Theories of Business Cycle

In a market economy all schools of economic thought whether monetarists, neoclassical, Keynesian or neo Keynesian or Marxist schools accept business cycle is a reality of a market economy. However, their explanations of business cycle and their theoretical explanation are to some extent entirely different and their solution to business cycle or stabilization methods and policies.

These theoretical explanations are fundamentally based on the way they perceive how the market system works and the nature of its equilibrium at full employment level is the norm or exception given the role of government is minimal. As well, the theories differ in their explanation of the causes and effects they attribute to the business cycle. In addition, the theories differ whether the business cycle is an inevitable outcome of the market economy or it is caused by economic shocks and its temporary nature and the ability of the market system to come in to equilibrium at full employment level given that the government do not distort the market system by inappropriate excessive intervention in to economic affairs.

The Monetarist and Neoclassical Theories of Business Cycle.

In the monetarist theory of business cycle the basic cause of the business cycle is because of excessive or restrictive money supply by the financial authorities and is caused by economic shocks, which are caused not by economic system failure but by external factors and excessive political and social policies of the government. That is, the business cycle is not caused by inadequate aggregate demand but by money supply in the economy and excessive government intervention or in appropriate polices to manage the economy.

In essence monetarist theory explain business cycle by in appropriate monetary policy and other external factors and economic shocks and it is temporary and the rational behavior of the market will automatically move the economy towards full employment and if government intervenes it will cause excessive inflation and will make the full employment unachievable. In addition, in their view it is also caused by rigid labor market practices and inflexible wage fixing systems and Union power in the labor market and imperfection and anti- competitive practices in the goods market. In summary, according to monetarist the business cycle is not inherent weakness of the market economy but is caused by monetary factors and excessive government intervention in the economy or inappropriate economic and social polices of the government and rigidity in the labor market and the role unions play in the labor market as well as imperfections in the goods market by anti-competitive practices and over regulation of business activity by government.

In their view, in all circumstances fiscal policy to boost aggregate demand by government expenditure or by tax credits will not work because it will affect prices not output and increases the rate of inflation at least in the medium term even temporarily it increases out put for a short time. The solution to business cycle is to have adequate money supply and control money supply by interest rates or some control of money supply by prudent supervision of the financial system and undertake microeconomic reform so that the market is close to a more competitive market system and make the system to become flexible to adept to changes in the market or adept to economic shocks faster as possible and to reduce government intervention to a minimum.

Keynesian and Neo Keynesian Theories of Business Cycle

In Keynesian theories of business cycle the business cycle is caused by inadequate aggregate demand because of lack of investment by the private sector and lack aggregate consumption within the economy as well as in an open economy by exports as imports.

In their view the aggregate demand function is the cause and money supply is an effect.

As well, the economy can come into equilibrium less than full employment because of wage stickiness that is wages do not adjust faster down wards compared to increases even without union power in the labor market. In addition, imperfection in competition in the market is reality and government regulation is necessary in the goods market to control monopoly and oligopoly practices. In addition, market failure is caused where the private cost and social cost diverge and in this respect government intervention is necessary. In Keynesian view, in a economic sense there is legitimate grounds governments must intervene in a market economy at least in the circumstances of deep recessions where if no government intervention the market mechanism will take a longer time to move towards full employment and if not resolved in a short to medium term it will cause social and political instability and may be threat to a market system because of high level of unemployment in a deep recession. In Keynesian and Neo Keynesian theory of business cycle if market is allowed to work in itself without any government intervention in the economy it will grow and the market is dynamic and adaptable however it can come in to equilibrium less than full employment frequently and may also can cause deep recessions, which may take a longer time to be resolved by market mechanism alone. In their view, the business cycle can be stabilized by appropriate fiscal and monetary policy and they are effective to reduce business boom and busts and reduce the possibility of unacceptable levels of unemployment.

If monetary policy is used alone according to Keynesian theory it will take time to work in the economy and it may not be effective to solve deep recessions and fiscal policy is important tool to reduce boom and busts to stabilize the economy.

