Real Business Cycle Theory

11 Key excerpts on "Real Business Cycle Theory"

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  Recessions and Depressions

  Understanding Business Cycles

  • Todd A. Knoop(Author)
  • 2009(Publication Date)
  • Praeger

    (Publisher)

  CONCLUSIONS Real Business Cycle Theory defined much of the cutting-edge business cycle research during the 1980s and its influence, though lessened, contin- ues in modern macroeconomic theory. Economists today pay much more attention to supply factors such as productivity, capacity utilization, and input prices when investigating business cycles than they did previously. While the supply shocks of the 1970s and the resurgence of interest in neoclassical economics played important roles in the popularity of Real Business Cycle models, another extremely important factor in their appeal to economists is that they are based on microeconomic principles— principles such as utility maximization, profit maximization, and market equilibrium. In many economists’ eyes, Real Business Cycle models are both elegant and theoretically consistent. The fact that the study of both long run growth and short run business cycles could be merged into one unified macroeconomic model is also incredibly appealing to economists. Gregory Mankiw (1989) argues that any good theory has to be both internally and externally consistent. By internally consistent he means that the theory has to be intuitively plausible and understandable. Because they are explicitly based on microeconomic theory that is widely accepted and has withstood the test of time, neoclassical models such as Real Business Cycle models are internally consistent. However, to be externally consistent a theory has to be able to match the empirical facts. As we have discussed, by asserting that only aggregate supply matters Real Business Cycle Models 95 in determining output, that money is neutral, that unemployment is entirely voluntary, and that productivity shocks are the only cause of business cycles, the predictions of Real Business Cycle models do not seem to fit the facts of business cycles as we currently understand them.

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  Central Bank Balance Sheet and Real Business Cycles

  • Mustapha Akinkunmi(Author)
  • 2018(Publication Date)
  • De Gruyter

    (Publisher)

  Chapter 9 Real Business Cycles

  The modern theory of business cycles originated from policy actions taken to address the Great Depression. While Keynesian economic models originally gained credibility and traction among economists after its central tenets (reduction in interest rates, government investment in infrastructure) were successful in tackling the Great Depression, the bouts of stagflation experienced during the 1970s, the absence of microeconomic theories, and inability of Keynesian models to predict policy changes challenged the assumptions of Keynesian economics and dented its popularity as an ethos to tackle economic downturns. The shortcomings of Keynesian theories of business cycles led to the development of the real business cycle (RBC) model. Rather than focusing on changes in aggregate demand, the RBC model provides a more sophisticated understanding that looks at the importance of changes in the aggregate supply curve, and how this interacts with changes in aggregate demand.

  The RBC model postulates that most changes in real short-term and longterm aggregate output are determined by changes in technology, a phenomenon usually referred to as “technology shocks” as well as other factors. According to the model, the growth rate of real gross domestic product (GDP) increases in line with significant technological advances, and declines when the technology improves slowly (moves at a normative pace). Thus, as productivity declines, the real GDP growth rate turns negative, which is the actual sign of a business downturn or recession.

  The RBC model was introduced to bridge the gaps observed in the Keynesian model, especially in regard to microeconomic aspects. Key questions the RBC model attempts to answer are: what causes economic (positive) fluctuations, and what can be done to reduce the depths of economic downturns?

  This chapter will provide more insights on RBCs as well as how these cycles relate to central bank balance sheets. In addition, the chapter will end with a mathematical look that is based on the utility function perspective in relation to the RBC.

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  Analysing Modern Business Cycles

  Essays Honoring Geoffrey H.Moore

  • Philip A. Klein(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  There are four main general conclusions of this review. First, for theoretical and policy purposes, it is necessary to treat each business cycle as an individual. It is important to do so since each cycle varies from one to the next in respect to amplitude and duration; and each varies in the timing and nature of the changes of the co-movements of key variables, which contribute to the variations in amplitude and duration. Nevertheless, one is justified in studying business cycles as a group since “each cycle in some important ways in its decomposition into sectors and in the aggregate bears a close ‘family likeness’ to earlier cycles” (Boehm and Moore 1984, 35; see also Hicks 1950, 2).

