The dominant paradigm for analysis of macroeconomic fluctuations takes full-employment equilibrium as the norm and attributes temporary and self-correcting deviations from this norm to exogenous shocks. Notions of the natural rate of unemployment and rational expectations for inflation rest on an equilibrium premise, as do contemporary dynamic stochastic general equilibrium (DSGE) models. There is, however, another way of thinking about business cycles to be found in the historical literature. This alternative paradigm takes the movement of an economy through business cycles as itself the norm and views endogenous forces as driving the process. At the heart of the dynamic is credit behavior in a story that goes back to Bagehot (1874) and found renewal with Minsky (1986). In the boom phase of the cycle, credit expands, business is good, risk is rewarded, and asset values are bid up. But the process overshoots, and collapse ensues, to be followed by a cleansing of excess as businesses fail and the financial system retrenches. Bagehot himself proposed a synthesis of the two paradigms, and this approach works well to interpret the ups and downs of the Philippine economy historically.

This chapter begins by noting the key ingredients in Akerlof and Shiller’s bestseller Animal Spirits but goes on to cover a far wider range of macroeconomics issues, including a detailed coverage of Minsky’s “financial instability hypothesis” that prefigures their work. After examining alternative theories of how speculative markets work and discussing herding behavior via both information and decision rule cascades, the chapter considers Keynesian view of animal spirits in relation to liquidity preference, leading to a discussion of Katana’s work on the impact of consumer confidence on discretionary spending. Next comes analysis of saving behavior in relation to innovative mortgage products and the impact of evolving bank lending rules on housing affordability. After considering Minsky’s work, material from earlier chapters is used to provide new perspectives on involuntary unemployment, inflation, exchange rate determination and the importance of non-price factors in the determination of international trade (with a discussion of the limited ways in which exchange rates shape trade). Finally, behavioral analysis of decision-making is applied to the making of macroeconomic policy.

In the framework of a critical illustration of the contemporary history of economics, this chapter presents a general picture of developments in monetary theory and in the theory of financial markets, beginning with the monetarist approach. The transition in the policy field from domination of the Keynesian to domination of the monetarist approach is then illustrated. The theory of efficient financial markets is then considered, from the Modigliani–Miller theorem to Fama’s contribution. A section is devoted to various issues in the theory of financial markets and institutions, as an introduction to Minsky’s ‘truly Keynesian’ analysis of financial markets and their fragility as the repeated origin of crises. Finally, Minsky's idea of a new stage in the development of capitalism, the so-called money managers capitalism, is recalled.