Question

What are some flaws with Real BusinessCycle (RBC) models? Why do these flaws give inaccurate predictions/results on what can be done to fight recessions?

Answer 1

Real business cycle models states that macroeconomic fluctuations in the economy can be largely explained by technological shocks and changes in productivity.Following are the major flaws of Real Business Cycle models:

1.Liquidity traps

Real business cycle argues higher government spending can cause crowding out and be ineffective. Hence result in a liquidity trap, there is surplus saving and governments can increase borrowing, spending without causing any crowding out.

2.Wage rigidity

Real business cycle theories assume flexible markets and output is always at its real output. However, this ignores the role price and wage rigidity. Even neo-classical economists argue that monetary policy can play a role in dealing with labour market imperfections such as nominal wage rigidity.

3.A clear link between interest rates and recession.

There is a clear link between higher interest rates and a sharp fall in demand. In the UK, in 1991-92, there was a clear link with interest rates rising to 15%. The sharp fall in demand and output has a clear link with a demand-side factor.

4.Long-term nature of technological change.

Technology takes time to diffuse into the economy. There wasn’t a big bang moment for the use of the internet; it steadily increased its scope in the global economy.

5.Technological change may be influenced by the economic cycle.

In a recession, firms will cut back on investment and this will lead to a lower technological process. Therefore, rather than changes in technology causing the business cycle, it could be the other way around.

Recessions are the result of excessively strained monetary policy, just as booms are the result of too-easy monetary policy. Hence, the business cycle is due to errors in monetary policy.Recessions as the result of an economic policy error and assume that voters will punish the perpetrators of the error and the errors in monetary policy will lead to inaccurate predictions.

Real business cycle appears more believable, if we use data from the 1950s and 1960s, where economic growth was more stable. However, if we look at the Great Depression (1929-34) and the Great Recession (2008-12), the length and extent of the recession cannot be explained by supply-side shocks. There is a clear impact on aggregate demand from a fall in confidence, a fall in money supply, a lack of bank lending. All demand-side factors that have a direct influence on the economy and all these together have to be cured in order to fight against the recession.