Real Business Cycle Theory

• This theory states that most business cycles result from negative supply shocks. These shocks may result from bad harvests, as in earlier economies that depended heavily on agriculture, or from increased prices of production inputs like oil. Examples of negative supply shocks leading to recessions in modern economies include falling commodity prices and bad government policy in Brazil.

• Advantages: Real business cycle theory effectively explains many historical business cycles.

• Disadvantages:

  • The theory fails to explain all business cycles, many of which can be attributed to monetary policy, banking, and credit.

  • The theory struggles to explain the high unemployment that accompanies many business cycles. It does not account for why workers would not accept lower wages to keep their jobs during an economic downturn.

Austrian School of Economics

• This theory emphasizes the importance of market price signals, which entrepreneurs use to make decisions, and postulates that central banks can distort those price signals, leading to cycles of boom and bust. When central banks increase the money supply, they artificially lower interest rates. Though these lower rates make some investments appear more profitable, this appearance is an illusion created by the distorted market. In reality, the economy's savings do not support these investments, and they are ultimately liquidated, leading to layoffs and a bust.

• Advantages: Austrian economics is a prominent heterodox school of economics that many use to explain historical events such as the 2008 financial crisis in the United States and the subsequent sovereign debt crisis in the Eurozone.

• Disadvantages:

  • The theory does not explain why so many entrepreneurs would be tricked by central bank manipulation of interest rates.

  • It is unclear why the bust must be so painful, and the theory may need to draw upon Keynesian or monetarist explanations such as sticky wages and prices.

  • The theory predicts that consumption and investment will move in opposite directions, which is not borne out in the data.

Keynesian Economics

• This theory focuses on aggregate demand – that is, the total spending in an economy. Aggregate demand is made up of consumption, investment, government spending, and net exports. The theory posits that, since wages are sticky and don't adjust quickly to drops in demand, a decline in aggregate demand leads to layoffs rather than wage cuts. This further decreases aggregate demand as unemployment rises, consumption falls, and investment drops. The theory cites the Great Depression as a key example.

• Advantages: Keynesian economics has been tremendously influential in macroeconomic theory and policy since the publication of John Maynard Keynes' The General Theory of Employment, Interest and Money in 1936.

• Disadvantages:

  • The theory does not fully explain what initially causes aggregate demand to fall. Declining aggregate demand may also be a symptom of deeper problems rather than the root cause.

  • Some economists believe that monetary policy is sufficient to stabilize nominal spending and that fiscal policy is therefore unnecessary.

  • The theory assumes that government spending can be efficiently timed and targeted to stabilize aggregate demand, which may not always be the case.

  • The theory predicts that high unemployment and high inflation cannot occur at the same time, though this did happen in the United States during the 1970s.

  • Governments may run deficits even in good times, contrary to the Keynesian prescription.

Monetarism

• This theory highlights the importance of the money supply and central bank decisions regarding the money supply. According to monetarism, in the long run, the total amount of money in an economy does not affect real output or employment. However, in the short run, changes in the rate of inflation can matter. Too much inflation distorts the allocation of resources, while too little inflation leads to lower aggregate demand and economic downturns. Because wages are sticky, a decline in nominal purchasing power leads to layoffs rather than wage cuts. Monetarists believe that the central bank should maintain a constant rate of money supply growth (e.g., 2-3%) and should not be allowed discretion in setting monetary policy.

• Advantages: Largely due to the work of Milton Friedman, monetarism led to economists paying much more attention to the money supply and central banking.

• Disadvantages:

  • The theory cannot fully account for business cycles that result from other causes, such as the bursting of asset bubbles or negative real shocks.

  • It is not clear what constitutes "the money supply," as there are many measures of money supply that do not always move together.

  • A fixed rate of money supply growth may prevent the central bank from responding adequately to other economic shocks.