The different business cycle theories center on the cause of fluctuations in macroeconomic activity. According to Keynesian theory, changes in the business cycle are due to normal occurrences, such as a drastic change in consumer spending. The New Classical theory, on the other hand, states that changes in business cycles do not always result from a change in interest rates, but rather a change in an economy's output and consumer preferences.
Business cycles are usually defined as periods of economic growth or periods of recession. Economic growth or expansion is usually characterized by ample employment, an overall higher market value of the economy's produced goods and services, and increased productivity. Higher rates of inflation may be seen in times of swift expansion, but do not necessarily occur during periods of growth.
Economic recessions and depressions are marked by a decrease in employment levels. Productivity may decline. The market value of the economy's goods and services typically falls as consumers tend to spend less. Speculation over job loss or a decrease in income can spur a tendency to save more, and borrow less.
Business cycle theories both agree that there tend to be peaks and troughs during a cycle's duration. Macroeconomic indicators such as the unemployment rate, the labor cost index, production capacity, commodity prices, and changes in inventories and worker productivity can be used to help determine what stage of the cycle an economy is in. These indicators are used to predict where the macro economy is headed next and to help identify trends. The labor cost index is used to determine if consumer prices will rise; the production capacity reveals whether increases in demand will lead to inflation; and commodity prices can reflect inflation in raw goods. Inventory levels show demand growth, while worker productivity shows whether the costs to produce goods and services is decreasing.
The two main types of business cycle theories are Keynesian and New Classical thought models. Keynesian theory states that business cycles can be caused by government policies such as increasing or decreasing the money supply through a change in interest rates. As one of the business cycle theories, it sharply differs from the New Classical thought in that there is room for flexibility in an economic environment. According to Keynesian theory, fluctuations in business cycles occur as a result of an inflexible parameter such as consumer prices, which then leads to a drastic change in economic output.
The second of the two business cycle theories, New Classical thought states that economic parameters do not always lead to a change in an economy's produced goods and services. Just because consumer prices shoot up, it does not mean that consumption will fall. Demand changes do not directly influence output, but a change in the types of goods and services consumers wish to purchase does.
