Question

The following questions are related to the Real Business Cycles (RBC) Model.
(a) What are the sources of economic fluctuation?
(b) Analyze the effect of positive supply shocks on output and employment in the RBC model.
(c) Why the RBC suggest the optimal policy recommendations must come through the supply side rather than the demand side?

Answer 1

Part (a)

According to real business-cycle theory, the only forces that can trigger economic fluctuations are those forces that alter the Walrasian equilibrium. The Walrasian equilibrium is simply the set of quantities and relative prices that balance supply and demand simultaneously in all the economical markets. To understand how real business cycle theory explains the business cycle, it is necessary to look into the fundamental forces that change the supplies and demands for various goods and services.

Business cycles vary considerably in terms of amplitude and duration, and no two cycles appear to be exactly alike. Nevertheless, these cycles also contain qualitative features or regularities that persistently manifest themselves. The one very regular feature of these fluctuations is the way variables move together. Cooley and Prescott report some features of the business cycle based on U.S time series:

• Employment fluctuates almost as much as output, while overage weekly hours fluctuate considerably less.
• Consumption of nondurables and services is smooth, fluctuating much less than output.
• Output movements in different sectors of the economy exhibit a high degree of coherence
• Velocity of money is counter cyclical in most countries, and there is considerable variation in the correlation between monetary aggregates and output. Long term interest are less volatile than short-term interest rates, and the latter are nearly always positively correlated with output, but the correlation of longer-term rates with output is often negative or close to zero.
• Prices appear to be counter cyclical
• Investment, or production of durables generally, is far more volatile that output.
• The capital stock much less variable than output and is largely uncorrelated with output.
• Productivity is slightly procyclical but varies considerably less than output. - Wages vary less than productivity.
• The correlation between average hourly compensation and output is essentially zero.
• Government expenditures are essentially uncorrelated with output.
• Imports are more strongly procyclical than exports.

Since real theory of the business cycle explains economic cycles as a changing Walrasian equilibrium, it means these fluctuations are efficient. Given consumer choices, it is difficult to increase the rate of jobs, production and consumption of individuals and of the technological possibilities facing society.Attempts by the government to alter the allocations of the private market, such as policies to stabilize employment, at best are ineffective and at worst can do harm by impeding the "invisible hand."

Part (b)

Advocates of real theories about the business cycle have trouble convincing skeptics that the economy is subject to such large and sudden technological changes. It is a more standard presumption that the accumulation of knowledge and the simultaneous increase in the technological opportunities of the economy are progressively taking place over time.

The residual Solow should not be construed as evidence of exogenous technological upheavals. The typical reason for cyclic productivity is that it represents the actions of labor hoarding and other "off the role of output." Productivity tends to collapse in a recession, so businesses remain inefficient and unsustainable less labor. In a boom the hoarded laborers begin to put out greater effort; output increases without a large increase in measured labor input.

Advocates expect very heavy wage procyclicality, and not enough job procyclicality. In fact, jobs (or total worked hour) is nearly as variable as production, and strongly procyclical, while real wages are at best slightly procyclic.

If most shocks hitting the economy shift the role of output and then adjust the marginal product of labor, ceteris paribus, the changes in labor demand will follow an upward-sloping pattern of labor supply in real wage-employment space. Because studies suggest that the wage elasticity of labour supply is low, much of the adjustment to a productivity shock should be borne by wages, rather than employment

Improvement in technology has two effects in the labour market: first, increases the marginal product of labour, thereby shifting the labour demand curve out. Second, it raises current consumption (if the wealth effect dominates), causing the labour supply curve to shift in.

The net result depends on the relative shifts in these two curves. If the demand curve shift dominate, then equilibrium employment and hence output tend to rise. If the supply curve shift dominates then employment will tend to fall, offsetting the earlier increase in output. However, note that in either case wage are going to be strongly procyclical, since both shifts cause wage to rise.

Part (c)

Two key features of the real business cycle model discussed so far are that business cycles are initiated by shocks to technology and that fluctuations are Pareto optimal. Neither of these conditions, however, are necessary features of the real business cycle approach. The incorporation of government into the real business cycle models makes it possible to address important questions regarding changes in fiscal policies in the presence of distortionary taxes. Variation in government spending introduces a potential source of demand disturbances to the model.

The basic line of thinking is that inside an economy with several agents, each can take the spending and taxation policies of the government as provided in their problem of choice. The only additional limitation is that aggregate activity meets the budget constraint on the government.

First, raising government purchases induces a negative wealth effect that acts to reduce consumption and raise work effort and output. Second, raising government purchases also induces intertemporal substitution when the increase is temporary. This results in lower consumption, lower investment, higher work effort and higher output.

Solow 's view on technical progress included something that affected the function of production other than capital or labor measurable. The findings of Solow, as an empirical proposition, suggest that these exogenous changes  account for a large portion of economic growth. The real business cycle model underlines these shifts also play a major role in economic fluctuations.

The idea is to permit human capital (labor-augmenting technical change) to be produced using physical capital and human capital as inputs to a constant returns technology

The reason is that a change in productivity that results in more output will generally result in some increased resources being allocated to the production of additional human capital. Thus allocation decisions affect the level of technology and the growth in the economy. These models have the additional implication that such variables as output, consumption and investment are integrated or possess a stochastic trend.

Finally, shocks in productivity in these models can cause complex transition patterns to a new growth path. In general, these transformation paths include dynamic shifts in work commitment, expenditure and consumption. Measuring economic development requires an understanding of these routes, thus reinforcing the notion that growth and volatility are closely linked