The Prominent Explanations of Business Cycles Rely Upon Aggregate Demand (AD) and Aggregate Supply (AS) Constructs

Ever since the advent of Keynesian economics, the prominent explanations of business cycles, including severe crises and bubbles, have proceeded in terms of aggregate demand (AD) and aggregate supply (AS) constructs. Any observed level of aggregate economic activity is perceived to be the result of AD-AS interaction. This has gone through various incarnations, from the simple hydraulic Keynesian model with its totals of consumer and producer spending, C I, and their functional determinants, to more sophisticated, general equilibrium models and dynamic stochastic general equilibrium models. All variants include aggregate measures of spending, prices, real output, total supply of money and total employment. Some models use a measure of the economy’s capital stock from which (together with labor employment) real output is assumed to flow (an aggregate production function).

To explain fluctuations in aggregate production and employment, these models must explain how these aggregates can be made to fluctuate. Broadly, business cycle theories can be divided into three groups, Keynesian (and new Keynesian) theories, monetarist (and later new classical) theories and real business cycle theories (RBC). The first group relies on different versions of what Keynes referred to as “animal spirits” (irrationality). For instance, the propensity of entrepreneurs to invest in production which is very much affected by waves of optimism and pessimism that produce herding behavior. Influential work along these lines was done by the financial economist Minsky (1986) — the turning point toward the boom based on speculative investments was referred in the literature as the “the Minsky moment.” Similarly, Alan Greenspan famously referred to “irrational exuberance” to describe widespread speculative investments on the stock market.

Alternatively, according to the Monetarist and new-classical approaches, fluctuations in the rate of growth of the money–supply produce the illusion of real output and expenditure changes which cause workers to erroneously believe that real wages have risen only to be reversed in the long run when inflationary expectations catch up to the new rate of inflation. Although Keynesian-type explanations emphasize some sort of irrational behavior, monetarist explanations rely on the money illusion produced by an expansionary monetary policy. Because new classical theories assume rational expectations, it is an unexpected monetary shock that produces a crisis.

RBC theories, like new classical theories, also rely on rational expectations but argue that business cycles are produced not by unexpected monetary shocks but by unexpected real shocks. These shocks usually occur to total factor productivity which, through a transmission mechanism that works as an amplifier, produce output fluctuations in the economy.

—Peter Lewin and Nicolas Cachanosky, “A Financial Framework for Understanding Macroeconomic Cycles,” Journal of Financial Economic Policy 8, no. 2 (2016): 272-273.