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