The possibility that the financial system might be a source of instability leading to crises was frequently discussed in pre-Keynesian business cycle literature, which is reviewed briefly in the next section. The main focus of the chapter is the revival of interest in the financial instability hypothesis (FIH) in the 1970s and 1980s. The FIH does not attempt to provide a complete theory of business cycles but concentrates instead on explaining speculative booms and subsequent crises. In most versions the speculative boom and the financial crisis that terminates it are both triggered by shocks; consequently it is implied that we should not look for too much regularity in the periodicity and amplitude of cycles in which such crises occur and that crises may not occur in all cycles. They are essentially individual events with certain common features but the economy’s reaction to them may be cyclical and basically similar in the sense that the comovements of various macroeconomic time series will be similar.
It has frequently been observed that interest in business or trade cycle theory is itself cyclical (e.g. Zarnowitz 1985, p.524). In periods of sustained prosperity interest wanes, as it did in the 1960s and early 1970s when research into macroeconomic dynamics concentrated on growth theory. At the end of the 1960s the continued existence of business cycles was questioned. The experiences of the 1970s and early 1980s, especially following the 1973 and 1979 oil price shocks, brought a resurgence of interest in business cycles. In this introductory section, the main themes in business cycle research in the 1980s will be reviewed. In section: Equilibrium Business Cycle (EBC) Modelling, the equilibrium approach to business cycle modelling, which has been dominant in the 1980s, will be discussed in more detail. In section: Nonlinear Cycle Theory, recent contributions by economists who do not accept that the business cycle can be adequately modelled using the linear Frisch-Slutsky approach, and that nonlinearities must be introduced, will be surveyed in order to update the survey of nonlinear business cycle models in Mullineux (1984,). This chapter does not seek to provide a comprehensive survey of the vast literature on business cycles. Zarnowitz (1985) has recently made a Herculean attempt at this.
Perhaps the most widely quoted and influential definition is that of Burns and Mitchell (1946, p.l)1 who state that:
Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organise their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; the sequence of changes is recurrent but not periodic; in duration cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own.