Introduction
Welcome to your final lesson in the module on Business Cycles and Macroeconomic Theory. In our previous lesson, we examined the Phillips curve, which describes the short-run trade-off between inflation and unemployment—a key symptom of business cycles.
Today, we shift our focus from the "what" to the "why." Our goal is to summarize the Keynesian, Monetarist, and Real Business Cycle theories of business cycles. These are three major schools of economic thought that offer different explanations for why economies fluctuate and, consequently, different prescriptions for how policymakers should respond. Understanding these foundational theories is crucial for interpreting economic events and is a core part of the CFA curriculum.
We will break down each theory by exploring:
- Its view on the primary cause of business cycles.
- Its key assumptions about how the economy works (e.g., wage flexibility).
- Its recommended policy response to economic downturns.
1. The Keynesian School: Demand-Side Instability and Intervention
The Keynesian school of thought, pioneered by John Maynard Keynes, emerged during the Great Depression of the 1930s. Classical economic theory at the time held that economies were largely self-correcting, but it could not explain the depth and persistence of the global downturn. Keynes offered a new perspective.
Core Idea: Keynesians argue that the primary cause of business cycles is fluctuations in aggregate demand. They believe that the decisions of households and firms are driven by shifts in confidence and expectations—what Keynes famously termed "animal spirits." A sudden loss of confidence can cause consumers and firms to cut back on spending and investment, plunging the economy into a recession.
A critical assumption of Keynesian theory is that wages are "downward sticky." This means that workers and unions strongly resist pay cuts. As a result, when aggregate demand falls, firms are more likely to lay off workers than to cut wages for everyone. This stickiness prevents the labor market from quickly adjusting to restore full employment, meaning the economy can get stuck in a recessionary state for a prolonged period.
Policy Prescription: Because the economy may not self-correct quickly, Keynesians advocate for active government intervention.
- Fiscal Policy: This is the preferred tool. During a recession, the government should use expansionary fiscal policy—increasing government spending and/or cutting taxes—to boost aggregate demand and pull the economy out of the downturn.
- Monetary Policy: Lowering interest rates can also help, but Keynesians are often skeptical of its effectiveness in a deep recession, fearing a "liquidity trap" where low rates fail to stimulate investment.
To get a detailed, CFA-focused explanation of this theory, please watch the following video segment.
Level 1 CFA Economics: Understanding Business Cycles-Lecture 2
Let's begin with the Keynesian school of thought. This video from IFT provides a detailed explanation of its core tenets, directly relevant to your CFA exam.
Please watch the segment from 02:53 to 07:14. Pay close attention to: The focus on aggregate demand fluctuations. The concept of 'downward sticky' wages and why it prevents the economy from self-correcting. The recommended policy response: active use of fiscal and monetary policy.
2. The Monetarist School: The Primacy of the Money Supply
Emerging in the mid-20th century as a prominent critique of Keynesianism, the Monetarist school is most closely associated with economist Milton Friedman. Monetarists offer a very different diagnosis of economic instability.
Core Idea: Monetarists argue that business cycles are caused primarily by government intervention, specifically by erratic and inappropriate changes in the nation's money supply. They believe the private economy is inherently stable. It is the mismanagement by central banks—either allowing the money supply to grow too quickly (causing inflation) or too slowly (causing a recession)—that creates economic fluctuations.
Critique of Keynesianism: Monetarists raise several key objections to Keynesian policy:
- It largely ignores the critical role of the money supply.
- Discretionary fiscal policy is hard to time correctly. The lags between recognizing a problem, implementing a policy, and seeing its effects can mean the intervention ends up destabilizing the economy rather than stabilizing it.
- It fails to consider the long-term costs of government deficits and debt.
Policy Prescription: The Monetarist solution is to remove discretion from policymakers and bind them to a simple, predictable rule. The central bank should aim to increase the money supply at a slow, steady rate, aligned with the long-run potential growth rate of the economy. This would provide a stable monetary environment, allowing the economy to flourish without policy-induced booms and busts.
Level 1 CFA Economics: Understanding Business Cycles-Lecture 2
Next, we'll examine the Monetarist school, which presents a strong counterargument to Keynesianism. This section of the IFT video explains the Monetarist perspective.
