Real Business Cycles - Real Business Cycle Theory

Real Business Cycle Theory

Economists have come up with many ideas to answer the above question. The one which currently dominates the academic literature on real business cycle theory was introduced by Finn E. Kydland and Edward C. Prescott in their seminal 1982 work Time to Build And Aggregate Fluctuations. They envisioned this factor to be technological shocks i.e., random fluctuations in the productivity level that shifted the constant growth trend up or down. Examples of such shocks include innovations, bad weather, imported oil price increase, stricter environmental and safety regulations, etc. The general gist is that something occurs that directly changes the effectiveness of capital and/or labour. This in turn affects the decisions of workers and firms, who in turn change what they buy and produce and thus eventually affect output. RBC models predict time sequences of allocation for consumption, investment, etc. given these shocks.

But exactly how do these productivity shocks cause ups and downs in economic activity? Let’s consider a positive but temporary shock to productivity. This momentarily increases the effectiveness of workers and capital, allowing a given level of capital and labor to produce more output.

Individuals face two types of tradeoffs. One is the consumption-investment decision. Since productivity is higher, people have more output to consume. An individual might choose to consume all of it today. But if he values future consumption, all that extra output might not be worth consuming in its entirety today. Instead, he may consume some but invest the rest in capital to enhance production in subsequent periods and thus increase future consumption. This explains why investment spending is more volatile than consumption. The life cycle hypothesis argues that households base their consumption decisions on expected lifetime income and so they prefer to “smooth” consumption over time. They will thus save (and invest) in periods of high income and defer consumption of this to periods of low income.

The other decision is the labor-leisure tradeoff. Higher productivity encourages substitution of current work for future work since workers will earn more per hour today compared to tomorrow. More labor and less leisure results in higher output today. greater consumption and investment today. On the other hand, there is an opposing effect: since workers are earning more, they may not want to work as much today and in future periods. However, given the pro-cyclical nature of labor, it seems that the above “substitution effect” dominates this “income effect”.

Overall, the basic RBC model predicts that given a temporary shock, output, consumption, investment and labor all rise above their long-term trends and hence formulate into a positive deviation. Furthermore, since more investment means more capital is available for the future, a short-lived shock may have an impact in the future. That is, above-trend behavior may persist for some time even after the shock disappears. This capital accumulation is often referred to as an internal “propagation mechanism”, since it may increase the persistence of shocks to output.

It is easy to see that a string of such productivity shocks will likely result in a boom. Similarly, recessions follow a string of bad shocks to the economy. If there were no shocks, the economy would just continue following the growth trend with no business cycles.

Essentially this is how the basic RBC model qualitatively explains key business cycle regularities. Yet any good model should also generate business cycles that quantitatively match the stylized facts in Table 1, our empirical benchmark. Kydland and Prescott introduced calibration techniques to do just this. The reason why this theory is so celebrated today is that using this methodology, the model closely mimics many business cycle properties. Yet current RBC models have not fully explained all behavior and neoclassical economists are still searching for better variations.

It is important to note the main assumption in RBC theory is that individuals and firms respond optimally all the time. In other words, if the government came along and forced people to work more or less than they would have otherwise, it would most likely make people unhappy. It follows that business cycles exhibited in an economy are chosen in preference to no business cycles at all. This is not to say that people like to be in a recession. Slumps are preceded by an undesirable productivity shock which constrains the situation. But given these new constraints, people will still achieve the best outcomes possible and markets will react efficiently. So when there is a slump, people are choosing to be in that slump because given the situation, it is the best solution. This suggests laissez-faire (non-intervention) is the best policy of government towards the economy but given the abstract nature of the model, this has been debated.

A pre-cursor to RBC theory was developed by monetary economists Milton Friedman and Robert Lucas in the early 1970s. They envisioned the factor that influenced people’s decisions to be misperception of wages—that booms/recessions occurred when workers perceived wages higher/lower than they really were. This meant they worked and consumed more/less than otherwise. In a world of perfect information, there would be no booms or recessions.