A Perspective on Modern Business Cycle Theory

T he global financial crisis and recession that started in 2007 with the surge of defaults of U.S. subprime mortgages is having a large impact on recent macroeconomic research. The framework of modern macroeconomics that has replaced traditional Keynesian economics since the 1970s has been widely criticized. Many of the criticisms have focused on the assumptions of the representative agent and its abstraction from firm and household heterogeneity. Critics are also skeptical about the model’s ability to explain unemployment and financial crises because it abstracts from market frictions and irrationality. As a result, modern macroeconomics has often been attacked for its futility in providing policy insight in the way that traditional Keynesian economics has done.1 Some criticisms are constructive and others are misleading. I would like to present my thoughts on what I believe are the contributions and shortcomings of modern macroeconomic theory, in particular the business cycle theory, by responding to some of these criticisms.2