Theories of the Business Cycle

The Classical School derives its name from the school of Adam Smith, David Ricardo and John Stuart Mill. This theory states that the economy is self-regulating. It also assumes full employment. The neo-classical school feels that business cycles are in fact responses to shocks to the system, particularly technological changes.

Using the aggregate demand and supply concepts of the classical economists, the neo-classical economists have juxtaposed technological changes with respect to the same. A technological change that increases productivity results in an increase in aggregate demand since more firms will purchase new machineries. If the technology lengthens the life of current capital, aggregate demand falls, since the need for new equipment reduces. Technological changes have a direct impact on the GDP in the sense that rapid technological developments result in growth of potential GDP and later real GDP.

The classical theory believes that stimulation in any form by the government to the economy is not advisable. Taxes in fact lead to inefficiency by stunting incentives. Lower taxes are a better incentive for investment, employment, and technological innovation that help the economy grow.

Keynesian theory argues that the economy can never really achieve full employment without monetary and fiscal intervention. According to this theory aggregate demand is also impacted by how the population views the prospects of the economy. If the prospects are poor, then this leads to a fall in aggregate demand.

With regards to aggregate supply, this theory assumes that wage rates are sticky in nature. Once they are set at a rate, they will not go down even if the economy is in the recessionary phase. If it were not sticky, the short term aggregate supply would increase, pushing the economy back to full employment.

The new Keynesian economists have added that the prices of goods and services are sticky as well. The Keynesian economists believe that in times of recession, the government can intervene to increase demand in the system (by undertaking large infrastructure projects for instance). In this way the economy will tend back to full employment.

Economists following the monetary theory believe that the quantity of money is the single most important factor that impacts aggregate demand. If the central monetary authority keeps a steady flow of money, fluctuations in demand will reduce and the economy will tend to full employment. If it does not it will lead to a contraction in aggregate demand and result in recession like conditions. Like the Keynesian economists it believes wage rates are sticky; they too like the classical economists feel taxes deincentivise demand.

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