Economic Principles Ch21. Business cycle theory and neuroeconomic theory
Chapter 21. Business Cycle Theory and New Business Cycle Theories
While economies grow continuously, they experience business cycles in which booms and recessions repeat along the way. This chapter analyzes the fierce debates among different schools of thought over whether ‘demand’ or ‘technology (supply)’ is the primary culprit behind these fluctuations.
Actual GDP fluctuates around potential GDP (trend line). Peaks and troughs repeat.
1. Traditional Business Cycle Theories
(1) Keynesian School (Demand-Oriented)
- Views ‘insufficient aggregate demand’ caused by fluctuations in consumption and investment as the cause of recessions.
- Because the market cannot heal itself, active government intervention is necessary.
(2) Monetarists (Friedman)
- Argue that rapid changes in the money supply exacerbate business cycles.
2. New Classical School: Real Business Cycle (RBC) Theory
Proposes ‘equilibrium business cycle theory’, arguing that business cycles can occur even in equilibrium states.
- Cause: Business cycles are driven by ‘real supply shocks’ such as technological innovations and changes in raw material prices, rather than aggregate demand shocks.
- Characteristics: Business cycles are not market failures, but the result of optimal choices made by economic agents in response to changed environments. Therefore, government intervention rather causes inefficiency.
3. New Keynesian School: Establishing Microfoundations
While accepting the rational expectations hypothesis of the New Classical school, they attempted to micro-prove why prices and wages are ‘sticky’.
- Menu Cost: Prices change sluggishly due to the cost of price adjustment.
- Efficiency Wage: Wages do not fall because firms pay wages higher than the market equilibrium to increase productivity.
- Staggered Price Setting: Timing varies by firm, creating a time lag in overall price adjustment.
4. Key Terms in Business Cycles
| Phase | Production/Consumption | Unemployment Rate | Prices/Interest Rates |
|---|---|---|---|
| Boom | Increasing (Active) | Low | Upward Pressure |
| Recession | Starting to Decrease | Starting to Increase | Slowdown in Rise |
| Depression | Decreasing (Severe) | Very High | Falling / Low Interest Rates |
| Recovery | Starting to Increase | Starting to Decrease | Stable |
5. Conclusion: Fluctuations are Inevitable Growing Pains
Perspectives on business cycles are largely divided into ‘disasters to be prevented through demand management’ and ‘natural processes resulting from technological progress’. Modern macroeconomic policy focuses on appropriately harmonizing these two views to reduce the amplitude of fluctuations and build social safety nets.
📖 References
- [Macroeconomics] - Jung Byeong-yeol: Comparative analysis of RBC and New Keynesian schools.
- [A Modern Guide to Macroeconomics] - Snowdon & Vane: History and development of macroeconomic schools.
Good job. In the next session, we will study Economic Growth Theory (Solow Model), which goes beyond temporary fluctuations to analyze how a nation’s national wealth grows in the long run.
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