  Secondly, interrelated with the first point, there are considerable but varying degrees of endogeneity from one business cycle to another as well as exogenous elements. Hence, business cycles cannot be explained entirely as the result of random events or unanticipated monetary shocks, as suggested by rational expectation theorists (Lucas and Sargent 1979, 14), or of random real shocks to technology as invoked by real business cycle exponents (Kydland and Prescott 1982; Long and Plosser 1983). The concept of the price-cost cycle is briefly reviewed. This recognizes an additional, largely endogenous force which helps to fill an important gap in business cycle theory concerning why the main business cycle in industrialized democracies is of relatively short duration.

  Thirdly, in formulating an adequate and acceptable theory, more explicit attention needs to be paid to the empirical evidence on business cycles. On the other hand, some empirical evidence itself, or at least the way it has been interpreted, may have contributed to a misunderstanding of the true characteristics of business cycles. This applies to both earlier theorists and the recent rational expectations and real business cycle theorists. Generally speaking, the variety of business cycle theories have, in important respects, fallen significantly short of providing a continuing explanation that is both adequate in the light of what is actually experienced in market-oriented economies and, in particular, in providing a basis which can confidently and continually be relied upon in the formulation of economic policies.

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  Business Cycles: Fact, Fallacy And Fantasy

  Fact, Fallacy and Fantasy

  • Sumru G Altug(Author)
  • 2009(Publication Date)
  • World Scientific

    (Publisher)

  Chapter 3 Models of Business Cycles The standard approach to classifying business cycle models follows Ragnar Frisch’s [95] terminology of impulses and propagation mechanisms. The shocks or impulses thought to instigate business cycles have typically been varied and diverse. Technology shocks which alter a society’s production possibilities frontier, whether they are permanent or transitory such as oil shocks, have figured prominently in the recent literature. Weather shocks have always had a place among the impulses thought to trigger fluctuations in economic activity. Political shocks, wars, and other disruptions in market activity have also been acknowledged to play a role. More controversially, one could also assign a role to taste shocks or changes in preferences of consumers. Equivalently, one could argue, as Keynes [127] did, that investors’ “animal spirits” or, more precisely, changes in their subjective beliefs could help to trigger business cycles. Much of the controversy in the business cycle literature has stemmed from differences attached to the importance of alternative propagation mechanisms and the associated shocks. Current real business cycle (RBC) theory argues that business cycles can arise in frictionless, perfectly competitive, complete markets in which there are real or technology shocks. This approach emphasizes the role of intertemporal substitution motives in propagating shocks. By contrast, Keynesian and New Keynesian models stress the role of frictions such as price stickiness . In a simple labor market model, if real wages do not adjust downward when there is a negative shock to demand, the result is unemployment and greater declines in output relative to a situation with flexible prices. The Great 33

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  Economic Thought and History

  An unresolved relationship

  • Monika Poettinger, Gianfranco Tusset(Authors)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  The history of economic thought has evolved through a twofold process. On one hand, there has been an increase in its internal consistency due to the continuous efforts to improve theories and models whose foundations had been settled before. On the other hand, the challenge of the facts has led economic thought to deep changes that sometimes have implied large modifications of the accepted wisdom. Both processes coexist and co-evolve and are difficult to disentangle. The drift of events may erode the adequacy of a theory to explain the facts unless we make a very serious effort of improving it. This is not to say that economic theories have to be set afresh every ten or twenty years, but some minor changes are always necessary and sometimes changes have to be large.

  This is the case of Real Business Cycles Theory (RBC). It has been one of the more successful economic theories over the last thirty years and it has driven a lot of changes in our discipline. Furthermore, it has allowed us to establish a link with growth theory and it has formed the backbone of a handful of models widely used by theorists. However, the current crisis casts many doubts about its usefulness and its future is at stake.

  In this chapter we first study the evolution of RBC and we explain why it has been so successful and why it is now under severe scrutiny. In the second part we explain the starting point of RBC and point out that it was a bold conjecture because it challenged the established wisdom on economic cycles. Before RBC, the economic cycles had been shown as a disequilibrium phenomenon; a kind of oscillation between a high peak and a deep hole. RBC theorists stated that the evolution of GDP over time was the joint outcome of an economic equilibrium and an external impulse, namely a technological shock.

  In the third part we show the evolution of the theory following its own internal logic.

