Business Cycles

What are business cycles?

Periodic but regular up and down movements in GDP, fluctuating around potential GDP

What is a recessionary phase of a business cycle, and when does it occur?

• A below full employment equilibrium

• Actual GDP < Potential GDP

When is a business cycle at full employment?

When Potential GDP = Actual GDP

What is an expansionary phase, and when does it occur?

• Occurs at above full employment equilibrium

• When Actual GDP > Potential GDP

• Amount by which Actual GDP exceeds Potential GDP known as an inflationary gap

What are the main themes from the Classical School about business cycles?

• Attributed cycles to various types of shock like good or bad harvests

• Believes the SR is unimportant

• Prices assumed to be flexible

• AS curve is vertical even in SR

• Shift in AD is almost exclusively due to a shift in the MS

• An increase in MS leads to inflation and has no effect on aggregate output

What does Keynes suggest about business cycles?

• Emphasised the SR effects of the business cycle, unlike Classicists would focussed purely on the LR

• Any shift in AD caused by shifting business confidence.

  • E.g. an expected fall in profits can lead to decreased investment which can cause recession

• His views led to MP and FP being used to smooth the business cycle

What are the monetarists’ views on the business cycle?

• Argued that during Great Depression, MP ineffective as interest rates already close to zero

• Argues for non-discretionary MP: GDP grows steadily if MS increases steadily on autopilot

• Advocates to not change interest rates to stabilise the economy

• MV = PY

How does the interactions of the multiplier and accelerator affect the business cycle?

• Each firm plans investment for the period to start

• It’ll have an optimum capital to output ratio

• Effects a shock starts one period in a business cycle e.g. shock could be an increase in investment

• Investment decisions depend on instincts or ‘animal spirits’

How do monetarists and the Keynesians differ in their beliefs about business cycles?

• Monetarists attributed cycles chiefly to demand shocks caused by a change in the MS

• Keynesians attribute shocks caused by any other factors

What is the new Keynesian view on business cycles?

• Caused by demand shocks, perhaps ones resulting from a change in the money stock

• Sticky wages mean that output may take a long time to return to its potential level after a shock, unless the govt intervenes

What are the new classicals view on business cycles?

• Similar to new Keynesian, but argue that wage flexibility may quickly return output to its potential level after any shock

• Accept output may stay away from its potential level if there are repeated demand shocks

What are the main tenets of the Real Business Cycle Theory?

• Business cycles caused by fluctuations in AS

• AS fluctuates due to fluctuations in the demand for labour

• Demand for labour fluctuates due to technology shocks that change labour productivity

Criticism is that it relies of AS to be elastic, which is potentially contentious