Marxist Theory of Business cycle

In the perspective of Marxist theory of Business cycle the boom and bust cycle is inherent weakness of the market system. It is caused by its own mode of production and

private ownership and profit motive. No policy whether monetary or fiscal policy will correct this inherent economic weakness of the capitalist system or the market. In their view, the market in the modern capitalist economies do not work because of the concentration of wealth and the law of accumulation in capitalist system do not allow to have adequate aggregate demand because it causes unequal distribution of income and purchasing power and produces overproduction and deflationary tendencies. They also point to the fact the labor theory is a regulator of the system and there fore if capital is used and labor is saved then the rate of profit will come down because the profit come from surplus labor and there fore investment levels even though they can mitigate this over a period of time however not indefinitely as this process will cause boom and busts which are more frequent and deeper and if markets are not overthrown by labor then it will continue the boom and bust indefinitely. That is monetary and fiscal policy is ineffective in solving the boom and busts of market economy because it is inherent to the capitalist system weaknesses.

Effectiveness of Business Cycle Theories in Context of Empirical Evidence

In all market economies boom and bust is a reality. However the boom and bust differ in its frequency and the level of boom and bust. In addition, all countries have not used one policy measure alone to stabilize the economy and the effectiveness of policies to stabilize the economy is not always effective. This may be due to in appropriate policy mix and the time lags they take to work in the economy and the economic condition changes and it may stabilize but destabilize further the economy. This shows that fiscal or monetary policy alone will not work in all market economies and different mix of policies work in different conditions in terms of their specific market conditions in terms of the characteristics of the labor market industrial structure and level of competition and degree of market failure in their own economic systems.

However, it is also evident from the recent experience of the market economies boom and bust cannot be completely eliminated by the functions of the market and governments have successfully used fiscal policy with monetary policy and other microeconomic reform to some extent indicate fiscal policy at least to solve deep recessions is an effective tool and monetary policy in itself have been proven not effective in these circumstances. However, there is evident from the experience of Germany particularly the fiscal deficit may produce inflation and fiscal policy as predicted by monetary policy if used not prudently may increase boom and bust cycles and also can produce stagflation. In addition, in the current global economy economic shocks can affect many economies in a shorter period of time and markets may not be able to correct all shocks in it self and some regulation is inevitable to have economic stability. In this context government in varying degrees must playa role to control or manage business cycle to acceptable levels of economic activity. In addition, in reality most market economies are mixed economies and government playa role in economic activity even though market plays a dominant role. It may due to historical, cultural and social factors.

However, it is also possible government intervene in the economy to reduce market failure and also where the private sector is impossible to provide public goods where the risks are higher and government can only provide such goods and services.

Even in the current economic climate of market based policies in Western Europe Social security is not totally abandoned because in a market economy conflict in distribution is inevitable and political stability is necessary to protect vulnerable groups with the society to reduce the negative impacts of the working s of the market systems. In addition, public education, public health and environmental protection are a norm to varying degrees in most of the western countries even in the 21st century.

This indicates, at least in some economic activities government has a role because private sector cannot provide it because of the nature of product or service as well as to the restriction in resource capacity and duplication, which is not economically efficient compared to the government at least in some circumstances.

It cannot be denied government intervenes in the economy due to political and social reasons or it is historical and cultural. However, it is also true that government has to intervene on economic grounds to correct market failure or to reduce unemployment due to deep recessions where the market alone will not be able to solve it at least very quickly and the uneven distribution of income it produces because of its workings which may produce political instability.

In summary no theory of business cycle is completely explain the complex issue of business cycle. However, the theories together at least to some extent explain the dynamics of business cycle. It is certain business cycle cannot be avoided because the empirical evidence shows that it is inevitable in a market economy. If one theory is used to formulate policies to manage business cycle then it is evident from the experience of most Western Europe that it will lead to increase the instability than control the instability or boom and bust. Ideologically driven explanation will lead to disaster than a solution. It is certain that market will not always even without intervention will produce full employment all the time as evidenced by the history of US economy, which has the most minimal government intervention in a market economy. That is, based on evidence. Mix of monetarist and Keynesian theories and some insights from even the Marxist perspective is essential to understand the issue of business cycle to formulate effective polices to manage business cycle on the basis of empirical evidence as discussed above.