Question

Real Business Cycle theory and the financial instability hypothesis of Hyman Minsky represent two distinct schools of thought regarding the causes of recessions. What are the major differences between the two theories of recessions and what are their implications for real estate investors?

Answer 1

Real business cycle theory and the financial instability hypothesis of Hyman Minsky have two distinct thoughts on the causes of recession.
Real Business Cycle theory sees recession and economic growth in response to the exogenous factors changing the environment.According to this theory recessioms are the output of technological change.The slow technical changes will result in recession in the economy This theory also asserts that the nominal variables does not influence the real variables.Real Business Cycle theory asserts that economy in its ability to turn their inputs in outputs will experience certain fluctuations in the technology and these changes in technology will lead to fluctuations in the employment and output.Recession is a term used to describe the period of economic decline.There is slow growth of economy during the recession.A significant fall in the spending will lead to the recession.When there is recession prevailing in the economy the GDP,employment ,profit ect

According to theory of financial instability hypothesis economic stability itself will lead to economic instability.According to this theory during the financial stability there is excess optimism .This excess optimism will result in financial bubbles which will burst leading to financial instability.Recession is a period of financial instability.According to this theory there are mainly three stages of debt namely Hedge,speculative and ponzi.The first stage banks and borrowers are more conscious about the loans .The borrower will only take limited amount of loans .At this stage there is no high amount of optimism.At this stage the borrower is able to repay both interest and the principal amount.
The second stage is known as speculative.Confidence of the borrowers will start increasing and the borrowers starts lending more.At this stage the borrowers are able to repay the interest only.
The third stage is known as ponzi.At these stage there is high degree of confidence and the borrowers starts lending more due to their over confidence.During these period the borrowers are not able to repay both the interest and principal amount.This is a stage of financial instability.
The Minsky moment are depicted in the figure below.Minsky moment is the point where the economy moves from stability to instability. Ponzi stage is the stage of financial instability or recession.At this stage borrowers are over debated,the price of assets falls and loss of confidence among the investor.According to this theory recession has a negative impact on the real investors.During the period of financial instability the asset prices falls down and the confidence of investors goes down.

Thus according to RBC technological changes are the cause of recession.Where as in financial instability hypothesis it is the financial stability itself paves the way for financial instability or recession.
In the figure in the initial stage there is only normal borrowing and there is steady growth.In the second stage there is speculative borrowing and there is economic boom and in the last stage there is ponzi borrowing or high borrowing and during this stage there is economic downturn or financi instability.This theory is well applicable to real estate business.During the period of financial instability there is increased optimist and the market demand will increase and there is real estate bubble.But when the period of financial instability the bubble will burst and the price of real estate decreases and the confidence of investors also decrease