Background

Free market economies have been observed for hundreds of years to experience semi-regular fluctuations, where growth and unemployment rise and fall periodically. One of the major focuses of economics, particularly since the Great Depression, has been on the causes of these fluctuations and how to prevent them.

Classical, 1800-1850

Initial thinking on the existence of business cycles stems from Say's Law. Jean-Baptiste Say argued that "supply creates its own demand"; the value of what people produce is equal to what they consume, so there can never be a situation where the total supply of products exceeds its demand. This implies that any recessions are caused by an incorrect level of production for particular goods, not for the entire economy. There were widespread debates on whether this law was true in the short run among the Classical economists, particularly between Ricardo and Malthus; Malthus' arguments against the law were not generally accepted at the time, but they foreshadow arguments by Keynes and Marx.
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Marx, 1860-1890

Marx brought the idea of the business cycle to greater prominence. In various books, Marx argued that regular crises were inherent to capitalism. He thought that they would repeatedly overaccumulate capital, to the point where they were no longer able to sell all of the goods that they produced. This would cause the rate of profit to fall, many businesses to fail and capital to be liquidated. He was dismissive of Say's Law, and called Say "a miserable individual". This idea that crises were regular and unavoidable in a capitalist economy was new to economics, and formed a large part of Marx's criticisms of capitalism as a system. Evidence from the past 150 years appears to have borne Marx out on this point - try as economists might, they have not yet been able to avoid recessions entirely. However, his explanation for these crises is largely ignored.1, 7

Henry George, 1890-1900

Henry George had a theory of the business cycle based on land. He believed in Say's Law to an extent, and argued that crises were a result of a reduction in production. This was caused by speculation on land driving land prices up to a level where it was too costly for them to continue producing, forcing them to reduce their output and triggering a collapse in land prices as demand for land fell. This theory was not generally accepted, but it bears some similarity to explanations of the crisis in 2008, which was driven by a bubble in mortgages and house prices in the United States.7

Austrian Business Cycle Theory, 1910-1935

An early but persistent theory of the business cycle was Austrian Business Cycle Theory, so called because its key advocates Ludwig von Mises and Friedrich A. von Hayek were both from Austria. Austrian Business Cycle Theory built on a theory developed by Knut Wicksell of the natural rate of interest, a rate of interest that balances the rate at which people want to save and invest in the economy. In an economy with a currency without a constraint on the money supply (such as the gold standard) the government would be tempted to push interest rates below the natural rate, so that credit is more freely available and unemployment is lower. This would lead to malinvestment, as too much investment took place. When interest rates inevitably rose towards the natural rate, these investments would prove unprofitable and have to be liquidated, leading to a fall in output and a rise in unemployment. Therefore business cycles could be avoided if the government resisted the pressure to lower interest rates, even in recessions. Again, this theory has not been given a great deal of academic support, particularly since Keynes' theories.1

Keynesian Revolution, 1935-1975

Keynes' General Theory, published in response to the Great Depression, transformed the mainstream understanding of business cycles, which had barely developed from the Say/Ricardo idea that markets would naturally reach equilibrium. Keynes developed the concept of aggregate demand as the sum of consumption, investment and government spending. A fluctuation in any of these would affect output and prices, but Keynes observed that prices tend not to change in the short run, and so output would be affected most. So fluctuations in aggregate demand, due to variations in consumer confidence, drive the business cycle and fluctuations in involuntary unemployment. Keynes' policy prescription was that the government should vary its level of spending to offset the fluctuations in consumption and investment, thus limiting the amount that they would affect aggregate demand and unemployment. This theory became very influential, and was dominant for approximately 30 years after the War, in a form developed by John Hicks and Paul Samuelson, among others.7, 18

Monetarism, 1950-1990

The theoretical basis for monetarism was created in the 1950s, but it gained increasing prominence by the 1970s. It was chiefly promoted by Milton Friedman. Monetarism emphasised the role of fluctuations in the money supply in causing depressions; when the money supply was growing too slowly, the result was recession, and when it grew too quickly the result was high inflation. He therefore argued that the government should aim to stabilise the rate of growth in the money supply, but not try to intervene in the economy using fiscal policy. This philosophy gained influence in the 1970s, after the 'stagflation' (period of low growth and high inflation) that was not prevented by fiscal intervention, but by 1990 was generally considered to be insufficient, although monetary policy remains more commonly used than fiscal policy to stabilise the economy.1, 18

Real Business Cycle Theory, 1975 -

A controversial recent theory on business cycles is Real Business Cycle Theory. This theory claims that fluctuations in productivity (real changes in the economy, as opposed to reversible changes such as fluctuations in the quantity of money or aggregate demand) are the cause of business cycles, and that these fluctuations do not reflect a movement away from equilibrium. As these are real changes, there ought to be a real response to them. The reduced production and consumption in recessions is, in fact, the efficient response to these changes, and the government should not try to reduce their magnitude or stabilise the economy. The theory was based on the work of Robert Lucas, who drew attention to the importance of people's expectations about the economy and the dangers of relying on historical data rather than microeconomic theory (the so-called Lucas Critique), although his views on the business cycle were largely monetarist. Economists such as Finn Kydland and Edward Prescott developed this into Real Business Cycle theory. In some ways, RBC theory is similar to the arguments of classical economists that there could not be a shortage of aggregate demand, and so the government need not take action to prevent recessions.18

New Keynesian theory, 1985 -

New Keynesian economics is an evolution of previous Keynesian and Monetarist theories. It takes into account the Lucas Critique and rational expectations, but adds in some new assumptions, notably that prices and wages are "sticky" (take a long time to adjust to the equilibrium level), as well as various other market imperfections. These imperfections mean that stabilising the economy is still important, either through monetary or fiscal policy (combining Keynesian and monetarist arguments). New Keynesian economics is probably the most influential current school of thought on business cycles; policies in 2008 followed the New Keynesian prescription closely, as opposed to the Real Business Cycle prescription, which would be that the government should take no action.18

The future

Modern business cycle theory has been widely criticised for its failure to predict or prevent the Great Recession of 2008. In response to this criticism, more attention is being paid to the impact of the financial sector, bubbles, and irrational behaviour. Before the crisis, many economists believed that we had entered a 'Great Moderation', where business cycles were far less severe than previously; this reduced to some extent the attention paid to business cycle theory. That belief is no longer accepted, and as a result greater emphasis is being placed on business cycles. It seems that the New Keynesian research programme has more useful insights on this; coupled with developments in behavioural economics (see the page on human behaviour) and greater emphasis on finance, business cycle theory is likely to develop notably in the next few decades.