Historical perspectives

Theories

Business cycle theories have a long history, going back more than 100 years to the days of the economist William Stanley Jevons, who, in 1884, proposed that fluctuations in agricultural plantings and output were related to changes in activity on the sun's surface. This Sunspot Theory at first seemed plausible, as the length of business cycles was thought to be approximately 10.4 years and close to the length of the sunspot cycle. But the linkage to economic activity was not later supported. The more important contribution of Jevons turned out to be the idea that future production decisions in business cycles are, to a degree, self-fulfilling.

Before the Great Depression of the 1930s, a mercantilist theory was generally accepted. This was based on the idea that the wealth and power of nations depended on the amount of gold held, and that trade surpluses would generate inflows of gold and thereby expand the money supply. According to the mercantilists, stable economic growth depended on stable growth of gold reserves. Although simplistic, this theory was a precursor of modern monetarist approaches.

The classical model that followed assumed perfect competition and homogeneous preferences of individuals, whose behavior is unaffected by money illusions; that is, changes in money supply do not have any affect on real economic activities and aggregate outputs. In this approach, there are no differences between financial and any other types of transactions (Knoop 2008, p. 71).