This minicourse is about business cycles. It first reviews basic facts about business cycles. It then presents a matching model of business cycles—both a static version for theoretical insights, and a dynamic version for policy analysis. It finally discusses the inefficiency of business cycles, and explain how monetary and fiscal policy can be used to tame business cycles.

So what are we going to find? First, we will see that business cycles correspond to fluctuations in the utilization of capacity, not fluctuations in capacity itself. Then we will find that business-cycle fluctuations can be explained by aggregate-demand shocks, in the presence of price and wage rigidity. We will then see that business cycles lead to inefficient utilization of capacity: there is too much slack in slumps and too little slack in booms. Finally, we will argue that monetary policy should set interest rates to maintain slack at its efficient level. When monetary policy is ineffective—at the zero lower bound for example—government spending should respond to fluctuations in slack to bring slack closer to its efficient level.

Accounting for business cycles

This first section reviews basic facts about business cycles. It decomposes business-cycle fluctuations into two components: fluctuations in productive capacity, and fluctuations in capacity utilization. It finds that the vast majority of business-cycle fluctuations are caused by fluctuations in capacity utilization—or equivalently fluctuations in slack. It also shows that such fluctuations in slack impose large welfare costs, due to the large non-monetary costs of unemployment.

Basic business-cycle model

This section develops a basic model of business cycles. The model is static. It is built around a matching function. The matching function summarizes the complex process through which workers searching for jobs meet firms searching for employees, and firms searching for customers meet consumers searching for sellers. Because of the matching function, self-employed workers are not able to sell all their services: there is always some slack.

Wealth enters the utility function. People derive direct utility from wealth, maybe because wealth is a marker of social status, and people value high social status. Thanks to this assumption, and although the model is static, the aggregate demand is nondegenerate.

The matching model requires to specify price norms. Theoretically, there are many possibilities. Evidence from microdata and ethnographic surveys suggests that prices and wages are not fully flexible but instead somewhat rigid. The section shows how such rigid pricing norms can be inserted into the model. Then the section derives comparative statics in response to aggregate demand and aggregate supply shocks under fixed prices and rigid prices.

Dynamic business-cycle model

This section presents a dynamic version of the business-cycle model. In the dynamic model, unemployment is determined by the intersection of an aggregate demand curve, stemming from households’ Euler equation, and an aggregate supply curve, corresponding to the Beveridge curve.

An advantage of moving to a dynamic environment is that interest rates appear into the model. Indeed, the real interest rate is a key determinant of aggregate demand. By setting a nominal interest rate, the central bank can stabilize the economy. The model is therefore useful to study the effect of monetary policy on unemployment—for instance to assess the possibility of a soft landing in the aftermath of the pandemic inflation spike.

Taming business cycles with monetary and fiscal policy

Unlike in neoclassical models, in matching models the economy generally operates inefficiently. Except in knife-edge cases, there is too much or too little unemployment. Since the unemployment rate is generally inefficient, it is critical to know whether the current unemployment rate is above or below the efficient unemployment rate.

This section therefore develops a simple formula for the efficient amount of unemployment. In general the US economy is inefficient. It is especially inefficiently slack in slumps. For instance, the unemployment gap reached 6 percentage points during the Volcker Recession, the Great Recession, and the Pandemic Recession. By contrast, in 2022, the US economy is inefficiently tight. The unemployment gap has been below -1 percentage point during the whole of 2022.

Since the US unemployment rate is always inefficiently high in slumps, and sometimes inefficiently low in booms, monetary policy has scope to stabilize the unemployment rate better. The section therefore describes optimal monetary policy over the business cycle. Monetary policy influences the aggregate demand curve, so it can be used to shrink the unemployment gap. The optimal monetary policy is to adjust interest rates to eliminate the unemployment gap entirely. So the central bank should lower rates in bad times, when unemployment is inefficiently high, and raise rates in good times, when unemployment is inefficiently low.

Once monetary policy reaches the zero lower bound, however, it becomes impotent, and it has to be supplemented by fiscal policy. The section finally studies how government spending should be adjusted when unemployment is inefficient. It shows that that optimal government spending deviates from the Samuelson rule to reduce, but not eliminate, the unemployment gap.