Theories of the Business Cycle

Various economists have formulated several theories in a bid to try and demystify the concept of business cycle.

1. Models With Money

Inflation is often considered a consequence of the business cycle. When monetary policy becomes encouraging, the economy grows at a rate that is not sustainable in the long run. This results in an inflationary gap. Consequently, this causes inflation because suppliers cannot keep pace with the high demand. Prices also tend to shoot up at an abnormally high rate.

In such a scenario, the central bank will have to increase interest rates so that the cost of borrowing goes up and the demand for goods and services decreases. As a result, there exists some possibility of a recession because of the decrease in equilibrium GDP.

2. New Classical School

Economists such as Robert Lucas agree with Milton Friedman’s position on macroeconomics model.  According to them, macroeconomics models should try to show the importance of economic agents with budget constraints and a utility function.

The concept of rational expectation is key to this model. According to the concept of rational expectation, individuals forecast their expectations. Individuals possess a rational sense thanks to which they look beyond instant gratification or present expectations. They focus, in fact, on future expectations.

 3. Neoclassical and Austrian Schools

The neoclassical analysis acknowledges the existence of free market forces, otherwise known as the invisible hands of demand and supply. Courtesy of these free market forces, the market attains equilibrium. This school of thought believes that during economic contraction or recession, the government should desist from initiating policy-based interventions with the intention of pulling the economy out of recession. Rather, the market forces should be allowed to take full effect. It is through the forces of demand and supply, and not government interventions, that the economy can quickly bounce back from recession.

When the economy stabilizes and/or when the economy is at equilibrium, supply will equal demand. In neoclassical schools, resources are maximized in such an instance because of the principle of marginal cost.

4. Keynesian and Monetarist Schools

As proposed by the Neoclassical and Austrian Schools, market forces can pull the economy out of recession. However, John Maynard Keynes disagrees with this argument. According to Keynes, market forces lack the capacity to pull the economy out of recession. Even if market forces can redeem a recessing economy, it will be very difficult to achieve this in the short run. For instance, a reduction in consumption resulting from a cut in the wage rate of consumers will further reduce aggregate demand. Hence in the short run, Keynes supports government intervention through fiscal policy to solve the recession. According to him, the short run is more crucial than the long run because “in the long run, we are all dead.”

Monetarists campaign on maintaining a steady growth of money supply. Therefore, there must be an interplay of monetary and fiscal policy if the economy is to experience steady growth.

Question

The monetarist school of thought is most likely based on which of the following?

A. Well-maintained monetary and fiscal policies are what the economy needs to hold together.

B. The government should desist from initiating policy-based interventions with the intention of pulling the economy out of recession.

C. Individuals possess a rational sense thanks to which they look beyond instant gratification or present expectation, and towards future expectation.

Solution

The correct answer is A.

According to monetarists, well maintained monetary and fiscal policies are all that the economy needs to hold together.

B is incorrect. The neoclassical and Austrian schools are of the opinion that the government should desist from initiating policy-based interventions with the intention of pulling the economy out of recession.

C is incorrect. The new classical school is based on the fact that individuals possess a rational sense in which they look beyond instant gratification or present expectation, and toward future expectations.