Question

Static versus Dynamic Analysis

Are each of the four cases of the Quantity Theory of Money static or dynamic propositions? Briefly distinguish the difference between static and dynamic analysis. Do prices always increase in the boom of the business cycle? If not, why not? Also why is the deflation of prices in the last 35 years of the 19^th Century in the United States not a refutation of the Quantity Theory of Money?

Answer 1

The economic theory is divided into two main branches, viz., economic statics and economic dynamics.  These terms were first introduced by August Comte in social sciences.  Stuart Mill made use of these concepts in economics.  These concepts were further explained by Ragnar Frisch.

Economic Statics:

Literally the word ‘static’ implies causing to stand or unchanged.  Static position is a position of rest or unchanged position.  However, economic statics does not imply absence of movement, rather it denotes a state in which there is a continuous, regular, certain and constant movement without change.

According to Clark, static state is the absence of five kinds of change: the size of population, the supply of capital, the methods of production, the forms of business organisation and the wants of the people.

Harrod is of the view that static analysis is concerned with a state of rest.  State of rest does not signify a state of idleness but simply lack of investment with the result that the economy repeats itself over time.  Unlikely other predecessor economists, he does not confine the concept of statics to a rigidly defined state of affairs.  He also includes in it the once-for-all change whereby the economy shifts from one state of rest to another.

Professor Hicks has a somewhat different notion of statics.  According to him, economic statics studies stationary situations which are devoid of any change and which do not require any relation to the past or the future.  Thus, the static economic of his vision is a timeless economy in which the various phenomena and their effects are analysed without reference to time.  For instance, when we say that if price is lowered by 5% demand rises by 3%, we are in the field of static analysis.

According to Frisch, in economic statics we do not study anything about the connection between conditions at various points of time, e.g., sequences, lags, etc.  The ordinary theory of demand and supply is an illustration of the static analysis.  It builds up a relationship between demand and supply as they are supposed to be at any moment of time.

The economic statics is based on the concept of a stationary state where everything churns steadily like a gramophone repeating itself endlessly.  It is an economic process which goes on at an even rate or which merely reproduces itself.  The tastes, resources and technology, etc, are not supposed to change over time.  The factors which control production, distribution, exchange and consumption are assumed to be constant, yet there is movement, though at a uniform rate.

Economic Dynamics:

The word ‘dynamics’ means causing to move.  In economics, the term ‘dynamics’ refers to the study of economic change.  It aims to trace and study the behaviour of variables through time, and determine whether these variables tend to move towards equilibrium.

According to Harrod, economic dynamics is chiefly concerned with continuing change, and therefore, necessitates the study of an economy wherein the rate of change of income (output) is itself changing.  The continuing acceleration and deceleration is the essence of Harrodian Dynamics.  

Ragnar Frisch has broadened the vistas of economic dynamics.  According to him, economic dynamics is the process of change, and should embody functional relationships of variables with different dates appended to them.  Frish’s definition of economic dynamics takes care of the past values of the several variables, their lags, sequences, rates of change and cumulative magnitudes, etc.

Sameulson’s definition of economic dynamics states that the essence of dynamics that economic variables at different points of time are functionally related including velocities, acceleration, or higher derivatives.  His definition of economic dynamics includes the phenomena of cyclical growth, cyclical fluctuations, speculation, cob-web theorems of price determinations, stagnation thesis, perspective planning, etc.

What is the difference between static and dynamic theory of economics?

1. Time Element:

Static economic analysis has nothing to do with time element. In static economics, all economic variables refer to the particular point of time.

Static economy is also called a timeless economy. Static economy, according to Hicks, is one where we do not trouble about dating.

On the contrary, in dynamic economics, time clement occupies an important role. Economic variables refer to the different points of time.

2. Process of Change:

Static analysis does not show the path of change. It only tells about the conditions of equilibrium.

On the contrary, dynamic economic analysis shows the path of change.

3. Equilibrium:

Static economics studies only a particular point of equilibrium.

But dynamic economics studies the process by which equilibrium is achieved. As a result, there may be equilibrium or may be disequilibrium.

Therefore, static analysis is a study of equilibrium only whereas dynamic analysis studies both equilibrium and disequilibrium.

4. Study of Reality:

Static analysis is far from reality while dynamic analysis is nearer to reality. Static analysis is based on the unrealistic assumptions of perfect competition, perfect knowledge, etc. Here all the important economic variables like fashions, population, models of production, etc. are assumed to be constant.

