Question

Based on New Keynesian Economics theory, discuss the business cycle in case of Malaysia.Based on New Keynesian Economics theory, discuss the business cycle in case of Malaysia.

Answer 1

BASED ON NEW KEYNESIAN ECONOMICS THEORY, DISCUSS THE BUSINESS CYCLE IN CASE OF MALAYSIA:

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. New Keynesian economics was conceived in the late 1970s, but several strands have evolved in new Keynesian macroeconomic theories/models since the mid 1980s. It developed partly as a response to criticisms of Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis, Keynesian macroeconomics by adherents of new classical macroeconomics.

The two main assumptions define the New usually assumes that households and firms have rational expectations; however, the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume that there is imperfect competition in price and wage setting to help explain why prices and wages can become "sticky," which means they do not adjust instantaneously to changes in economic conditions. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) and the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez-faire policy could.

Some of the most important features of new Keynesian economics are as follows:

1. Sticky nominal wages:  In the Keynesian theory, involuntary unemployment exists which can be removed by a cut in real wages by increasing aggregate demand, output and employment. Keynes held that money wages are sticky. Within the Keynesian tradition, new Keynesian economists have developed the new Keynesian theory of the labour market based on nominal wages stickiness.

2. Sticky nominal prices:  The classical and new classical microeconomic theories are based on the assumption of the flexibility in prices, where prices clear markets by adjusting demand and supply quickly. New Keynesian economists, on the other hand, believe in the stickiness of prices in the short-run. Markets do not clear quickly because adjusting prices is costly. Frequently adjusting prices of their goods involve costs to firms. A large sector of the economy is made up of price-makers who sell goods in monopolistic or imperfectly competitive markets. For them, adjusting prices is costly. This macroeconomic impact of one firm’s price adjustment on the demand for the products of all other firms is called an aggregate-demand externality by Mankiw. With aggregate demand externality, small menu costs can make prices sticky.

3. Sticky real wages:  In the new classical labour theory, labour market is cleared continuously at the market-clearing real wage rate, but it does not explain involuntary unemployment. On the other hand, the new Keynesian theories focus on the real wage rigidity, where workers are not paid market-clearing wage and involuntary unemployment exists even in the long run.  There are four main approaches to real wage rigidities. They are:

(a) Asymmetric information model.

(b) Implicit contract theory.

(c) Insider-outsider theory.

(d) Efficiency wage theory.

4. Coordination failures:  New Keynesian theories of wage and price stickiness have inconsistencies because they neglect constraints and spillovers and focus on single markets, one at a time, in a partial equilibrium framework. Cooper and John showed that spillovers and strategic complementarities lead to coordination failure. Coordination failure arises when firms and unions try to fix prices and wages to anticipate the actions of other price and wage setters. If there is a change in nominal demand, no firm will have an incentive to change its price exactly in the same proportion unless it believes that other firms will do so immediately.

The New Keynesian Phillips curve:

The New Keynesian Phillips curve was originally derived by Roberts in 1995, and has since been used in most state-of-the-art New Keynesian DSGE models. The new Keynesian Phillips curve says that this period's inflation depends on current output and the expectations of next period's inflation. The curve is derived from the dynamic Calvo model of pricing and in mathematical terms is:

The current period t expectations of next period's inflation are incorporated as: where is the discount factor. The constant captures the response of inflation to output, and is largely determined by the probability of changing price in any period, which is :

The less rigid nominal prices are (the higher is ), the greater the effect of output on current inflation.

Monetary Policy:
The ideas developed in the 1990s were put together to develop the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) used to analyze monetary policy. This culminated in the three equation new Keynesian model found in the survey by Richard Clarida, Jordi Gali, and Mark Gertler in the Journal of Economic Literature. It combines the two equations of the new Keynesian Phillips curve and the Taylor rule with the dynamic IS curve derived from the optimal dynamic consumption equation (household's Euler equation).

These three equations formed a relatively simple model, which could be used for the theoretical analysis of policy issues. However, the model was oversimplified in some respects (for example, there is no capital or investment) and also it does not perform well empirically.

In the new millennium, there have been several advances in new Keynesian economics. The introduction of imperfectly competitive labor markets. Whilst the models of the 1990s focused on sticky prices in the output market, in 2000 Christopher Erceg, Dale Henderson, and Andrew Levin adopted the Blanchard and Kiyotaki model of unionized labor markets by combining it with the Calvo pricing approach and introduced it into a new Keynesian DSGE model.

