From Cycles to Shocks: Progress in Business-Cycle Theory

Earl y analysts of business cycles believed that each cyclical phase of the economy carries within it the seed that generates the next cyclical phase. A boom generates the next recession; that recession generates the next boom; and the economy is caught forever in a self-sustaining cycle. In contrast, modern theories of business cycles attribute cyclical fluctuations to the cumulative effects of shocks and disturbances that continually buffet the economy. In other words, without shocks there are no cycles. The evolution of thought about business cycles from an emphasis on self-sustaining behavior toward one in which random shocks take center stage is a significant development in macroeconomics , and it is an especially important one for policymaking institutions like the Federal Reserve. The view that cycles are self-sustaining implies that a market economy cannot deliver stable economic performance on a sustained basis. Generally speaking, this view points to aggressive countercyclical policies or institutional reform as the appropriate response to cyclical fluctuations. In contrast, the view that shocks are the ultimate sources of business cycles does not point *Satyajit Chatterjee is an economic advisor in the Research Department of the Philadelphia Fed.