Business cycle theories explain fluctuations in macroeconomic activity. Keynesian theory attributes changes to consumer spending, while New Classical theory claims changes result from output and consumer preferences. Economic growth is characterized by high employment and productivity, while recessions are marked by declines. Macroeconomic indicators help predict trends. Keynesian theory allows for flexibility, while New Classical theory emphasizes changes in consumer preferences.
Different business cycle theories focus on the cause of fluctuations in macroeconomic activity. According to Keynesian theory, changes in the business cycle are due to normal events, such as a drastic change in consumer spending. New classical theory, on the other hand, claims that changes in business cycles do not always result from a change in interest rates, but rather from a change in an economy’s output and consumer preferences.
Business cycles are generally defined as periods of economic growth or periods of recession. Economic growth or expansion is usually characterized by high employment, an overall higher market value of the goods and services produced by the economy, and higher productivity. Higher rates of inflation can be observed in times of rapid expansion, but they don’t necessarily occur during times of growth.
Economic recessions and depressions are marked by a decline in employment levels. Productivity can decrease. The market value of the economy’s goods and services generally declines as consumers tend to spend less. Speculation about job losses or decreased income can stimulate a tendency to save more and borrow less.
Business cycle theories both agree that there are peaks and troughs during the duration of a cycle. Macroeconomic indicators such as the unemployment rate, the labor cost index, production capacity, commodity prices, and changes in inventories and worker productivity can be used to determine where in the cycle a economy. These indicators are used to predict where the macroeconomy is next and to help identify trends. The labor cost index is used to determine whether consumer prices will rise; production capacity reveals whether increased demand will lead to inflation; and commodity prices may reflect commodity inflation. Inventory levels show demand growth, while worker productivity shows whether the costs to produce goods and services are decreasing.
The two main types of business cycle theories are the Keynesian and the New Classical models of thought. Keynesian theory states that business cycles can be caused by government policies such as increasing or decreasing the money supply through a change in interest rates. As one of the business cycle theories, it differs markedly from New Classical thinking in that there is room for flexibility in an economic environment. According to Keynesian theory, fluctuations in business cycles occur due to an inflexible parameter such as consumer prices, which then leads to a drastic change in economic output.
The second of two business cycle theories, New Classical thinking states that economic parameters do not always lead to a change in the goods and services an economy produces. Just because consumer prices go up, that doesn’t mean consumption will go down. Changes in demand do not directly affect production, but a change in the types of goods and services consumers want to buy.
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