a.  Different schools of economic thought are used to explain the causes of business cycles.
These schools of thought offer different prescriptions with regard to government actions that may affect the economy.

b.  Some of the major school of thoughts that have explained the business cycles in the past were:

     i.  Neoclassical

    ii.  Austrian

   iii.  Keynesian

   iv.  Monetarists

    v.  New classical

   vi.  Real business cycle theory

  vii.  Neo-Keynesian

1.1.         Neo-Classical and The Austrian School of Thought

a.  The neo-classical and the Austrian are a work of Friedrich A. Hayek and Ludwig von Mises.

b.  Neoclassical school of economic thought says that:

     i.  There exists ‘an invisible hand’ (that is, free-market), which will result in a price for every good for which there are supply and demand. The economy, according to this school, is self-correcting, thus there is no theory of the business cycle.

    ii.  Says’s law states that ‘all that is produced will sell because supply creates its own demand’.

   iii.  This school cannot explain a prolonged depression. Any declines in aggregate demand would be temporary.

   iv.  According to this school of thought, the prices are flexible and there are no general gluts and any persistent unemployment.

c.  The Austrian school of economic thought is similar to neoclassical but considers the role of the money supply and government actions.

     i.  The government intervention, in the form of changes in the money supply and the interest rates, may cause a boom-and-bust cycle.

    ii.  According to this school, the attempts to engineer steer markets are a cause of fluctuations and it distorts the market/price signals and leads to malinvestments.

d.  According to both theories, there should be no or a very limited government role, as the markets do have the self-correction mechanism.

1.2.         Keynesian Theory of Business Cycles

a.  This theory is a result of the work of British economist John Maynard Keynes.

b.  According to this school of thought, the economy is not self-correcting, and:

     i.  It believes in the concept of ‘sticky wages’. Also, in the event of lower aggregate demand, lower wages result in lower spending, hence affecting demand further.

    ii.  Also, very low-interest rates would not stimulate the economy because confidence would be too low.

c.  Therefore, according to this theory, the government should intervene in a crisis, running a deficit. It may use some of the fiscal policy tools, such as:

     i.  deficit spending to boost aggregate demand, and

    ii.  lowering of taxes.

d.  There are certain criticisms of this theory:

     i.  Government debt could get out of control.

    ii.  The expansionary policy may cause the economy to grow too fast, resulting in inflation and other ills.

   iii.  It takes time for fiscal policies to work, so they may be ill-timed for a short-term crisis.

1.3.         Monetarist School of Thought

a.  This school of thought was given by Milton Friedman.

b.  Those following the monetarist school of thought object to the Keynesian approach because of Keynesian theory:

     i.  does not consider the role of the money supply.

    ii.  is not logical in light of utility-maximizing market participants.

   iii.  ignores the long-term cost of government intervention.

   iv.  does not consider the unpredictability of the timing of fiscal policy changes on the economy.

c.  According to this school of thought, the money supply is way more critical in deciding the levels of output in the economy:

     i.  If the money supply grows too fast, it creates an inflationary gap.

     ii.  If the money supply grows too slowly, it creates a recessionary gap.

d.  Thus according to him, steady growth in money supply and limited government intervention is a key to smoothening high levels of fluctuations in the business cycles.

1.4.         New Classical Theory

a.  This theory is the work of Robert Lucas.

b.  The new classical theories of the business cycle consist of the real business cycle theory, which suggests that business cycles are the result of an efficient response to shocks to the economy, and the neo-Keynesian theory, which advocates for government intervention because of the slowness of the response of the economy.

c.  As per this theory, there is a shift from ‘static partial equilibrium’ towards the ‘dynamic stochastic general equilibrium’.

d.  As per the static partial equilibrium, there is a price modeling in one market, and which is adapted by the consumers and businesses otherwise.

e.  The dynamic stochastic general equilibrium:

     i.  models how the economy changes over time,

    ii.  also allows for the random exogenous shock, and

   iii.  assumes that market participants expect change and display behavior according to their expectations.

f.  The new classical theory:

     i.  Starts from the micro principles, such as preferences and constraints of the decision-makers, rather than the correlations between the aggregates.

    ii.  Believes in modeling the behavior that leads to the aggregate reaction instead of modeling the relationship between the aggregates.

g.  The real business cycle (RBC) theory:

     i.  Beliefs business cycles are the result of the efficiency of operation of the economy in response to the real

    ii.  The RBC theory considers unemployment as a result of a person’s desire for higher wages.

   iii.  It is criticized as being an unrealistic assumption.

h.  Neo-Keynesians (new Keynesians):

     i.  Neo-Keynesians assume slow-to-adjust wages and prices.

    ii.  Government intervention is needed in the event of disequilibrium, since the markets may not equilibrate on themselves.