THE REAL BUSINESS CYCLE THEORY
The real business cycle theory has been evolved out of the American new classical school of
1980s. It is the outcome of research mainly by Kydland and Prescott, Barro and King, Long
and Plosser, and Prescott. Later, Plosser, Summers, Mankiw and many other economists gave
their views of the real business cycles.
They view aggregate economic variables as the outcomes of the decisions made by many
economic agents acting to maximize their utility subject to production possibilities and
resource constraints. Their views mainly relate to technology shocks, labour market, interest
rate, role of money, fiscal policy, prices and wages in business cycles. They are explained
below.
Role of Technological Shocks:
The theory of real business cycles explains short-run economic fluctuations based on the
assumptions of the classical theory. According to this theory, business cycles are the natural
and efficient response of the economy to economic environment.
They are primarily caused by real or supply side shocks that involve exogenous large random
changes in technology. An initial shock in the form of a technological advance shifts the
production function upward. This leads to increase in available resources, investment,
consumption and real output. With the increase in investment, the capital stock increases
which further increases real output, consumption and investment.
Assumptions:
1. There is a single commodity in the economy.
2. Prices and wages are flexible.
3. Money supply and price level do not influence real variables such as output and
employment.
4. Fluctuations in employment are voluntary.
5. Population is given. So there is fixed labour force.
6. There are rational identical economic agents in the economy.
7. These agents make optimising decisions.
8. Everyone has the same preferences which depend only on consumption in each year.
9. More consumption is preferred to less so that the marginal utility from consumption
diminishes.
10. The economy is subject to irregular (random) real supply side shocks.
Technological Shock:
Given these assumptions, the production function of the economy is given by
Y = Zf (K,N)
Where Y is total output, Z is the state of technology, K is predetermined capital stock and N
is labour input. The produced output can either be consumed or invested.
Assuming that population is given and there is a fixed labour force, output depends on
technology and capital stock. So output is determined by the production function, Y= Zf (K).
The capital stock, K depreciates at the rate S, so that the undepreciated capital stock evolves
as (1-δ) K. This capital stock is available as input for production in the next period.
With a capital stock K, output is Y and the total resources available in the economy in the
current period are Y + (1-δ) K.
Since Y = Zf (K), the total resources can be expressed as Zf (K) + (1-δ) K. These resources
can either be consumed or accumulated as capital to be used as investment for the next
period.
A real business cycle is generated in a steady state economy when there is a positive
exogenous and permanent technological shock. This leads to increase in productivity. As a
result, the aggregate production function shifts upward.
The improvement in technology from the initial level Z to Z1 and the consequent upward shift
of the production function from Zf(K) to Z1f(K) is shown in Figure 1. Given the initial capital
stock OK, output increases from OY to OY1.
As a result, total resources increase from OR to OR1 and the total resources curve shifts
upward from Zf(K)+(1-δ) K to Z1f(K)+(l-δ)K. With the increase in total resources, both
current consumption and capital accumulation also increase. There is increase in capital stock
to OK1.
With no change in technology, the increase in capital stock to K1 in the next period leads to a
further rise in output to OY2 and the increase in total resources to OR1. In this way, the
economy continues to expand when consumption, investment and output increase gradually
leading to a new steady state.
Labour Market:
The real business cycle theory emphasises that there is intertemporal substitution of labour in
the labour market. When a technology advance leads to a boom, the marginal product of
labour increases. There is increase in employment and real wage. In response to a high real
wage, workers reduce leisure.
On the contrary, when technology is unfavourable and declines, the marginal product of
labour, employment and real wage rate are low. In response to a low real wage, workers
increase leisure. Thus an important implication of real business theory is that the real wage is
procyclical.
Interest Rate:
The real business cycle theory also takes into account the role of real interest rate in response
to a technological shock. The real interest is equal to the marginal product of capital. When a
favourable technological change leads to a boom, the marginal product of capital and the real
interest rate rise.
Flexibility of Wages and Prices:
The real business cycle theory assumes that wages and prices are flexible. They adjust
quickly to clear the markets. There are no market imperfections. It is the “invisible hand” that
clears the market and leads to an optimal allocation of resources in the economy.
Neutrality of Money:
Money plays no role in the real business cycle theory. Money is neutral. Money does not
affect such real variables as employment and output. The role of money is to determine the
price level. The money supply is endogenous in the real business cycle theory. It is
fluctuations in output that cause fluctuations in the money supply.
Fiscal Policy:
Fiscal policy has little role to play in the real business cycle theory. Since the “invisible hand”
guides the economy, the government role is limited. In fact, business cycles are the natural
and efficient response of the economy to favourable and unfavourable technological shocks.
A fiscal policy measure such as a tax on income will adversely affect output and
employment.