Economists generally agree about the basic business cycle facts outlined in Chapter 8.
They know that economic growth isn't necessarily smooth and that occasionally there are periods of recession in which output declines and unemployment rises. They know that recessions typically are followed by periods of recovery in which the economy grows more strongly than normal.
And they also know a great deal about how other macroeconomic variables— such as productivity, interest rates, and inflation—behave during recessions.Recall that recessions and booms in the economy raise two basic questions:
(1) What are the underlying economic causes of these business cycles? and
(2) What, if anything, should government policymakers do about them? Unfortunately, economists agree less about the answers to these two questions than about the basic business cycle facts.
The main disagreements about the causes and cures of recessions are between two broad groups of macroeconomists, the classicals and the Keynesians. As discussed first in Chapter 1 and again in Chapters 8 and 9, clas- sicals and Keynesians—although agreeing on many points—differ primarily in their views on how rapidly prices and wages adjust to restore general equilibrium after an economic shock. Classical macroeconomists assume that prices and wages adjust quickly to equate quantities supplied and demanded in each market; as a result, they argue, a market economy is largely "self-correcting," with a strong tendency to return to general equilibrium on its own when it is disturbed by an economic shock or a change in public policy. Keynesians usually agree that prices and wages eventually change as needed to clear markets; however, they believe that in the short run price and wage adjustment is likely to be incomplete. That is, in the short run, quantities supplied and demanded need not be equal and the economy may remain out of general equilibrium. Although this difference in views may seem purely theoretical, it has a practical implication: Because Keynesians are skeptical about the economy's ability to reach equilibrium rapidly on its own, they are much more inclined than are classicals to recommend that government act to raise output and employment during recessions and to moderate economic growth during booms.
In this chapter and Chapter 11 we develop and compare the classical and Keynesian theories of the business cycle and the policy recommendations of the two groups, beginning with the classical perspective in this chapter. Conveniently, both the classical and Keynesian analyses can be expressed in terms of a common analytical framework, the IS-LM/AD-AS model. In this chapter we use the classical (or market-clearing) version of the IS-LM/AD-AS model, composed of the IS-LM/AD-AS model and the assumption that prices and wages adjust rapidly. The assumption that prices and wages adjust rapidly implies that the economy always is in or near general equilibrium and therefore that variables such as output and employment always are close to their general equilibrium levels.
Learning Objectives
10.1 Summarizethe real business cycle theory and describe how well it accounts for the business cycle facts.
10.2 Discuss the effects of fiscal policy shocks in the classical model.
10.3 Discuss unemployment in the classical model.
10.4 Explain the roles of money and monetary policy in the classical model.
10.5 Summarize the fundamentals and implications of the misperceptions theory.
In comparing the principal competing theories of the business cycle, we are particularly interested in how well the various theories explain the business cycle facts. The classical theory is consistent with many of the most important facts about the cycle. However, one business cycle fact that challenges the classical theory is the observation that changes in the money stock lead the cycle. Recall the implication of the classical assumption that wages and prices adjust quickly to clear markets, so that the economy reaches long-run equilibrium quickly. Money is neutral, which means that changes in the money supply do not affect output and other real variables. However, most economists interpret the fact that money leads the cycle as evidence that money is not neutral in all situations. If money isn't neutral, we must either modify the basic classical model to account for monetary nonneutrality or abandon the classical model in favor of alternative theories (such as the Keynesian approach) that are consistent with nonneutrality. In Section 10.5 we extend the classical model to allow for nonneutrality of money. We then examine the implications of this extended classical approach for macroeconomic policy.
10.1