Paul Krugman reminds us that one of the most misguided questions in macroeconomics is ‘are business cycles self-correcting’. This is a particular case of another mistake, which is to say that the duration of the business cycle depends on the speed of price adjustment. That answer is seriously incomplete, because it only holds for a particular set of monetary policy rules (plus assumptions about fiscal policy).
It is very easy to see this. Suppose monetary policy is so astute that it knows perfectly all the shocks that hit the economy, and how interest rates influence that economy. In that case absent the Zero Lower Bound the business cycle would disappear, whatever the speed of price adjustment. Or suppose monetary policy followed a credible rule that related real interest rates to the output gap rather than excess inflation. Once again the speed of price adjustment is not central to how long business cycles last. As Nick Rowe points out, if you had a really bad monetary policy recessions could last forever.
A better answer to both questions (self-correction and how long business cycles last) is it all depends on monetary policy. Actually even that answer makes an implicit assumption, which is that there is no fiscal (de)stabilisation. The correct answer to both questions is that it depends first and foremost on policy. The speed of price adjustment only becomes central for particular policy rules.
So why do many economists (including occasionally some macroeconomists) get this wrong? Why are textbooks often quite unclear on this point? It could be just an unfortunate accident. We are so used to teaching about fixed money supply rules (or in my case Taylor rules), that we can take those rules for granted. But there is also a more interesting answer. To some economists with a particular point of view, the idea that getting policy right might be essential to whether the economy self-corrects from shocks is troubling. They prefer to think of a market economy as being ‘naturally’ self-correcting, and to think that government intervention only has a role to play if there is some serious ‘market imperfection’. The market imperfection in the case of business cycles is price rigidity.
Focusing on this logic alone can lead to big mistakes. I have heard a number of times good economists say that in 2015 we can no longer be in a demand deficient recession, because price adjustment cannot be that slow. This mistake happens because they take good policy for granted. It is almost certainly true that no recession should last this long, because fiscal policy can substitute for monetary policy at the Zero Lower Bound. But with sub-optimal policy the length of recessions has much more to do with that bad policy than it has to do with the speed of price adjustment.
Just how misleading a focus on the speed of price adjustment can be becomes evident at the Zero Lower Bound. With nominal interest rates stuck at zero, rapid price adjustment will make the recession worse, not better. Price rigidity may be a condition for the existence of business cycles, but it can have very little to do with their duration.