In a market economy all schools of economic thought whether monetarists, neoclassical, Keynesian or neo Keynesian or Marxist schools accept business cycle is a reality of a market economy. However, their explanations of business cycle and their theoretical explanation are to some extent entirely different and their solution to business cycle or stabilization methods and policies.
These theoretical explanations are fundamentally based on the way they perceive how the market system works and the nature of its equilibrium at full employment level is the norm or exception given the role of government is minimal. As well, the theories differ in their explanation of the causes and effects they attribute to the business cycle. In addition, the theories differ whether the business cycle is an inevitable outcome of the market economy or it is caused by economic shocks and its temporary nature and the ability of the market system to come in to equilibrium at full employment level given that the government do not distort the market system by inappropriate excessive intervention in to economic affairs.
The Monetarist and Neoclassical Theories of Business Cycle.
In the monetarist theory of business cycle the basic cause of the business cycle is because of excessive or restrictive money supply by the financial authorities and is caused by economic shocks, which are caused not by economic system failure but by external factors and excessive political and social policies of the government. That is, the business cycle is not caused by inadequate aggregate demand but by money supply in the economy and excessive government intervention or in appropriate polices to manage the economy.
In essence monetarist theory explain business cycle by in appropriate monetary policy and other external factors and economic shocks and it is temporary and the rational behavior of the market will automatically move the economy towards full employment and if government intervenes it will cause excessive inflation and will make the full employment unachievable. In addition, in their view it is also caused by rigid labor market practices and inflexible wage fixing systems and Union power in the labor market and imperfection and anti- competitive practices in the goods market. In summary, according to monetarist the business cycle is not inherent weakness of the market economy but is caused by monetary factors and excessive government intervention in the economy or inappropriate economic and social polices of the government and rigidity in the labor market and the role unions play in the labor market as well as imperfections in the goods market by anti-competitive practices and over regulation of business activity by government.
In their view, in all circumstances fiscal policy to boost aggregate demand by government expenditure or by tax credits will not work because it will affect prices not output and increases the rate of inflation at least in the medium term even temporarily it increases out put for a short time. The solution to business cycle is to have adequate money supply and control money supply by interest rates or some control of money supply by prudent supervision of the financial system and undertake microeconomic reform so that the market is close to a more competitive market system and make the system to become flexible to adept to changes in the market or adept to economic shocks faster as possible and to reduce government intervention to a minimum.
Keynesian and Neo Keynesian Theories of Business Cycle
In Keynesian theories of business cycle the business cycle is caused by inadequate aggregate demand because of lack of investment by the private sector and lack aggregate consumption within the economy as well as in an open economy by exports as imports.
In their view the aggregate demand function is the cause and money supply is an effect.
As well, the economy can come into equilibrium less than full employment because of wage stickiness that is wages do not adjust faster down wards compared to increases even without union power in the labor market. In addition, imperfection in competition in the market is reality and government regulation is necessary in the goods market to control monopoly and oligopoly practices. In addition, market failure is caused where the private cost and social cost diverge and in this respect government intervention is necessary. In Keynesian view, in a economic sense there is legitimate grounds governments must intervene in a market economy at least in the circumstances of deep recessions where if no government intervention the market mechanism will take a longer time to move towards full employment and if not resolved in a short to medium term it will cause social and political instability and may be threat to a market system because of high level of unemployment in a deep recession. In Keynesian and Neo Keynesian theory of business cycle if market is allowed to work in itself without any government intervention in the economy it will grow and the market is dynamic and adaptable however it can come in to equilibrium less than full employment frequently and may also can cause deep recessions, which may take a longer time to be resolved by market mechanism alone. In their view, the business cycle can be stabilized by appropriate fiscal and monetary policy and they are effective to reduce business boom and busts and reduce the possibility of unacceptable levels of unemployment.
