A financial framework for understanding macroeconomic cycles

Abstract

Purpose A comprehensive understanding business cycles needs to account not only for the allocation of resources over time but also for resource allocation across industries at any point in time. But to properly understand how these “time-distortions” take place and how the price mechanisms that drive them work, a clear and well-defined conceptualization of the “average length” of the structure of production is required. The authors use insights provided by Macaulay’s duration and Hicks’s average period to show that financial duration and related concepts have a direct connection to macroeconomic stability. Design/methodology/approach This study uses a theoretical and conceptual approach. It first presents the connection between average period of production and financial duration and then compares and applies this to macroeconomic business cycle theories. Findings This study points to important implications for macroeconomic policy. It not only claims that a low interest rate contributes to the creation of asset bubbles but also shows the market mechanism through which the real sector is affected. The application of financial concepts to macroeconomic cycles shows the price mechanism through which resources are allocated across industries. Originality/value The financial approach we offer to business cycles is fairly unexplored. As such, this paper offers a novel conceptual and theoretical framework for business cycles.