Now watch from 07:14 to 10:53. Focus on: The four main objections Monetarists have to Keynesian policy. The central role of the money supply in their theory. Their recommended policy: a steady, predictable growth rate for the money supply.
To help you consolidate the differences between these two opposing viewpoints, review the table below.
3. The New Classical School & Real Business Cycle (RBC) Theory
The New Classical School emerged in the 1970s, seeking to provide stronger microeconomic foundations for macro theory. The most prominent model within this school is the Real Business Cycle (RBC) theory.
Core Idea: RBC theory proposes that business cycles are natural and efficient responses to real shocks in the economy, primarily changes in technology and productivity. In this view, a recession is not a sign of market failure. Instead, it is a period where a negative technology shock (e.g., a spike in oil prices, a disruption of supply chains) has made production temporarily less profitable. The resulting fall in output and employment is an optimal response by rational firms and workers.
Key Assumption: Unlike Keynesians, RBC theorists assume that prices and wages are fully flexible and that markets are always in equilibrium. They build models based on the actions of utility-maximizing individuals and profit-maximizing firms.
Policy Prescription: Since business cycles are viewed as efficient market outcomes, the government should not intervene. Attempts to smooth the cycle with fiscal or monetary policy would only distort markets and lead to worse outcomes. The best policy is a hands-off, or laissez-faire, approach.
Level 1 CFA Economics: Understanding Business Cycles-Lecture 2
Finally, we turn to the New Classical school and its most prominent model, the Real Business Cycle (RBC) theory. This theory offers a fundamentally different perspective on the nature of economic fluctuations.
Please watch the segment from 10:53 to 12:58. Focus on: The emphasis on microeconomic foundations (utility and profit maximization). The idea that business cycles are caused by 'real' shocks, like changes in technology. The conclusion that government intervention is not recommended.
The diagram below helps visualize the RBC mechanism. A negative shock makes both investment and labor less productive, causing demand in those markets to fall, leading to lower interest rates, wages, investment, and employment.
Summary of Theories
You now have an overview of three distinct ways of thinking about the business cycle. The table below summarizes their key features for easy comparison, which is essential for the CFA exam.
| Feature | Keynesian Theory | Monetarist Theory | Real Business Cycle (RBC) Theory |
|---|---|---|---|
| Primary Cause of Cycles | Fluctuations in Aggregate Demand ("animal spirits") | Erratic changes in the money supply by policymakers | Real shocks (e.g., technology, input prices) |
| Wage/Price Flexibility | Wages are "downward sticky" | Flexible in the long run, can be sticky in the short run | Fully flexible |
| View of Recessions | A market failure; economy can get stuck below potential | Caused by policy mistakes (e.g., monetary contraction) | An efficient market response to a negative shock |
| Recommended Policy | Active fiscal (and monetary) intervention to manage AD | Follow a stable money growth rule; no discretion | Laissez-faire; no government intervention |
To hear a final summary that recaps these key distinctions, you can watch the concluding section of the IFT video.
Level 1 CFA Economics: Understanding Business Cycles-Lecture 2
To tie everything together, the IFT video provides a concise summary of all the schools of thought we've discussed. This is an excellent final review to ensure you can distinguish between them on the exam.
Watch the final summary from 12:58 to 16:32. This recap reinforces the most important points for each theory.
Conclusion
In this lesson, we have summarized three major macroeconomic theories of the business cycle, fulfilling the final learning outcome for this module.
Key Takeaways:
- Keynesian theory attributes cycles to unstable aggregate demand and sticky wages, advocating for active government intervention via fiscal policy.
- Monetarist theory blames cycles on erratic monetary policy and prescribes a stable, predictable money supply growth rule.
- Real Business Cycle theory views cycles as efficient responses to real technology shocks and argues against any government intervention.
Preview of the Next Lesson:
In this lesson, we saw how central the concept of "money" is to the Monetarist school and, to a lesser extent, the Keynesian school. This sets the stage perfectly for our next module, where we will dive deep into the nature of money itself. We will begin by describing the functions and definitions of money and understanding how it is created in a modern economy through the banking system.