The development of complex DSGE models:
In order to have models that worked well with the data and could be used for policy simulations, quite complicated new Keynesian models were developed with several features. Seminal papers were published by Frank Smets and Rafael Wouters and also Lawrence J. Christiano, Martin Eichenbaum, and Charles Evans. The common features of these models included:

• Habit persistence. The marginal utility of consumption depends on past consumption.
• Calvo pricing in both output and product markets, with indexation so that when wages and prices are not explicitly reset, they are updated for inflation.
• Capital adjustment costs and variable capital utilization.
• New shocks. Demand shocks, which affect the marginal utility of consumption markup shocks that influence the desired markup of price over marginal cost.
• Monetary policy is represented by a Taylor rule.
• Bayesian estimation methods.

New Keynesian theory implications:

New Keynesian economists agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions.  Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short-run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization i.e., suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession.

Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se.). In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the ‘divine coincidence’. Recently, it was shown that the divine coincidence does not necessarily hold in the non-linear form of the standard New-Keynesian model. This property would only hold if the monetary authority is set to keep the inflation rate at exactly 0%. At any other desired target for the inflation rate, there is an endogenous trade-off, even under the absence real imperfections such as sticky wages, and the divine coincidence no longer holds.

New Keynesianism is a response to Robert Lucas and the new classical school. The school criticized the inconsistencies of Keynesianism in the light of the concept of "rational expectations". The new classicals combined a unique market-clearing equilibrium (at full employment) with rational expectations. The New Keynesians use "microfoundations" to demonstrate that price stickiness hinders markets from clearing. Thus, the rational expectations-based equilibrium need not be unique.  Whereas the neoclassical synthesis hoped that fiscal and monetary policy would maintain full employment, the new classicals assumed that price and wage adjustment would automatically attain this situation in the short run. The new Keynesians, on the other hand, see full employment as being automatically achieved only in the long run, since prices are "sticky" in the short run. Government and central-bank policies are needed because the "long run" may be very long.  Keynes' stress on the importance of centralized coordination of macroeconomic policies (e.g., monetary and fiscal stimulus) and of international economic institutions such as the World Bank and International Monetary Fund (IMF), and of the maintenance of a controlled trading system was emphasized during the 2008 global financial and economic crisis. This has been reflected in the work of IMF economists and of Donald Markwell.

What is a Business Cycle?
A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural growth rate. It explains the expansion and contraction in economic activity that an economy experiences over time. A business cycle is completed when it goes through a single boom and a single contraction in sequence. The time period to complete this sequence is called the length of the business cycle. A boom is characterized by a period of rapid economic growth whereas a period of relatively stagnated economic growth is a recession. These are measured in terms of the growth of the real GDP, which is inflation adjusted.

Stages of the Business Cycle
In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves about the line. Below is a more detailed description of each stage in the business cycle:

#1 Expansion:  The first stage in the business cycle is expansion. In this stage, there is an increase in positive economic indicators such as employment, income, output, wages, profits, demand, and supply of goods and services. Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment is high. This process continues until economic conditions become favorable for expansion.

#2 Peak:  The economy then reaches a saturation point, or peak, which is the second stage of the business cycle. The maximum limit of growth is attained. The economic indicators do not grow further and are at their highest. Prices are at their peak. This stage marks the reversal in the trend of economic growth. Consumers tend to restructure their budget at this point.

#3 Recession:  The recession is the stage that follows the peak phase. The demand for goods and services starts declining rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive economic indicators such as income, output, wages, etc. consequently start to fall.

#4 Depression:  There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as this falls below the steady growth line, the stage is called depression.

#5 Trough:  In depression stage, the economy’s growth rate becomes negative. There is further declined until the prices of factors, as well as the demand and supply of goods and services, reach their lowest. The economy eventually reaches the trough. This is the lowest it can go. It is the negative saturation point for an economy. There is extensive depletion of national income and expenditure.

#6 Recovery:  After this stage, the economy comes to the stage of recovery. In this phase, there is a turnaround from the trough and the economy starts recovering from the negative growth rate. Demand starts to pick up due to the lowest prices and consequently, supply starts reacting, too. The economy develops a positive attitude towards investment and employment and hence, production starts increasing. Employment also begins to rise and due to the accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced by producers, leading to new investment in the production process. Recovery continues until the economy returns to steady growth levels. This completes one full business cycle of boom and contraction. The extreme points are the peak and the trough.

