Question

Propose another view of how the economy operates on the Real Business Cycle.

Answer 1

An economy witnesses a number of business cycles in its life. These business cycles involve phases of high or even low level of economic activities. A business cycle involves periods of economic expansion, recession, trough and recovery. The duration of such stages may vary from case to case.

The real business cycle theory makes the fundamental assumption that an economy witnesses all these phases of business cycle due to technology shocks. Technological shocks include innovations, bad weather, stricter safety regulations, etc.

According to RBC theory, business cycles are therefore "real" in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy.

Real business cycle theory categorically rejects Keynesian economics and the real effectiveness of monetary policy as promoted by monetarism and New Keynesian economics, which are the pillars of mainstream macroeconomic policy.

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.

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.

To quantitatively match the stylized facts in Table 1, Kydland and Prescott introduced calibration techniques. 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.

The main assumption in RBC theory is that individuals and firms respond optimally all the time. 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.