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 (Y^N) for any length of time; if Y < Y^N, then firms would be producing below capacity, and would tend to cut nominal wages and prices, which would continue until Y^N was again reached. If Y > Y^N, then above-capacity production could support hikes in nominal wages and prices, until real output fell back to Y^N. 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.

Practice Question 1

No government intervention is needed if a recession occurs. Unemployment and excess supply of goods will be solved by allowing market prices to decrease until all markets clear. This is the view of the ______.

A. Neoclassical school
B. Keynesian school
C. New Classical school

Correct Answer: A

Neoclassical economists believe that supply creates its own demand and that all markets will reach equilibrium because of the "invisible hand."

Practice Question 2

The New Classical view believes that ______ are the most significant influence on aggregate demand.

A. expectations
B. technological changes
C. real wage rates

Correct Answer: B

In contrast, the Keynesian view believes that expectations are the most significant influence on aggregate demand.

Practice Question 3

The monetarist view believes that the ______ is the most significant influence on aggregate demand.

A. quantity of money supplied
B. quantity of money demanded
C. intersection of money supply and demand

Correct Answer: A

Monetarists argue that the money supply should be kept growing at an even pace.

Practice Question 4

The Keynesian model believes that changes in ______ bring an economy to equilibrium.

A. demand
B. output prices
C. resource prices

Correct Answer: A

Classical economists believe that prices bring the economy to full employment.

Practice Question 5

Keynes argued that the ______

A. long-run is more relevant than the short run.
B. short run is more relevant than the long run.
C. short run and the long run are equally important.
D. distinction between the short run and the long run is irrelevant.

Correct Answer: B

For Keynes, the short-run was more important because output seldom reached its potential, even over long periods of time.

Practice Question 6

The macroeconomic view that the money wage rate and the prices of goods and services are inflexible is the ______.

A. Keynesian view
B. Neoclassical view
C. New Classical view

Correct Answer: C

The Keynesian view holds that the money wage rate is sticky in the downward direction. The New Classical view holds that not only is the money wage rate sticky but that prices of goods and services are also sticky.

Practice Question 7

According to the real business cycle theory, the impulse that leads to business cycles is ______.

A. unexpected changes in aggregate demand and/or fluctuations in business confidence
B. fluctuations in the growth rate of the quantity of money
C. changes in the growth rate of productivity resulting from technological change

Correct Answer: C

Practice Question 8

The Keynesian school concludes that business cycle fluctuations in real GDP are generally the result of fluctuations in ______.

A. short-run and long-run aggregate supply
B. aggregate demand
C. potential GDP

Correct Answer: B

Practice Question 9

Which model is based on the belief that supply creates its own demand?

A. The Neoclassical and Austrian schools
B. The Keynesian and Monetarist schools
C. The New Classical school

Correct Answer: A

This is Say's law: all that is produced will be sold.

Practice Question 10

Within the Keynesian model, when planned aggregate demand equals total output, ______

A. the employment rate will equal the labor force participation rate.
B. government expenditures will equal revenues.
C. the output level will tend to persist into the future.

Correct Answer: C

Because Keynesian equilibrium is dependent on equality between planned aggregate expenditures and output, it need not take place at full employment. An economy in Keynesian equilibrium has no tendency for output to change even if output is well below full employment capacity.

Practice Question 11

Which statement is false based on the real business cycle theory?

A. A period of rapid productivity growth brings an expansion and a decrease in productivity triggers a recession.
B. Productivity shocks are as likely to be caused by changes in aggregate demand as by technological change.
C. Real business cycle theory regards random fluctuations in productivity as the main source of economic fluctuations.

Correct Answer: B

This is actually one of the main criticisms of RBC theory.

Practice Question 12

Which statement is false?

A. The real business cycle theory states that unemployment can only be short-term.
B. Austrian economists advocate government intervention in the form of fiscal policy.
C. Keynesian cyclical policies are focused on the short-term.

Correct Answer: B

Austrian economists actually advocate limited government intervention in the economy.

Practice Question 13

Which model(s) assume(s) sticky wages (workers don't want to lower their wages to help the market reach a new equilibrium)?

I. Keynesian school
II. Neo-Keynesian school
III. New Classical school

A. I only
B. III only
C. I and II

Correct Answer: C

They both assume slow-to-adjust wages. The Neo-Keynesian school, in addition, assumes that other prices are slow to adjust as well (menu costs).

Practice Question 14

The belief that money wage rates are sticky is least likely to be associated with ______.

A. Keynesian macroeconomics
B. monetarist macroeconomics
C. classical macroeconomics

Correct Answer: C

Both Keynesians and monetarists believe that money wage rates are sticky. Classical macroeconomics does not believe so.