Stock Prices and the Business Cycle

In the post-WWII period, the biggest stock price downturns usually—but not always—occurred around business cycle downturns (i.e., recessions). Exceptions include the crash of 1987, which was part of a 35%-plus plunge in the S&P 500 that year, its 23%-plus pullback in 1966, and its 28%-plus drop in the first half of 1962.¹¹

However, each of those major stock price declines occurred during GRC downturns. Indeed, while stock prices generally see major downturns around business cycle recessions and upturns around business cycle recoveries, a better one-to-one relationship existed between stock price downturns and GRC downturns—and between stock price upturns and GRC upturns—in the post-WWII period, in the decades leading up to the Great Recession.

Following the Great Recession of 2007–09—while full-fledged stock price downturns, featuring over-20% declines in the major averages, did not occur until the 2020 COVID-19 pandemic—smaller 10%–20% "corrections" clustered around the four intervening GRC downturns, from May 2010 to May 2011, March 2012 to Jan. 2013, March to Aug. 2014, and April 2014 to May 2016. The 20% plunge in the S&P 500 in late 2018 also occurred within the fifth GRC downturn that began in April 2017 and culminated in the 2020 recession.¹²

In essence, the prospect of recession usually, but not always, brings about a major stock price downturn. But the prospect of an economic slowdown—and specifically, a GRC downturn—can also trigger smaller corrections and, on occasion, much larger downdrafts in stock prices.

For investors, therefore, it is vital to be on the lookout for not only business cycle recessions, but also the economic slowdowns designated as GRC downturns.

Were There Any Periods of Major Deflation in U.S. History?

Deflation is a decrease in the general price level of goods and services. It is the opposite of inflation, which occurs when the cost of goods and services is rising. Deflation can be caused by many different economic factors, including a decrease in the demand for products, an increase in the supply of products, excess production capacity, an increase in the demand for money, or a decrease in the supply of money or availability of credit.

Deflation can be a cause for concern amongst economists because a fall in the prices of goods and services can sometimes result in a fall in home prices, stock prices, and even people's salaries as well. There have been several deflationary periods in U.S. history, including between 1817 and 1860, and again between 1865 to 1900. The most dramatic deflationary period in U.S. history took place between 1930 and 1933, during the Great Depression. Deflation rarely occurred in the second half of the 20th century. In fact, the dramatic and consistent price increases from 1950 to 2000 has been unparalleled since the founding of the country. The most recent example of deflation occurred in the 21st century, between 2007 and 2008, during the period in U.S. history referred to by economists as the Great Recession.

Deflation in the 19th Century

While the U.S. did not have a single national currency until after the Civil War, economists can still track consumer prices in terms of the exchange value of gold. During the War of 1812, a conflict fought between the United States and the United Kingdom from June 1812 to February 1815, prices rose and the U.S. government printed money and borrowed money heavily during this time. Buoyed by the rise of industrial mechanization after the war, the prices of goods dropped starting in 1817 and continued to drop until 1860. Even though prices were dropping, output grew consistently during this time and continued to grow at the same time that prices were dropping until approximately 1860, at the start of the Civil War.

During the period between 1873 and 1879, prices dropped by nearly three percent every year, yet real national product growth was at almost seven percent during the same time period. However, despite this economic growth and the rise of real wages, historians have called this period "The Long Depression" because of the presence of deflation.

The Great Depression

In the 19th century, deflationary periods were the result of an increase in production, rather than a decrease in demand. During the Great Depression, deflation was the result of a collapsing financial sector and bank failures. The deflation that took place at the outset of the Great Depression was the most dramatic that the U.S. has ever experienced. Prices dropped an average of ten percent every year between the years of 1930 and 1933. In addition to a drop in prices, there was also a dramatic drop in output during the Great Depression.

Deflation in the 21st Century

The most recent deflationary period in U.S. history was during the Great Recession, which officially lasted from December 2007 to June 2009. During this time period, there was a drop in commodity prices, particularly oil, and economists worried that deflation would lead to a prolonged recession, rising unemployment, and further strain on the U.S. economy. In reality, the deflation that occurred was less severe than some economists predicted. While the exact reason for this is unclear, some economists have speculated that the unusually high cost of borrowing in late 2008 and 2009 put pressure on businesses and prevented them from cutting their prices.