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

Real business cycle models state that macroeconomic fluctuations in the economy can be largely explained by technological shocks and changes in productivity. These changes in technological growth affect the decisions of firms on investment and workers (labour supply)

• Real business cycle models state that macroeconomic fluctuations in the economy can be largely explained by technological shocks and changes in productivity.
• These changes in technological growth affect the decisions of firms on investment and workers (labour supply). Hence changes in output can be traced to microeconomic and supply-side factors.
• Real business cycle models either completely reject or play down the role of aggregate demand in influencing the economic cycle.
• Real business cycle models suggest that government intervention to influence demand in the economy is generally counterproductive and the optimal policy is to concentrate on supply-side reforms which help the economy to be more efficient and flexible.
• Real business cycle models reject the Keynesian approach to the macroeconomy and also reject monetarism. It tends to be associated with neo-classical economics and the Chicago School of economics.

  Aspects of Real Business Cycle

  The macro economy stems from individual microeconomic decisions. In particular, how do individuals respond to a changing environment and technology in deciding what to produce and how much to work? Thus according to real business cycle, economies have a strong basis in microeconomic principles.

  Real business cycle models assume individuals are rational agents seeking to maximise their utility. A basis for real business cycle theory is a simple neo-classical model of capital accumulation where individuals seek to invest in capital, and the price of labour will be determined by market forces. Thus under a broad set of conditions, work effort, investment and output will converge to a steady rate.

• Unemployment

  A technological shock can cause resources to move from one sector to another. But, it can take time for labour to move between different jobs. Therefore, there can be temporary structural unemployment.

  Another cause of unemployment in a real business cycle is due to the consequences of agents changing their decision to supply labour. Under some circumstances of technological change/change in trade unions power – workers may choose voluntary unemployment rather than supplying labour.

• Pareto efficiency and real business cycle

  Real business cycles generally assume that shocks to productivity lead to fluctuations in the economy that are Pareto optimal. In others words, a temporary fall in output is an inevitable consequence of fall in productivity and not a cause for concern. The fall in output is a way for the economy to adjust to this new equilibrium and enable resources to find more productive uses.

  This is similar to Joseph Schumpeter’s work on “Creative Destruction” – the idea that failure of inefficient business is important for enabling productivity gains and economic growth

(A) Cyclical fluctuations in the level of economic activity can be observed by examining annual changes in real national income over a long period of years. These changes are inversely related to variations in the rate of unem­ployment. The fluctuations were much reduced, possibly as a result of the adoption of Keynesian demand management policies by all governments in the developed capitalist economies since 1950s.

None the less, even in this period, the economy has been subjected to fairly regular cycles of minor expansions and recessions. In the 1970s, the business cycle was marked by world recession—due to the energy crisis—which resulted in an upward trend in the rate of unemployment.

B) Recent empirical work has suggested that in response to a positive technology shock employment shows a persistent decline. This finding has raised doubts concerning the relevance of flexible prices as well as the quantitative significance of technology shocks as a source of aggregate fluctuations. We show that the standard, open economy, flexible price RBC model can match the negative conditional correlation between productivity and employment quite well if trade elasticities are sufficiently low. In addition, the model also has satisfactory overall empirical performance.

C) Real business cycle models suggest that government intervention to influence demand in the economy is generally counterproductive and the optimal policy is to concentrate on supply-side reforms which help the economy to be more efficient and flexible.