On Business Cycles and Countercyclical Policies

Economists are still trying to assess the severity of this slowdown, and this assessment has clearly become more difficult since the events of September 11. It is worth emphasizing that this article is silent about the economic implications of wars and similar cataclysms and focuses instead on the analysis of " typical " business cycles. The slowdown that began prior to September 11 had already served as a reminder that the business cycle is still alive—that the U.S. economy is likely to continue to experience both expansions and contractions. This situation raises the following questions: What do we know about the driving forces behind the business cycle? What should policymakers do in the face of economic fluctuations? Not surprisingly, there are a number of competing explanations for business cycles, and there is no shortage of policy recommendations. This article focuses on only two of these explanations: the animal spirits theory and the real business cycle theory. The former is closely connected with the Keynesian economic tradition and identifies market partici-pants' mood swings as the key source of economic fluctuations. The second explanation is rooted in the classical economic tradition and views productivity shocks as the driving force behind economic fluctuations. These explanations are examined because they are some of the better-known and most widely quoted business cycle theories among academic economists. Both theories meet modern academic standards—one of them from its inception and the other after a significant reformulation. Modern academic standards explicitly acknowledge the dynamic nature of economic decisions—that macroeconomic variables interact with each other in such a way that the relevant economic relations must be considered simultaneously—and the importance of microeco-nomic theory as a sound foundation for macroeconomic theory. In addition to reviewing these two theories, the article looks at what they suggest about counter-cyclical policies—policies aimed at trying to eliminate business cycle fluctuations or insulate market participants from the effects of these fluctuations. This article first presents the " everyday " adaptation of the original animal spirits explanation for business cycles and then sketches the foundations of the real business cycle and the reformulated animal spirits explanations. The article next reviews the real business cycle and Neo-Keynesian views and, finally, discusses the policy implications of these two theories. Espinosa-Vega is a senior economist in the macropolicy section of the Atlanta Fed's research department. Guo is an associate professor at the University of California, Riverside. They thank Ellis …