There are basically two important phases in a business cycle that are prosperity and depression. The other phases that are expansion, peak, trough and recovery are intermediary phases.

New Keynesian model in relation to business cycle:

John Keynes explains the occurrence of business cycles as a result of fluctuations in aggregate demand, which bring the economy to short-term equilibriums that are different from a full employment equilibrium. Keynesian models do not necessarily indicate periodic business cycles, but imply cyclical responses to shocks via multipliers. The extent of these fluctuations depends on the levels of investment, for it determines the level of aggregate output.  On the contrary, economists like Finn E. Kydland and Edward C. Prescott, who are associated with the Chicago School of Economics, challenge the Keynesian theories. They consider the fluctuations in the growth of an economy not as a result of monetary shocks, but a result of technology shocks, such as innovation. It is generally rejected by mainstream economists who follow the path of Keynes.

Within mainstream economics, the debate over external (exogenous) versus internal (endogenous) being the causes of the economic cycles, with the classical school (now neo-classical) arguing for exogenous causes and the underconsumptionist (now Keynesian) school arguing for endogenous causes. These may also broadly be classed as "supply-side" and "demand-side" explanations: supply-side explanations may be styled, following Say's law, as arguing that "supply creates its own demand", while demand-side explanations argue that effective demand may fall short of supply, yielding a recession or depression. This debate has important policy consequences: proponents of exogenous causes of crises such as neoclassicals largely argue for minimal government policy or regulation (laissez-faire), as absent these external shocks, the market functions, while proponents of endogenous causes of crises such as Keynesians largely argue for larger government policy and regulation, as absent regulation, the market will move from crisis to crisis. This division is not absolute – some classicals (including Say) argued for government policy to mitigate the damage of economic cycles, despite believing in external causes, while Austrian School economists argue against government involvement as only worsening crises, despite believing in internal causes.

BASED ON NEW KEYNESIAN ECONOMICS THEORY, DISCUSS THE BUSINESS CYCLE IN CASE OF MALAYSIA:

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. New Keynesian economics was conceived in the late 1970s, but several strands have evolved in new Keynesian macroeconomic theories/models since the mid 1980s. It developed partly as a response to criticisms of Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis, Keynesian macroeconomics by adherents of new classical macroeconomics.

The two main assumptions define the New usually assumes that households and firms have rational expectations; however, the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume that there is imperfect competition in price and wage setting to help explain why prices and wages can become "sticky," which means they do not adjust instantaneously to changes in economic conditions. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) and the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez-faire policy could.

Some of the most important features of new Keynesian economics are as follows:

1. Sticky nominal wages:  In the Keynesian theory, involuntary unemployment exists which can be removed by a cut in real wages by increasing aggregate demand, output and employment. Keynes held that money wages are sticky. Within the Keynesian tradition, new Keynesian economists have developed the new Keynesian theory of the labour market based on nominal wages stickiness.

2. Sticky nominal prices:  The classical and new classical microeconomic theories are based on the assumption of the flexibility in prices, where prices clear markets by adjusting demand and supply quickly. New Keynesian economists, on the other hand, believe in the stickiness of prices in the short-run. Markets do not clear quickly because adjusting prices is costly. Frequently adjusting prices of their goods involve costs to firms. A large sector of the economy is made up of price-makers who sell goods in monopolistic or imperfectly competitive markets. For them, adjusting prices is costly. This macroeconomic impact of one firm’s price adjustment on the demand for the products of all other firms is called an aggregate-demand externality by Mankiw. With aggregate demand externality, small menu costs can make prices sticky.

3. Sticky real wages:  In the new classical labour theory, labour market is cleared continuously at the market-clearing real wage rate, but it does not explain involuntary unemployment. On the other hand, the new Keynesian theories focus on the real wage rigidity, where workers are not paid market-clearing wage and involuntary unemployment exists even in the long run.  There are four main approaches to real wage rigidities. They are:

(a) Asymmetric information model.

(b) Implicit contract theory.

(c) Insider-outsider theory.

(d) Efficiency wage theory.

4. Coordination failures:  New Keynesian theories of wage and price stickiness have inconsistencies because they neglect constraints and spillovers and focus on single markets, one at a time, in a partial equilibrium framework. Cooper and John showed that spillovers and strategic complementarities lead to coordination failure. Coordination failure arises when firms and unions try to fix prices and wages to anticipate the actions of other price and wage setters. If there is a change in nominal demand, no firm will have an incentive to change its price exactly in the same proportion unless it believes that other firms will do so immediately.

