Subject 2. Theories of the Business Cycle

We consider a few fundamentally different theories of the business cycle.

Neoclassicial and Austrian Schools - Self-Correcting Economy

The neoclassical economists assumed that the economy would not operate with real GDP (Y) away from the level of natural real GDP (YN) for any length of time; if Y < YN, then firms would be producing below capacity, and would tend to cut nominal wages and prices, which would continue until YN was again reached. If Y > YN, then above-capacity production could support hikes in nominal wages and prices, until real output fell back to YN. The consequence was no business cycle in real GDP.

The Austrian school economists argued that business cycles are caused by governments as they try to increase GDP and employment.

Keynesian School - No Self-Correction

It is the changes in output and employment, not price changes, that restores equilibrium in the Keynesian model.

  • Aggregate demand fluctuations. Demand is the driving force of the economy. Expectations are the most significant influence on aggregate demand.
  • Aggregate supply response. Wages and prices are highly inflexible, particularly in a downward direction. With a sticky price level, the short-run aggregate supply curve is horizontal at a fixed price level.
  • Policy response is needed. When aggregate expenditures are deficient, there are no automatic forces capable of assuring full employment. Recessions and depressions result when total spending falls because businesses reduce production. Therefore, government intervention is required to keep the economy at full employment capacity without inflation.

To reduce economic disturbances, fiscal policy must be put into effect at the proper time in the business cycle. Policy changes take time; thus, when they take effect, the recession or inflationary overheating may have passed.

Monetarist School

The economy is self-regulating and it will normally operate at full employment if monetary policy is properly timed and the pace of money growth is kept steady. The quantity of money is the most significant influence on aggregate demand.

The New Classical Model - Policy Ineffectiveness

Real business cycle theory assumes that real shocks to the economy are the primary cause of business cycles.

  • Adverse cost shocks lead to a recession, as individuals should spend less time working because it is not profitable.
  • Favorable cost shocks lead to a boom period because it is advantageous to produce as much as possible.

Production fluctuates because of the changing value of output and the changing productivity of the economy. Government intervention is generally not necessary because it may exacerbate this fluctuation or delay the convergence to equilibrium.

The Neo-Keynesian school assumes that the prices of most goods don't change daily (sticky price, or menu cost), as the cost of changing prices may outweigh the benefits of changing prices. Therefore, markets do not reach equilibrium quickly.

User Contributed Comments 2

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rjh512: try to memorize
Salim6: Keynesian = Demand / Short-run