Question

Discuss the sources of business cycles in keynesians, monetarist, new classical models and real business cycle economist view. What are the major policy conclusions of the models?

Answer 1

We will discuss the sources of business cycles in Keynesians, monetarist, new classical models and real business cycle economist view.

Keynesian view:

This is one of the most discussed view in recent times proposed by John Maynard Keynes. He was in favor of government interventions at times of recession or economic crisis to minimize bad effects & boost growth because he considered that free markets are not always self-balancing. He was of view that business cycle reflects variations in the rate of investment caused by fluctuation in marginal efficiency of capital. Here marginal efficiency means expected profits from new investments. He was of opinion that in short run wages & prices are rigid & do not adjust with fluctuations in aggregate demand. So when aggregate demand falls wages do not decrease immediately which leads to contraction in output. This decline in output ultimately causes recession. According to him business cycle reflects the possibility of economy attaining short run equilibrium at levels above or below full employment. He considered that monetary & fiscal policy can play a positive role in balancing fluctuations of business cycle.

Monetarist view:

The economists of this view consider that fluctuations in business cycle are mostly caused by changes in money supply in an economy. According to them free market economy is inherently stable & doesn’t need fiscal intervention. In this view slowdown in an economy is caused due to actions of central bank which reduces money supply decreasing aggregate demand. They consider that wages are flexible & insist on reducing inflation than keeping unemployment low.

New classical business cycle:

In this view business cycle fluctuations or boom & slump in an economy are caused due to real shocks or rational agents like technology shock, fiscal shock. They consider that actual output depends on the potential so no policy intervention is needed but to maximize the growth of potential output. They consider all agents maximize utility on the basis of rational expectations. According to them economy gains unique equilibrium at full employment (potential output) through price & wage adjustments. They consider that prices & wages are flexible, people use all available information in making decision & all resources & markets are purely competitive meaning all markets clear automatically & don’t require government intervention.

Real business cycle view:

This view is actually derived from new classical theory of business cycle to explain fluctuations in business cycle. They consider that economy can have a number of business cycles in its life whether it’s high or low. Business cycle may have periods of expansion or recession. It makes a key assumption that economy have all these phases mainly due to technology shocks & not monetary shocks or expectations. They propose that business cycles in itself is a real phenomenon which doesn’t represent failure of a market to clear but reflects most efficient possible way of economy to operate.