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Business Cycle Theory Notes

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Economics Part IIB Paper 2 Macroeconomics Lent Supervision 04 Real Business Cycles Essay Business Cycles are an economic phenomenon that is fully understood and
explained by economic theory. Discuss. The family of economic theories explaining business cycles can be grouped into old
Keynesian theories, misperception and imperfect information theories, New
Keynesian settings, real business cycle (neoclassical) models and the new
neoclassical synthesis. While they can all reproduce past business cycles (in fact,
many of them are designed to do so), each of them have their limitations and
drawbacks. In addition, no theory has been able to predict the turning points of a
business cycle reliably. If we understand "explaining" as being able to offer a
theoretical background and being able to reproduce past business cycles, parts of
the statement can be agreed upon. However, business cycles are not yet fully
understood in the sense that we cannot predict them in a satisfactory way.
Old Keynesian theories tried to explain business cycles arguing that price stickiness
and private decision may lead to undesirable macroeconomic outcomes and can thus
produce the upswing and downswings that we observe. However, Keynesian
economics is based on the ad hoc assumption of sticky prices and does not have a
microeconomic foundation. It can thus explain how business cycles may come about,
but not why.
New Keynesian settings tried to overcome this problem by developing models that
included a microeconomic foundation. This included imperfect competition and the
notion of menu costs, that together generate the price stickiness that causes
business cycles in traditional Keynesian models. One shortcoming of New Keynesian
model is that people may expect that very large menu costs are needed to generate
the demanded price stickiness. However, this has been disputed by Mankiw (1985).
Another drawback is the fact the New Keynesian models partly made the same
mistakes in their development. For example, they assume exogenously that a certain
fraction of firms have flexible prices, whereas the rest of the firms will have their
prices fixed. This ad hoc assumption is as unsatisfactory as the ad hoc assumption of
sticky prices was in the traditional Keynesian models.
Misperception and imperfect information theories predict that business fluctuations
only occur when policy changes are unannounced so that the resulting changes
catch agents by surprise. However, this is refuted by empirical evidence, where e.g.
central banks are acting in the opposite direction by announcing every change in
policy and trying to make their policies as transparent as possible, thereby using the
rule of expectations in economics. Furthermore, the assumption of imperfect

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