  RBC was very well acknowledged among theorists who engaged on a process of refining its ideas, measuring the required data, testing the predictions of the theory and in some cases introducing minor changes to fit the data, and applying the approach to the analysis of the cyclical behavior of the main economies. Since the theory had some flaws, the second phase helped to reduce these and to gain internal coherence as well. The theory spread out in many fields and gained a lot of support.

  One of the reasons for the success of RBC was that from 1985 onwards, the figures of the world’s largest economies fitted very well with the main features of the theory. Developed countries grew following a fairly smooth trend, and the scope and size of the economic crisis in these countries did not challenge the backbone of RBC. We address this point in the fourth part of the chapter. Then, we show that RBC has focused mainly in the transmission process and has paid less attention to the impulse process. Besides, it has stressed that the impulses came from outside the economy, or that they could be considered that way. The fifth section of the chapter addresses the improvements made in the analysis of the impulse process.

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  Macroeconomics for MBAs and Masters of Finance

  • Morris A. Davis(Author)
  • 2009(Publication Date)
  • Cambridge University Press

    (Publisher)

  Since the level of technology is, on average, increasing over time, the modern theory of business cycles is fundamentally linked to the theory of growth. Specifically, business cycles arise because the level of technology does not increase at exactly the same rate in each period, but rather displays cyclical patterns around a relatively fixed rate of growth. Business Cycles 169 5.1 Business Cycle Dates A group of economists at the NBER label the periods when the econ-omy is in “recession” and when the economy is in “expansion.” Basi-cally, and this is not quite a rule, the NBER economists label the economy as being in a recession when the growth rate of real GDP is negative for two consecutive quarters. In other words, a recession is associated with a decrease in the level of real output. The economy is expanding otherwise. On the NBER’s main business cycle page, www.nber.org/cycles/ cyclesmain.html, a list of contraction and expansion dates for the US economy is presented. The quarterly reference dates starting in 1945, along with duration data (in months) are listed in Table 5.1 . Figure 5.1 graphs the quarterly change in the natural log of real GDP over the 1949:1–2007:4 period. The shaded gray areas in this graph indicate the NBER recession dates that are listed in Table 5.1 . Note that the change in the natural log of real GDP is approximately equal to the growth rate of real GDP: Defining y t as real GDP in period t , 1 then ln ( y t ) − ln ( y t − 1 ) = ln y t y t − 1 = ln 1 + y t − y t − 1 y t − 1 ≈ y t − y t − 1 y t − 1 . 5.2 Trends and Cycles Although the NBER labels are helpful, macroeconomists have also developed formal procedures for defining business cycles and study-ing the cyclical properties of major macroeconomic variables. 1 See the appendix for a review.

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  Demystifying Global Macroeconomics

  • John E. Marthinsen(Author)
  • 2020(Publication Date)
  • De Gruyter

    (Publisher)

  There was one downturn in economic activity (from January to July 1947) during which real GDP fell for two con-secutive quarters without triggering an official recession. To understand who officially dates U.S. recessions, see “ Who Measures U.S. Business Cycles? ” in The Rest of the Story section of this chapter. 410 Chapter 14 Business Cycles Real GDP is just one of several macroeconomic variables used to describe the level of and changes in real economic activity. The problem with real GDP is that it is reported only quarterly, and when it is, initial estimates are often inaccurate, due to incomplete information and revisions of submitted infor-mation. The differences between initial GDP estimates and the final reported statistics can be quite large. For these reasons, other economic variables are used, in combination, to measure and date business cycles. These comple-mentary variables provide a fuller reflection of real economic activity and are timelier, with initial estimates that are more accurate than real GDP (more about this later). What Causes Business Cycles? There is no single cause of a business cycle. The stimulus could come from the demand or supply side. Furthermore, random shocks that set a nation ’ s econ-omy into a tailspin or that ignite a recovery could be domestic-based or foreign-based, and they could originate in the real, financial, political, or social sectors. Examples of real sector stimuli are natural disasters, drastic increases in the prices of essential resources (e.g., oil), and the worsening of business and con-sumer expectations. On the financial side, a downward spiral could be set off by the collapse of a banking system, a burst housing bubble, speculative inter-national capital flows, or hyperinflation.

