Traditional theories of business cycles:

Two different theses about cycles in economic activity in the developed world currently exist. One is the real business cycle (RBC) approach (to which you will be introduced in Unit 12) and the other is generically referred to the classical business cycle (CBC) orientation as an umbrella for all methodologies other than the RBC.  The first approach (RBC) proposes that fluctuations in economic activity are driven by real shocks, while the latter body of work (CBC) suggests that a modern economy is a monetary and financial system and, therefore, cycles are generated as economic agents take positions in financial markets. For our purposes, it is sufficient to observe that by quantitative testing, which is  not necessarily theory-driven, the CBC approaches are not inferior as explanations of fluctuations in the developed world. In other words, it is not illegitimate to explain business cycles without recourse to so-called first principles. This means that it is unnecessary to conduct the enquiry solely on the basis of infinitely-lived agents optimising their intertemporal objective functions. Secondly, the dichotomy between real sector and financial sector may not apply. Note that business cycle is a feature of the capitalist economy. It turns out that aggregate investment contributes to most of the fluctuations of GDP in most developed economies.   

A stylised fact is that both a long and a short cycle in aggregate output can be discerned for both the prewar and the postwar period. The long cycle, of a length of six to nine years, is most pronounced for the structure of fixed investment. The short cycle, of a duration of three to four years, dominates the cyclical structure of inventory investment. The relative strength of these cycles is explained by the speed with which the associated capital stock can be adjusted. The speed is naturally greatest for inventories, intermediate for equipment and machinery, and the longest for building and structures. The term business cycle here is taken to mean the irregular periodic movement brought about by a first-order difference or differential equation.

The traditional approach to business cycles  by and large emphasized real factors. Few and far between were the classical  economists who satisfactorily (even to themselves!) integrated monetary and financial factors into their study of the rhythmic waves of activity that characterised capitalist economies. Thus, we record below three important moments in the evolution of thought on business cycles associated with landmarks in the subject. First is the seminal contributions of Richard Goodwin who pioneered the tools and techniques of dynamic economic analysis. Modern work in complex economic dynamics can be traced back to one or other of his papers. His models were cast entirely in real terms. Secondly, springing from the same Marxian stock, although developing his trade cycle by first grounding his framework in the monopoly capitalism of his time, is the theory of Michal
Kalecki. We should note that Kelecki, the Polish economist-mathematical statistician, is one of the founding fathers of modern macroeconomics. His long-term dynamics, then, follows from his short-term dynamics. The rudimentary inclusion of monetary elements are to be found here in the accommodating stance of the Central Bank to any lead provided by the investment plans of businessmen. Finally, the veil of money is completely torn asunder in the work of Hyman Minsky for whom the capitalist economy is a financially layered entity prone to fluctuations in connected financial and real activities. The list is, by no means, exhaustive. For example, the set of non-RBC approaches to business fluctuations is dense. Dennis Robertson, for instance, emphasised monetary factors in  the genesis and propagation of cycles.

Another illustrious member of that tradition was Ralph Hawtrey who underscored the importance of bank credit which is indispensable for carrying inventories. Reductions in interest rates induce businessmen to carry larger  inventories. Greater orders, in their turn, encourage increased investment and, with a lag, investment in fixed capital.