The New Keynesian Phillips curve:

The New Keynesian Phillips curve was originally derived by Roberts in 1995, and has since been used in most state-of-the-art New Keynesian DSGE models. The new Keynesian Phillips curve says that this period's inflation depends on current output and the expectations of next period's inflation. The curve is derived from the dynamic Calvo model of pricing and in mathematical terms is:

The current period t expectations of next period's inflation are incorporated as: where is the discount factor. The constant captures the response of inflation to output, and is largely determined by the probability of changing price in any period, which is :

The less rigid nominal prices are (the higher is ), the greater the effect of output on current inflation.

Monetary Policy:
The ideas developed in the 1990s were put together to develop the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) used to analyze monetary policy. This culminated in the three equation new Keynesian model found in the survey by Richard Clarida, Jordi Gali, and Mark Gertler in the Journal of Economic Literature. It combines the two equations of the new Keynesian Phillips curve and the Taylor rule with the dynamic IS curve derived from the optimal dynamic consumption equation (household's Euler equation).

These three equations formed a relatively simple model, which could be used for the theoretical analysis of policy issues. However, the model was oversimplified in some respects (for example, there is no capital or investment) and also it does not perform well empirically.

In the new millennium, there have been several advances in new Keynesian economics. The introduction of imperfectly competitive labor markets. Whilst the models of the 1990s focused on sticky prices in the output market, in 2000 Christopher Erceg, Dale Henderson, and Andrew Levin adopted the Blanchard and Kiyotaki model of unionized labor markets by combining it with the Calvo pricing approach and introduced it into a new Keynesian DSGE model.

The development of complex DSGE models:
In order to have models that worked well with the data and could be used for policy simulations, quite complicated new Keynesian models were developed with several features. Seminal papers were published by Frank Smets and Rafael Wouters and also Lawrence J. Christiano, Martin Eichenbaum, and Charles Evans. The common features of these models included:

• Habit persistence. The marginal utility of consumption depends on past consumption.
• Calvo pricing in both output and product markets, with indexation so that when wages and prices are not explicitly reset, they are updated for inflation.
• Capital adjustment costs and variable capital utilization.
• New shocks. Demand shocks, which affect the marginal utility of consumption markup shocks that influence the desired markup of price over marginal cost.
• Monetary policy is represented by a Taylor rule.
• Bayesian estimation methods.

New Keynesian theory implications:

New Keynesian economists agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions.  Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short-run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization i.e., suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession.

Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se.). In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the ‘divine coincidence’. Recently, it was shown that the divine coincidence does not necessarily hold in the non-linear form of the standard New-Keynesian model. This property would only hold if the monetary authority is set to keep the inflation rate at exactly 0%. At any other desired target for the inflation rate, there is an endogenous trade-off, even under the absence real imperfections such as sticky wages, and the divine coincidence no longer holds.

New Keynesianism is a response to Robert Lucas and the new classical school. The school criticized the inconsistencies of Keynesianism in the light of the concept of "rational expectations". The new classicals combined a unique market-clearing equilibrium (at full employment) with rational expectations. The New Keynesians use "microfoundations" to demonstrate that price stickiness hinders markets from clearing. Thus, the rational expectations-based equilibrium need not be unique.  Whereas the neoclassical synthesis hoped that fiscal and monetary policy would maintain full employment, the new classicals assumed that price and wage adjustment would automatically attain this situation in the short run. The new Keynesians, on the other hand, see full employment as being automatically achieved only in the long run, since prices are "sticky" in the short run. Government and central-bank policies are needed because the "long run" may be very long.  Keynes' stress on the importance of centralized coordination of macroeconomic policies (e.g., monetary and fiscal stimulus) and of international economic institutions such as the World Bank and International Monetary Fund (IMF), and of the maintenance of a controlled trading system was emphasized during the 2008 global financial and economic crisis. This has been reflected in the work of IMF economists and of Donald Markwell.

What is a Business Cycle?
A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural growth rate. It explains the expansion and contraction in economic activity that an economy experiences over time. A business cycle is completed when it goes through a single boom and a single contraction in sequence. The time period to complete this sequence is called the length of the business cycle. A boom is characterized by a period of rapid economic growth whereas a period of relatively stagnated economic growth is a recession. These are measured in terms of the growth of the real GDP, which is inflation adjusted.

