Capital and the Business Cycle A Synthesis (With a Didactic Exposition)

Abstract

This paper presents a synthesis of capital theory and business cycle analysis. Capital is the neglected child of macroeconomics. Despite its obvious importance, capital has not received the attention that it deserves in modeling the business cycle. While many business cycle models pay no or very little attention to capital, the formation and structure of capital are an integral part of the exposition in this paper. Based on a strict distinction between the goods side and the monetary side of the economy, the present model combines time preference with the determination of the interest rate and puts these concepts consistently into a modified version of the standard growth model. The analysis then shows how monetary and fiscal policies produce business cycles. When the macroeconomic policy authorities calibrate the market liquidity and set the interest rate below the level set by the time preference of the economic actors, monetary and fiscal policy does not cure the business cycle but prolong the stagnation. The approach presented in this paper provides a framework for the analysis of macroeconomic policies and offers an innovative template for general macroeconomic analyses. The appendix adds a didactic exposition with indications for a course in macroeconomics guided by the main propositions of this paper. Following this plan, macroeconomic teaching and research could win consistency and regain the relevance that has been lost over the past decades.