical view asserting that the demand would not be able to self-correct in an economy due to an impotence of money, that is, the failure of real GDP to respond to increases in real money supply or a decrease in real interest rates. Similarly, they argue that supply side would also not be self-correcting because of a failure to maintain equilibrium wages in the labour market.

Keynes (1936) asserts that the most important factor generating busi-ness cycles is fluctuations in efficiency of capital. Accordingly, a boom caused mainly by excessive investments is compelled by the increase in marginal efficiency of capital. Similarly, he states that economies recover regularly from recessions due to the depreciation of excess capital stock accumulated during boom. This will eventually return to normal levels within several years.

The Keynesians, like RBC theory, also attempt to predict increases in real interest rate through temporal increases in government purchases (demand side); however, they do not give much importance to the effect of real interest rate on labour supply. The proponents of the Keynesian theory of business cycles choose to focus more on the macrodynamic explanations of business cycle fluctuations.

2.3.3 Austrian Business Cycle Theory

Developed by Mises (1912), it is based mainly on conservative macro-economic variables of savings, money supply, interest rates and investments. Fundamentally, the theory argues that because of the monetary authority’s ability to expand the money supply, there would be an impact on interest rates, saving and investments, which causes business cycles.

According to Mises, the most essential determinant of business cycle is the impact of monetary expansions on interest rates. This is so because when more money is available in the economy, it becomes cheaper for investors to borrow to expand their investments, and choose to invest in long production processes thereby shifting consumption from present to future.

This concept, advanced by Hayek (1935) who argued that the business cycle growth because of credit creation, is not sustainable because the fall in interest rates is not a permanent phenomenon.

The ABC theory, however has limitations, in that, it over emphasizes the impact of interest rates. Interest rates on their own may not create the effects that ABC theory asserts. Increased investments after a fall in interest rates can be a result of other economic factors.

The mainstream economics ascertain that credit expansion leads to inflation, suggesting that business cycles produce inflation. The Austrian position has not integrated this economic fact in their analysis. The ABC theory does not hinge on there being any inflation during the business cycle boom. However, inflation is always a monetary fact and cannot be denied.

The ABC theory also ignores the rational expectation hypothesis. The theory fails to explain the ability of people to distinguish between an increase in personal savings and an increase in central bank holdings of government debt, which is an important and reasonable requirement of individual rationality in economic actions.