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...
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