Stages of the Business Cycle
In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves about the line. Below is a more detailed description of each stage in the business cycle:

#1 Expansion:  The first stage in the business cycle is expansion. In this stage, there is an increase in positive economic indicators such as employment, income, output, wages, profits, demand, and supply of goods and services. Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment is high. This process continues until economic conditions become favorable for expansion.

#2 Peak:  The economy then reaches a saturation point, or peak, which is the second stage of the business cycle. The maximum limit of growth is attained. The economic indicators do not grow further and are at their highest. Prices are at their peak. This stage marks the reversal in the trend of economic growth. Consumers tend to restructure their budget at this point.

#3 Recession:  The recession is the stage that follows the peak phase. The demand for goods and services starts declining rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive economic indicators such as income, output, wages, etc. consequently start to fall.

#4 Depression:  There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as this falls below the steady growth line, the stage is called depression.

#5 Trough:  In depression stage, the economy’s growth rate becomes negative. There is further declined until the prices of factors, as well as the demand and supply of goods and services, reach their lowest. The economy eventually reaches the trough. This is the lowest it can go. It is the negative saturation point for an economy. There is extensive depletion of national income and expenditure.

#6 Recovery:  After this stage, the economy comes to the stage of recovery. In this phase, there is a turnaround from the trough and the economy starts recovering from the negative growth rate. Demand starts to pick up due to the lowest prices and consequently, supply starts reacting, too. The economy develops a positive attitude towards investment and employment and hence, production starts increasing. Employment also begins to rise and due to the accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced by producers, leading to new investment in the production process. Recovery continues until the economy returns to steady growth levels. This completes one full business cycle of boom and contraction. The extreme points are the peak and the trough.

There are basically two important phases in a business cycle that are prosperity and depression. The other phases that are expansion, peak, trough and recovery are intermediary phases.

New Keynesian model in relation to business cycle:

John Keynes explains the occurrence of business cycles as a result of fluctuations in aggregate demand, which bring the economy to short-term equilibriums that are different from a full employment equilibrium. Keynesian models do not necessarily indicate periodic business cycles, but imply cyclical responses to shocks via multipliers. The extent of these fluctuations depends on the levels of investment, for it determines the level of aggregate output.  On the contrary, economists like Finn E. Kydland and Edward C. Prescott, who are associated with the Chicago School of Economics, challenge the Keynesian theories. They consider the fluctuations in the growth of an economy not as a result of monetary shocks, but a result of technology shocks, such as innovation. It is generally rejected by mainstream economists who follow the path of Keynes.

Within mainstream economics, the debate over external (exogenous) versus internal (endogenous) being the causes of the economic cycles, with the classical school (now neo-classical) arguing for exogenous causes and the underconsumptionist (now Keynesian) school arguing for endogenous causes. These may also broadly be classed as "supply-side" and "demand-side" explanations: supply-side explanations may be styled, following Say's law, as arguing that "supply creates its own demand", while demand-side explanations argue that effective demand may fall short of supply, yielding a recession or depression. This debate has important policy consequences: proponents of exogenous causes of crises such as neoclassicals largely argue for minimal government policy or regulation (laissez-faire), as absent these external shocks, the market functions, while proponents of endogenous causes of crises such as Keynesians largely argue for larger government policy and regulation, as absent regulation, the market will move from crisis to crisis. This division is not absolute – some classicals (including Say) argued for government policy to mitigate the damage of economic cycles, despite believing in external causes, while Austrian School economists argue against government involvement as only worsening crises, despite believing in internal causes.

Politically based business cycle:
Another set of models tries to derive the business cycle from political decisions. The partisan business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. Regime A adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high. The replacement, Regime B, adopts contractionary policies reducing inflation and growth, and the downwards swing of the cycle. It is voted out of office when unemployment is too high, being replaced by Party A.  The political business cycle is an alternative theory stating that when an administration of any hue is elected, it initially adopts a contractionary policy to reduce inflation and gain a reputation for economic competence. It then adopts an expansionary policy in the lead up to the next election, hoping to achieve simultaneously low inflation and unemployment on the election day.

