Real Business Cycles - Criticisms

Criticisms

Real business cycle theory is a major point of contention within macroeconomics (Summers 1986): RBC theory categorically rejects Keynesian economics and the real effectiveness of monetarism, which are the pillars of mainstream macroeconomic policy, while such noted mainstream economists as Larry Summers and Paul Krugman categorically reject RBC theory in turn:

"(My view is that) real business cycle models of the type urged on us by Prescott have nothing to do with the business cycle phenomena observed in the United States or other capitalist economies." –(Summers 1986)

It is a common misconception that RBC theories are purely based on shocks to supply, as opposed to Keynesian theories, which are based on shocks to demand, and this leads to the common criticism of RBC theories as ignoring the demand side of the economy. However, technology-based theories of real business cycles also imply that consumers will change their intertemporal consumption and savings decisions based on the real interest rate available to them, which is a shift in demand. Other RBC theories based on preferences implicate the demand side to an even greater extent (Plosser, 1989). Intuitively, as a market-clearing model, RBC theories do not fall clearly into either a demand-side theory or a supply-side theory as Say's law will hold in these theories and supply and demand will automatically move together.

By way of specific criticism of RBC theory as advanced by Prescott, (Summers 1986) lists four:

• Prescott uses incorrect parameters (one third of household time devoted to market activity rather than one sixth; historical real interest rates of 4% rather than 1%);
• absence of independent evidence for the technology shocks that supposedly cause the business cycle, and notably being unable to point to technological causes of observed recessions;
• Prescott's models ignore prices, and its predictions on asset prices are rejected by 100 years of data by Prescott's own work;
• Prescott ignores exchange failures (e.g., failures of factories to trade their goods for workers' labor), which are central to Keynesian accounts of the causes of the Great Depression, among other crises.