IFT Notes for Level I CFA® Program

R15 Understanding Business Cycles

Part 2


3.  Theories of the Business Cycle

Until the 1930s, economists believed that business cycles were a natural feature of the economy, and recessions were temporary. The Great Depression changed that view and gave rise to new schools of economic thought. All these theories attempt to explain the fluctuations in an economic cycle, and what must/must not be done to restore equilibrium.

3.1. Neoclassical and Austrian Schools 

The basic premise of the neo-classical school is: markets will reach equilibrium because of the invisible hand or free markets. No government intervention is needed for equilibrium.

  • All resources are used efficiently based on MR = MC.
  • If an economic shock shifts the AD or SRAS curve, the economy will quickly adjust and reach equilibrium via lower interest rates and lower wages. This is the self-correcting adjustment mechanism for unemployment and excess supply of goods.
  • It relies on Say’s law: All that is produced will be sold because supply creates its own demand.

However, Neo-classical theory could not explain:

  • Unemployment during the Great Depression. According to the theory, unemployment was not possible, yet it happened. And many countries that were affected could not come out of this situation without any intervention.
  • Fluctuations in GDP. If an economy has the power to reach equilibrium on its own accord (invisible hand), how can the situation in the Great Depression be explained? Lowering wages and interest rates did not help.

Austrian School

The Austrian school believes that business cycles are the outcome of excessive credit growth due to an artificially low interest rate.

  • During boom, low interest rates leads to excessive borrowing from banking system for funding projects with low returns. Low interest rates lead to widespread malinvestment.
  • Subsequently, when interest rates increase, investments that were profitable at low rates now become unprofitable. As a result, the economy moves back into recession.

Since the business cycles are the result of government / central bank’s expansionary monetary policies, the Austrian school believes that the government’s interference should be minimal because markets are self-stabilizing.

3.2. Keynesian and Monetarist Schools

Keynesian School

Key points related to the Keynesian school of thought are as follows:

  • There is no quick adjustment mechanism for markets as advocated by neoclassicals.
  • The focus is on AD fluctuations.
  • The theory believes that it would be hard to restore equilibrium in the event of a crisis by wage and price reduction alone. Wages are downward sticky, but even if lower wages are accepted, consumption, and hence AD will be lower because workers would cut their spending.
  • Simply lowering interest rates would not ignite growth because business confidence (or animal instincts) was low.
  • The government’s intervention is needed during a severe crisis. The government should use monetary and fiscal policy to keep capital and labor employed even if this means a large fiscal deficit.
  • The fiscal policy tools are government spending and taxes. The government can either reduce taxes or increase spending to increase AD.
  • Monetary policy tools are money supply and interest rates. The government can either increase money supply or lower interest rates to increase AD.
  • Agreed with neoclassical and Austrian schools about the economy self-correcting in the long run, but states that by that point we will all be dead.

Why is the Keynesian policy criticized?

  • Fiscal deficit leads to more government debt.
  • It focuses on the short term. In the long run, the impact of low interest rates could be inflationary.
  • Takes time to implement fiscal policy. By then the economy is already recovering.

Monetarist School

The Monetarist school objected to Keynesian intervention for four reasons:

  • The Keynesian model does not recognize the importance of the money supply. If the supply is too fast, the boom will be unsustainable. If the supply is low, it will lead to recession.
  • The Keynesian model lacks complete representation of utility-maximizing agents. The major agents in the economy are households and firms. Households try to maximize their utility while firms try to maximize their profit.
  • The Keynesian model fails to consider long-term costs of government intervention. Reducing taxes or increasing government spending can have a detrimental effect in the long run, which the Keynesian model does not consider.
  • The timing of the government’s economic policy response is uncertain.

What do the Monetarists say?

  • Monetary and fiscal policy should be clear and consistent.
  • Minimal intervention from the government.
  • Steady money supply, i.e., money supply must grow at a steady rate.
  • Business cycles occur because of exogenous shocks and government intervention.
  • Let AD and AS find own equilibrium rather than risking further economic fluctuation.

3.3. The New Classical School

The basis of this school of thought is that macro outcomes are based on microeconomic principles of utility maximization and profit maximization. A worker may choose to enjoy leisure (give up consumption) or consume more (give up leisure).

New classical macroeconomic models emphasize that economic agents should be represented by a utility function and a budget constraint. These models assume that all agents are roughly alike. There are two major flavors: models without money and models with money

Models without Money: Real Business Cycle (RBC) Theory

  • The initial new classical models did not include money just like neo-classical models. These were called the real business cycle (RBC) models.
  • Cycles are caused by real economic variables such as changes in technology and external shocks. According to this model, monetary variables such as inflation have no effect on GDP and unemployment.
  • Unlike the Keynesian model, aggregate supply is an important part of the model. It shows that new technology can improve GDP and move LRAS to the right. Similarly, high input prices may move LRAS to the left.
  • Expansions and contractions are natural responses of the economy in response to external real shocks → government should not intervene with monetary and fiscal policy. The level of economic activity is consistent with maximizing utility.
  • RBC models rely on efficient markets and believes that unemployment can only be short term: apart from frictional unemployment, according to RBC, a person who does not have a job can only be a person who does not want to work or is asking for a higher wage. Criticism: If markets are efficient as the model suggests, then there should be no unemployment unless a person does not want to work or is asking for a higher wage.

Models with money

  • Builds on RBC models, but recognizes the role of monetary policy. Inflation is seen as a cause of the business cycle.
  • When inflation is high, central banks intervene by increasing rate; or, lower rates to boost growth.
  • So, this model includes money to explain economic growth.
  • Two models: one model says that shocks can come from technology, input prices, and monetary policy.
  • Another model: Neo-Keynesians (or New Keynesians) build models on microeconomic principles, but say that frictions (sticky wages and prices) in the economy may prevent it from reaching equilibrium and government intervention is necessary.
  • A key difference between New Classical (RBC) and New Keynesian theories is that the RBC model assumes that prices adjust quickly to changes in supply and demand.

Summary of Business Cycle Schools:

Economic Schools of Thought
School of Thought Comment Recommended Policy
Neo-classical Invisible hand. Do nothing.
Austrian Fluctuations caused by misguided government intervention. Do nothing.
Keynesian Focus on the AD curve.

Economy does not automatically correct in the short-run.

Use fiscal/monetary policy because in the “long run, we are all dead”.
Monetarist Monetary policy. Steady, predictable growth of money supply.
New Classical: RBC Expansions and contractions represent efficient operation of the economy in response to external real shocks. Do nothing.

Economics Understanding Business Cycles Part 2