The political business cycle theory is strongly linked to the name of Michał Kalecki who discussed "the reluctance of the 'captains of industry' to accept government intervention in the matter of employment." Persistent full employment would mean increasing workers' bargaining power to raise wages and to avoid doing unpaid labor, potentially hurting profitability. (He did not see this theory as applying under fascism, which would use direct force to destroy labor's power.) In recent years, proponents of the "electoral business cycle" theory have argued that incumbent politicians encourage prosperity before elections in order to ensure re-election – and make the citizens pay for it with recessions afterwards.

New Keynesian Economics theory in relation with business cycle in case of Malaysia:

Stable economic growth is the major macroeconomic goal which most or even all nations seek. Economists and policy makers have been entrusted to find ways to sustain and maintain economic growth in order to guarantee a higher and stable standard of living of their respective countries. However, evidence suggests at least in the long run economic growth
has never been stable but is interrupted by periods of economic instability. Meaning that, the actual growth tends to fluctuate. In some years, there is a higher rate of economic growth and the country is at boom whilst other times the economy grows at slowly or even negative and the country is at recession. This cycle of boom and recession is known as business cycle or trade cycle.

Business cycle is a cycle of expansions occurring at about the same time in many economic activities followed by similarly general recessions, contractions, and revivals, which merged the expansion phase of the next cycle; the sequence of change is recurrent but not periodic; in duration business cycle vary from more than one year to ten or twelve year; they are
not divisible into shorter cycles of similar character with amplitudes approximating their own. Many economists agree that trade can play a crucial role in linking economies and transmitting disturbances, the impact of trade linkages on the degree of business cycle synchronization is ambiguous. Therefore, the importance of government in the current openness economic system is to ensure that the business cycle can work effectively to realize the economic objectives.

There are many research conducted to study about the relationship of macroeconomic and business cycle. James H Stock and Watson (1998) conducted research about business cycle fluctuation in U.S macroeconomic. This research included as the comprehensive research that uses more than 70 macroeconomic indicators as an independent variable. In addition, some literature said that there is significant effort for the government to ensure that the good macroeconomic variable can push the business cycle is better.

The main objective here is to find the impact of macroeconomic variable on the business cycle per sa Malaysia. There are many macroeconomic variables, but in this study we will use some main important indicator of macroeconomic, namely; Interest rate, Exchange rate, Money supply, and Inflation. In addition, as proxy for the business cycle this study uses Industrial Production Index (IPI). IPI is used because of the limitation of monthly data.

Taking the Malaysia in perspective, macroeconomics emphasizes the interaction of various sectors in the economy. Hence any disturbance of one sector of the economy causes fluctuation in other sectors.  Real business cycle is attributable to the cyclical ups and downs in economic activities to changes in productivity. Of all the reasons that changes productivity over time are most importantly improvements in technological for producing goods and service and improvement in the worker’s skills that are most important. Meaning that, as a result of technological progress, the productivity of capital is supposed to increase over time. Similarly, as a result of, new skills, improved education, training and better health, the productivity of labor increases over time. Moreover, such as output, consumption, investment and hours worked also raise in the longterm trend. In addition, above the average total factor of production is the means that macroeconomic variables tend to existing for some time and the reason boom exists for a while.

The data utilized in the analysis has been collected from different sources. for Malaysia, Consumer Price Index (CPI), Exchange Rate (ER), Money Supply (MS), Lending Interest Rate (LR) and Industrial Production (IP) has been collected from Bank Negara Malaysia, while stock price from yahoofinance. The data used is Monthly data covering the period from first
January 2007 to June 2010, with sample size of 42 data items. Using the Multiple Regression Analysis to show the relationship between Industrial Production (IP) of Malaysia, which is the dependent variable of the study and the selected independent macroeconomic variables that are: Consumer Price Index (CPI), Exchange Rate (ER), Money Supply (MS), Lending Interest Rate (LR) and stock price. Industrial Production (IP) is a function of the foreign exchange rate, the level of money supply, the interest rate, the consumer price index and stock price. We restricted the influencing factors to five as representatives of the macroeconomic factors. A simple linear regression model derived from Al-Tamimi (2007).

IPI = f (ER, MS, LR, CPI, stock price)

IP is the dependent variable which will be regressed against the independent variables (ER, MS, LR, CPI, stock price). The outcome of the regression would show how far the independent variables can explain the variation on the dependent variable. A multiple regression software (SPSS) was used to conduct the regression analysis.  In multiple regressions we use, the dependent variable (Industrial production (IP)) denoted as Y, while the independent variables (X1, X2, X3, X4, X5) represented respectively as ER, MS, LR, CPI and stock price represented by KLCI/JCI