Summary of Business Cycle Theories

Monetarist Business Cycle 

Inflationary booms are not necessarily followed by deflationary recession. They can have soft landings. Depression is caused by fall in the money stock or, likewise, a rise in demand for money unreciprocated by a fall in prices. (Yeager, Cash Balance Interpretation of Depression) Monetarist analysis relies on the equation of exchange: MV = Py. In the long run, a change in M leads to a change in P, but if prices are not fully flexible, y will be effected. Thus a fall in the money stock or a rise in demand for money (drop in velocity) effect real production when prices do not adjust instantaneously. Changes in MV shift the AD curve along the SRAS curve.

Implicit in this analysis is the assumption of an upward sloping SRAS curve. There is an SRAS because prices and wages are not fully flexible.  Changes in MV not met by changes in prices effect the real economy.

A depression might also be caused by too much inflation. Costs of adjustment – shoe leather cost – lead to a lower level of output (a level shift).

*Monetarists formalism relies on aggregates and ignores the Austrian argument about shifts in relative prices caused by monetary policy.

Keynesian Business Cycle 

The macroeconomy tends not to reach full employment on its own. The loanable funds market does not serve as an optimal nexus for equilibrating savings and investment. An excess of savings of investment lead to a drop in demand. If AD = C + G + I, increased savings that results in a drop in C but no increase in I represents a drop in demand. A fall in AD is concomitant with a drop in demand for labor. Keynes posited that changes in the money stock that are not channeled through the labor market will not increase prices. Prices rise when money enters an industry that is in full employment. Only when the entire economy is at full employment will prices begin to rise in full proportion to increase in the money stock.

Given this framework, depression are an endogenous and persistent phenomena, only able to be vanquished by macroeconomic management. Keynes suggests that deficiencies in aggregate demand should be offset by increases in fiscal expenditures. These can be financed by either the central bank or underutilized private lending.

New Classical Business Cycle (Lucas Islands Model)

New Classical economics is tied intimately to rational expectations and the efficient market hypothesis. Agents in these models are rational optimizers. Lucas describes his model as being comprised of a rational economic agents in a world where “all prices are market clearing.” Price changes result from either “a relative demand shift or a nominal (monetary) one (Snowdon and Vane, 2005 236).”

It is difficult to imagine depression in a world with continuous market clearing and rational expectations. In Lucas’s model, agents are optimizing with imperfect information, which allows for systematically biased error. Producers perceive changes in P, general prices, but are unable to determine whether a change in P is joined by a rise in the relative price of the good they produce. This is Lucas’s case for an upward sloping SRAS. An unexpected increase in P leads producers to increase production even if relative prices are unchanged. This is what Lucas refers to as the “signal extraction problem”.

Lucas’s model beautifully shows the logical implications of rational expectations under imperfect information. Everyone is simultaneously fooled because of a nominal-real confusion. Business fluctuations are a function of upset expectations that result from unexpected changes in prices via changes in the money stock. Lucas’s model is of little use in a country where agents are accustomed to inflation. However, “an unanticipated monetary disturbance that takes place in a country where agents are expecting price stability will lead to a significant real output disturbance.” (Snowdon and Vane 2005, 241)

Real Business Cycle Theory

Real Business Cycle Theory is a continuation of the New Classical research program. It forgoes the impulse mechanism of Lucas – inaccurate expectations leading to nominal-real confusion – for a model that employs rational expectations with perfect information. In this model, actors are rational and perfectly informed. Macroeconomic changes occur due to technology shocks that affect the LRAS curve. “These supply-side shocks to the production function generate fluctuations in aggregate output and employment as rational individuals respond to the altered structure of relative prices by changing their labour supply and consumption decisions.” (Snowdon and Vane 2005, 297) Remember that, with no upward sloping SRAS curve, business cycles cannot be explained by nominal changes. Money-illusion ceases to impact y because expectations adjust prices immediately. Thus, real business cycle theory represents the logical end of rational expectations.

Implications of RBCT include: 1) Labor and leisure are highly substitutable. Changes in employment rates are the result of voluntary action. 2) Monetary policy is impotent because nominal changes are accounted for by rational expectations. 3) Output follows a random walk where all changes are due to real factors. Defined as Y_t = g_t + Y_t-1 + z_t where Y is output, g is the drift (growth) of output, and z represents a technology shock (Snowdon and Vane 2005, 301-303)

New Keynesian Business Cycle Theories

It is important to recognize that the New Keynesian research program is less focused than other programs. Models represent a search for explanation of short-run deviations from the long-run growth path. According to Mankiew and Romer, New Keynesian research confronts two questions:

1 Does the theory violate the classical dichotomy? That is, is money non-neutral?
2 Does the theory assume that real market imperfections in the economy are crucial for understanding economic fluctuations. (Snowdon and Vane 2005, 363)

New Keynesian theories do not rely exclusively on supply or demand shocks. Either can cause economic fluctuation. New Keynesians are concerned about market imperfections that slow the process of adjustment to the long-run growth path. The textbook New Keynesian model considers the impact of rigid nominal prices and real wages. Firms operate as price searchers that tend not to reduce prices due to menu costs. Firms hire labor at efficiency wages – wages slightly above the market wage – in order to hold onto labor during recessions and to ensure productivity. That is, the higher is one’s wage, the greater is the cost of unemployment. During a recession, firms are slow to reduce prices due to menu costs. In the labor market, real wages do not lower, so drop in demand for labor augments what would already be an increase in unemployment. In the Greenwald-Stiglitz model, firms are risk averse and reduce output in order to lower the risk of bankruptcy. Therefore, what begins as a recession caused by a negative AD shock can lead to a reduction in AS. Lastly, hysteresis is the phenomenon where prolonged periods of elevated unemployment sustain memory in the economic system. Because workers have remained out of the workforce for an extended period of time, their willingness and/or ability to return or diminished. High unemployment begets future high unemployment.

Austrian Business Cycle 

Expansion of the money stock by a central bank leads to a lowering of the real interest rate and a distortion of relative prices. The change in the interest rate represents a change in the minimum rate of return required to sustain a project. With a drop in the rate, long term projects appear to be more profitable than before. Investment flows into these projects. The lower interest rate, since it does not reflect real preferences, distorts the structure of production. Eventually, the long term projects no longer appear profitable and the economy enters a period of depression, during which resources are reallocated.