Real Business Cycle Term Paper

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Business cycle theories have been the topic of discussion for many years. There are several business cycle theories that are reliable and trustworthy, while others are controversial and easily disproved. The purpose of this discussion is to distinguish among the different theories of the business cycle. These theories include Keynesian aggregate demand theory, the Monetarist aggregate demand theory, and the new classical and new Keynesian theories of the business cycle and the real business theory. In addition, this discussion will describe the origins of, and the mechanisms at work during, the expansion of the 1990's, the recession of 2001, and the great depression.

Keynesian Theory

Aggregate Demand Theory

Aggregate demand simply describes the correlation between the amount of aggregate output and the price height when every other variable is held constant.

According to an article entitled "Aggregate Demand and Supply Analysis" from the Keynesian point-of-view the aggregate demand is determined "in terms of its four components: consumer expenditures, investment (meaning investment in physical capital, not investment in assets) spending, government expenditures, and net exports."

The equations that Keynesian use to express an aggregate demand curve is Y = C + I + G + Xn.

The article also explains Keynesians use a downward slope to interpret aggregate demand. The use of the downward slope is justified because when price levels decrease and the money supply is constant, the amount of real balances within the economy will rise.

Likewise, this increase in real money will result in a decrease in interest rates.

A decrease in interest rates increases investment expenditures and aggregate output rises.

According to the article, Keynesians also believe that factors other than money supply can have an impact upon the aggregate demand.

The article explains that Keynesians held the belief that consumer and business optimism are key mechanisms in shaping aggregate demand.

Therefore, when optimism increases, aggregate demand also increases.

A book entitled, "Effective Demand and Income Distribution: Issues in Alternative Economic Theory" explains that Keynesian economics had a profound impact upon the understanding of the business cycle. The book asserts that

"Keynes's approach meant accepting the idea that some form of aggregate analysis was necessary to understand capitalist systems. His theory required an understanding of consumption and the acquisition of capital goods for the economy as a whole ... Keynes's analysis required that money be explicitly integrated into the theory of employment and distribution."

Indeed, the Keynesian viewpoint has been influential in defining economics and the business cycle, as we know them. Although Keynes views were innovative and seemed to answer some of the questions associated with defining aggregate demand it was also controversial. For this reason, other business cycle theories were also established. One such theory came from monetarists. Over the next few paragraphs, we will explain how monetarists' views differ from Keynesian views.

Monetarist theory

Aggregate Demand theory

Although there are similarities between Keynesian and monetarist, views concerning aggregate demand there are also some notable difference. The article entitled "Aggregate Demand and Supply Analysis" explains that monetarists express aggregate demand as MV=PY.

The article explains that monetarists believe that "that velocity is constant ... changes in the money supply directly influence the level of nominal income. If the money supply increases, nominal income will increase."

Although Keynesians believed that factors other than money supply good effect aggregate demand, monetarists believed that only shifts in many supply can change aggregate demand.

Since a shift in money supply is the only factor that affects the aggregate demand, monetarists concede that increases in the money supply lead to increases in aggregate demand.

In many ways, the monetarist view of aggregate demand is more simplistic than the Keynesian view. In any case, both views provide an explanation of the business cycle.

The new classical and new Keynesian theories

The new classical theory of business cycles and economics were developed after World War II. An article found in The Wilson Quarterly asserts that the new classical model incorporates the ideas of Keynes and John Smith.

The author explains that the new classical model "holds that markets always tend toward "general equilibrium." Whether the market is for factory workers or candy bars, in other words, supply and demand will eventually reach a perfect, albeit temporary, balance if left to their own devices."

Indeed, many modern theories concerning the business cycle incorporate Keynesian principles. According to an article found in the Journal of Economic Perspectives, the new Keynesian theories revolve around two main approaches. The article explains that one approach asserts that small price rigidities are the fundamental way in which market economies are different from Walrasian Arrow-Debreu model.
They contend that the absence of this rigidity would permit the economy to adjust rapidly to whatever shocks it experiences, while upholding economic efficiency and full employment.

The other approach suggests, "that increased flexibility of wages and prices might exacerbate the economy's downturn. This insight implies that wage and price rigidity are not the only problem, and perhaps not even the central problem."

Real Business Cycle Theory

According to an article entitled "Real Business Cycle Theory" the real business cycle theory refers to "a class of theories explored first by John Muth (1961), and associated most with Robert Lucas. The idea is to study business cycles with the assumption that they were driven entirely by technology shocks rather than by monetary shocks or changes in expectations."

This definition is but one explanation of the real business cycle and tends to reflect the more modern approach to the real business cycle theory.

In addition, a book entitled "Reflections on the Development of Modern Macroeconomics" explains that there are several models of the business cycle. The book asserts that the real business cycle theory began with the IS/LM-AD/AS model in the 1970's. The author asserts that this technique came under great scrutiny. According to the book the "A typical 1970s IS/LM-AD/AS model consists of a system of equations such as the consumption and investment functions, which give the IS curve; money demand and supply functions which give the LM curve; a production function and a labour-supply curve."

The equation presented by this model of the business cycle theory was reduced to Ye = aG + bM.

The reduced form of the equation was met with controversy when in 1976 Robert Lucas questioned the validity of utilizing the equation when dealing with economic policy issues.

Lucas believed that 'the parameters of the consumption and investment functions, for example, depend on the decisions we have made previously about how much to consume and save, given our utility function. That is, there is an earlier optimization process, which we have bypassed in our estimation of the consumption and investment functions. Suppose now we wish to examine the effect of a change in government expenditure and that a side effect of this new policy is to change the incentive to consume and save. This side effect will result in a change in the underlying consumption function. Unfortunately, the AD/AS fiscal-policy multiplier will not take this into account since the consumption parameters in the multiplier will be those previously estimated from the old data. As a result, our multiplier could well give us a misleading answer to the policy change.

The disapproval of the modified equation led economist to create an equation that could fully explain the economic environment.

These economists sought to explain the impact of capital and labor on endogenously demanded output. The economists concluded the economy reacts to shocks and that these shocks could cover a broad range of spectrums.

The jest of the real business cycle theory is that real shocks from the supply side and the demand side result affect businesses.

The expansion of the 1990's

When one examines the economic expansions that took place during the 1990's it is obvious that the modern definition of business cycle theory appears to be true. During the 1990's businesses were profoundly impacted by technology. This technology included the wide and inexpensive use of the internet, user-friendly software programs, and an expansion in the overall knowledge of computer-based systems. More than any other factor the wide spread use of the internet changed the way that corporations do business forever.

Many entrepreneurs and investors attempted to start dot com businesses. Billions of dollars were invested in technology stocks and the economy was robust. Many new jobs were created and America enjoyed phenomenal economic growth.

The recession of 2001

Indeed if the 1990's saw the highest economic boom ever the recession of 2001 was the largest bust ever. The demise of the dotcoms coupled with the outsourcing of manufacturing and computer related jobs to other countries created a recession. In addition, the events of September 11 hurt the economy even further. According to an article found in Monthly Labor review, 'the U.S. economy entered a recession in March 2001, after an unprecedented 10 years of growth. (1) Manufacturing's downturn started in late summer of 2000 and deepened in 2001, as businesses sharply reduced spending on machinery, computers, and other capital….....

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