Expectations Driven Nonlinear Business Cycles

There are two traditional conflicting views about the workings of a market economy. The socalled “Classical” school stresses the virtues of free markets and their intrinsic internal stability. According to that school, persistent, nonexplosive fluctuations should be esssentially due to repeated external macroeconomic shocks to the “fundamental” characteristics of the system (technology, tastes, resources). Productivity of capital equipment is assumed to vary randomly across the economy by following an exogenously given stationary stochastic process. Demand for goods and services, supply of labor are by assumption subject to exogenous aggregate random shocks. Government agencies and monetary authorities regularly throw dices when tuning up their policy instruments. Models of the “Classical” vintage typically assume that expectations are self-fulfilling, i. e. every individual’s assessment of the future (a probability distribution) is correct at any moment given his information. According to that view, expectations cannot be an independent source of economic fluctuations. Business cycles are forced by aggregate random exogenous shocks to the “fundamentals” and without them, no persistent economic fluctuations would be observed.