business cycle theory

This is a great post by Lee Doren. He’s spot on pointing out that “the [video producers/Larry White] don’t claim that 100 percent of the disruptions in the market are caused by the Federal Reserve.” After all, boom and bust cycles, or business cycles, existed even before central banks — not that governments didn’t tamper with money before central banks. I wanted to elaborate on this business cycle theme a little by providing a (very brief) outline of some other theories of business cycles.

Essentially, there are two largely different schools: Austrian and neoclassical. When Keynes published his General Theory Employment, Interest, and Money in 1936, this created modern neoclassical macroeconomics. F.A. Hayek had a competing book that was supposed to strengthen Austrian macroeconomics, the Pure Theory of Capital (1941). The book was a dismal mess and Austrian Business Cycle theory became latent (although Austrian macroeconomics appears to be making a comeback 60 years later). I won’t elaborate on the differences between those two schools here, because I want to take a look at the three neoclassical theories on business cycles. One of these shares characteristics similar to Austrian macroeconomics:

(1) New Keynesians assume that prices and wages are “sticky.” Sticky prices and wages indicate that it takes a long time (like 3 months or more, rather than minutes) for prices and wages to adjust to their correct levels. Keeping in mind that the price system exists to coordinate where resources flow to and from, if prices and wages don’t change quickly enough, then resources won’t flow to and from where they need to. This is why New Keynesians argue that government intervention is necessary — in order to push prices and wages up to where the resources could be flowing to and from where they’re needed.

(2) At the polar extreme of New Keynesianism, Real Business Cycle (RBC) theorists believe that business cycles are driven by “real shocks” (or “productivity shocks”). Unlike the New Keynesians, RBC assumes that prices and wages adjust really quickly (i.e., they’re not sticky but flexible) and that central banking policy doesn’t have any real effects on the economy (i.e., so no Austrian-style business cycles). Real shocks include new technological developments (e.g., the Internet), wars, natural disasters, etc. RBC argues that the economy is continuously buffeted by these real shocks. A cluster of positive shocks (e.g., new technology) leads to booms and a cluster of negative shocks (e.g., high oil prices, natural disasters) lead to busts.

(3) New Keynesians and RBC are the two extreme sides of the neoclassical schools. In between the two is the New Classical theory. In the world we live in there are two types of price changes we observe: (1) real changes, where society actually values a particular good more or less and (2) inflationary price changes, where all prices rise because there’s more money being printed by the central bank and it’s not because society changes how it values some goods over others. If a central bank starts printing more money and causes all prices to inflate, businesses might mistake this with a real change in the demand for their goods. So they’ll say, “Oh, the price of my product is rising, I should produce more, because people are demanding more. If all businesses think the same way, they all produce more, and we get a boom. Later on it’s discovered that it was all inflation from the central bank, they’ll cut production and labor, and we end up in a recession.

Most macroeconomists don’t strictly subscribe to one theory or the other. The New Keynesians tend to think markets don’t work well, whereas RBC and New Classical economists have faith in markets. The New Classical School in particular does share many characteristics with the Austrian Business Cycle theory, particularly regarding central banks as the cause of business cycles.