December 22 - Business Cycle Theory
The economics of business cycle theory revolves around understanding the recurrent fluctuations in aggregate economic activity—expansions and contractions—that characterize market economies. These cycles, while irregular in timing and amplitude, display certain regularities in employment, production, investment, and prices. Over the past century, economists have developed two main traditions in explaining them: one empirical and inductive, epitomised by the work of Geoffrey H. Moore and Victor Zarnowitz; the other theoretical and deductive, culminating in Real Business Cycle (RBC) theory. The contrast between these approaches highlights a broader tension in macroeconomics between data-driven description and model-based explanation.
Empirical business cycle analysis began as a systematic study of historical economic fluctuations. Wesley C. Mitchell, founder of the National Bureau of Economic Research (NBER), and his successors Geoffrey H. Moore and Victor Zarnowitz, sought to identify, classify, and date business cycles using observed economic indicators. Their approach was largely atheoretical, driven by statistical regularities rather than formal models. Moore and Zarnowitz developed composite indexes of leading, coincident, and lagging indicators—collections of time series such as industrial production, employment, and new orders—that helped anticipate turning points in the cycle. This empirical program culminated in Zarnowitz’s Business Cycles: Theory, History, Indicators, and Forecasting (1992), where he synthesised decades of NBER research showing that cycles were pervasive features of market economies, shaped by expectations, inventory adjustments, investment behaviour, and financial conditions.
The empirical tradition’s strength lay in its attention to the data. Moore’s leading indicator indexes, for example, became practical tools for policy institutions, including the U.S. Department of Commerce. The NBER’s dating of recessions—still the official reference today—reflects this pragmatic focus on observable turning points rather than theoretical constructs. For Moore and Zarnowitz, the goal was to map how cyclical dynamics evolved over time, not to explain them through microeconomic foundations. Their work, while descriptive, shaped forecasting and policy debates throughout the post-war era.
Real Business Cycle theory, by contrast, emerged in the late 1970s and 1980s as a radical rethinking of macroeconomics grounded in the principles of general equilibrium and rational expectations. Pioneered by Finn E. Kydland and Edward C. Prescott in their seminal paper “Time to Build and Aggregate Fluctuations” (1982), RBC theory interpreted business cycles as efficient responses to real (i.e., non-monetary) shocks, such as changes in technology or productivity. In this framework, recessions are not failures of markets or policy missteps but the rational outcome of individuals optimising intertemporally given new information. Agents adjust labour supply, consumption, and investment in response to productivity shocks, leading to cyclical movements in output and employment that reflect changes in the economy’s productive potential.
RBC theory was methodologically revolutionary. It integrated dynamic stochastic general equilibrium (DSGE) modelling, calibration, and rational expectations into mainstream macroeconomics. Its proponents argued that traditional Keynesian explanations, relying on nominal rigidities or demand shocks, were inconsistent with microfoundations and empirical evidence. By attributing cycles to real shocks and optimising behaviour, RBC theory sought to explain fluctuations without invoking ad hoc frictions or policy errors. This appealed to economists seeking rigor and consistency with neoclassical principles.
However, the empirical validity of RBC theory has long been contested. Critics, including Zarnowitz himself, argued that the theory’s reliance on technology shocks as the main driver of fluctuations was implausible. Empirical studies found that productivity often fell during recessions, suggesting that causality might run from demand to productivity rather than the reverse. Moreover, RBC models typically failed to replicate certain stylised facts of business cycles documented by Moore and Zarnowitz, such as the persistence and asymmetry of contractions or the predictive power of financial variables. The theory’s implication that recessions are welfare-maximising equilibria also jarred with real-world experiences of involuntary unemployment and policy interventions.
Despite these differences, there are complementarities between the two traditions. Empirical business cycle analysis provides the stylised facts that any theoretical model must replicate. RBC theory, for its part, offered a coherent framework for thinking about those facts within a general equilibrium context. Later developments, such as New Keynesian DSGE models, sought to bridge the gap by reintroducing nominal rigidities and policy roles into the RBC structure. The evolution from Moore and Zarnowitz’s descriptive empiricism to Kydland and Prescott’s formalism reflects the broader trajectory of macroeconomics itself—from the study of patterns in data to the search for microfounded explanations.
In sum, the economics of business cycle theory encompasses both the inductive mapping of economic fluctuations and the deductive modelling of their causes. Moore and Zarnowitz gave economists the empirical grammar of cycles; Kydland and Prescott supplied the theoretical syntax. The continuing dialogue between these approaches remains central to macroeconomic thought, policy design, and the ongoing effort to understand why economies expand and contract.
References
Kydland, F. E. and Prescott, E. C. (1982). “Time to Build and Aggregate Fluctuations.” Econometrica, 50(6), 1345–1370.
Mitchell, W. C. (1927). Business Cycles: The Problem and Its Setting. NBER.
Moore, G. H. and Zarnowitz, V. (1986). “The Development and Role of the National Bureau of Economic Research’s Business Cycle Chronologies.” Journal of Business, 59(1), 55–80.
Zarnowitz, V. (1992). Business Cycles: Theory, History, Indicators, and Forecasting. University of Chicago Press.
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Prompt: “Hi, can you write a 600 word essay on the economics of business cycle theory. Contrast real business cycle theory and its origins with empirical business cycle theory pioneered by Geoffrey H. Moore and Victor Zarnowitz. Avoid bullet points and bold sections, but write a free-flowing essay. Use academic references if you want, in Cambridge notation, and list your references at the end.”