Keynesian View

Keynesian's believe instability arises from two sources:

Changes in investment and consumption shift the Aggregate Demand curve in or out, causing recession or inflation.

Adverse Supply side shocks shift the Aggregate Supply curve in, causing stagflation.

Monetarists View

Bad Government policies are a major cause

Wages Inflexibility: Wages can't adjust because of government policies like the minimum wage, farm price supports, and monopoly protection.

This label is applied to a modern form of classical economics.

• Money supply is the focus of monetarist theory.
• Monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in product and resource prices, rather than output and employment.
• Therefore, a competitive market system would provide substantial macroeconomic stability if there were no government interference in the economy.
  • It is government that has caused downward inflexibility through the minimum wage law, pro?union legislation, and guaranteed prices for some products as in agriculture.
  • Monetarists say that government also contributes to the economy's business cycles through clumsy, mistaken, monetary policies.

It's due to 'Government failure' rather than 'Market Failure'.

Monetarists say that inappropriate monetary policy is the single most important cause of macroeconomic instability. An increase in money supply will increase aggregate demand.

Real Business Cycle View

Real business-cycle theory (RBC theory) is a class of new classical macroeconomics models in which business-cycle fluctuations to a large extent can be accounted for by real (in contrast to nominal) shocks. Unlike other leading theories of the business cycle, RBC theory sees business cycle fluctuations as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility, and governments should therefore concentrate on long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations.

According to RBC theory, business cycles are therefore "real" in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy.

A third perspective on macroeconomic stability focuses on a aggregate supply.

• The view that business cycles are caused by real factors affecting aggregate supply such as a decline in productivity, which causes a decline in AS.
• In the real?business cycle theory declines in GDP mean less demand for money.Here, the supply of money is decreased after the demand declines.AD falls, but price level is the same because AS also declined.