Business cycle theories can be divided into two groups: theories where entrepreneurial errors drive the cycle, and theories where errors play a secondary or negligible role. The traditional Austrian theory of the business cycle falls into the former category, whereas most varieties of real business cycle theory fall into the latter category. The Austrian view postulates that entrepreneurs make systematic mistakes (in response to monetary policy), and the real business cycle mechanism does not rely on individual mistakes at all. Risk-based theories, as considered in the next two chapters, provide a middle ground or halfway house between these two views.
A business cycle theory based on risk is the logical outcome of a focus on entrepreneurial errors. Once we take all possible signal extraction problems into account, the economic theorist cannot easily pinpoint the net direction of signal extraction errors. Economic theories of learning and expectations simply are not advanced enough to produce such definitive results (see Chapter 5 for more on related points). Furthermore, the very nature of an error suggests a factor which the economist cannot easily model or comprehend. We should not deny the concept of error outright but, rather, economists should make strong claims about errors only at a very general level, rather than at a very particular level.
Most monetary misperceptions theories, such as Lucas’s islands model (1972) or traditional Austrian business cycle theory, attempt to make definite claims about the nature of forecasting errors. For Lucas, unexpected inflation leads to excess labor supply in present periods, and for the Austrian inflation induces excessive long-term investment. In my perspective inflation may distort resource allocation, but it does so in a variety of ways, and in ways which are hard to predict or foresee in advance. Rather than trying to isolate particular distortive effects, and argue their relative potency, an alternative version of monetary business cycle theory considers the impact of inflation, and other exogenous shocks, on economic riskiness. Inflation generates greater economic cyclicality only when it leads to higher