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  Macroeconomics for Managers

  • Michael K. Evans(Author)
  • 2008(Publication Date)
  • Wiley-Blackwell

    (Publisher)

  The latter two are not entirely absent in the recent eco- nomic environment, but because of lessons learned in the past, they are far less common, and generally far less important. In the post-WWII period, most of the business cycle fluctuations both in the US and other major industrialized countries can be explained by the first two factors. Until the recession of 2001, most analysis of recent business cycles focused on the confluence of higher inflation and higher interest rates shortly before the upper turning point. However, those factors did not occur in advance of the 2001 down- turn. Instead, the boom was largely driven by technological advances, which eventually resulted in overcapacity in high-tech industries, a decline in profit mar- gins, and a substantial cutback in capital spending. This theory, sometimes known as Real Business Cycle Theory, has its roots in the work of noted economists in the late nineteenth and early twentieth centuries. The discussion of the various causes of business cycles is followed by a brief summary of the global transmission of business cycles. The question of whether the Great Depression could happen again is considered next. The chapter ends with a summary of the various exogenous and endogenous factors that determine busi- ness cycles. While many cycles are indeed caused by exogenous shocks, business cycles will probably continue even if these shocks do not reoccur. 15.1 The long-term historical record The National Bureau of Economic Research (NBER) formally started measuring the business cycle in 1854. However, the US economy went through several cycles before then. The Cleveland Trust Company, once the leading bank in Ohio, con- structed an index of economic activity dating all the way back to the beginning of the Republic in 1789.

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  Economics for Investment Decision Makers

  Micro, Macro, and International Economics

  • Christopher D. Piros, Jerald E. Pinto(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  Chapter 6 Understanding Business Cycles 301 adjust prices to make markets clear, just like it would be costly for a restaurant to print new menus daily with updated prices. 9 Another explanation is that every time an economic shock hits a company, the company will need some time to reorganize its production. In recent years, a consensus concerning business cycles has gradually started building in macroeconomics. It is too early to say that economists agree on all causes of and remedies for business fluctuations, but at least an analytical framework has emerged that encompasses both new classical and neo-Keynesian approaches. Woodford (2009), among others, shows that new research seems to be leading to a unified approach. The debate about business cycles often receives a politically partisan treatment in the press because some people are generally against government intervention in the economy (for 9 Clearly, both this example and the “menu costs” name were initially envisioned before personal computers and laser printers became affordable and widely used. Still, one can imagine the cost for a store owner to replace the price tags on every item in the store on a daily basis, and also how this would confuse shoppers. EXAMPLE 6-7 Real Business Cycle Models 1. The main difference between new classical (RBC) and neo-Keynesian models is that the new classical models: A. are monetarist. B. use utility-maximizing agents, whereas neo-Keynesian models do not. C. assume that prices adjust quickly to changes in supply and demand, whereas neo-Keynesians assume that prices adjust slowly. 2. Basic RBC models focus on the choices of a typical individual, who can choose between consuming more (thus giving up leisure) and enjoying leisure more (thus giving up consumption). What causes persistent unemployment in this model? A. Contractionary monetary policy causes a shock to real variables. B. The economy returns to equilibrium promptly; thus persistent unemployment does not exist.

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  The National Economy

  • Bradley A. Hansen(Author)
  • 2006(Publication Date)
  • Greenwood

    (Publisher)

  Changes in demand can knock the economy away from potential output, but the economy tends to move back toward potential output and the natural rate of unemployment as wages and prices adjust to the changes in demand. This is the basic outline of the economics of business cycles. The basic outline of the economics of business cycles leaves us with a couple of important details to complete. First, we have not discussed the causes of changes in aggregate demand. Second, we have not discussed the details of the adjustment process. Specifically, how long does it take for the economy to move back to potential output? The story becomes more complicated at this point because economists do not all agree on the answers to these questions. There are, in fact, many different theories about how the economy as a whole, the macro-economy, functions. For example, there is the Real Business Cycle Theory, the Rational Expectations theory, the New Keynesian theory, the Post-Keynesian theory, the Classical theory, the New Classical theory, and the Monetarist theory. Fortunately, these many the- ories can generally be grouped into two broad categories: the Classical view and the Keynesian view. THE CLASSICAL VIEW OF BUSINESS CYCLES The essence of the Classical view is that market economies are pretty stable. If demand decreases in one sector of the economy, another sector of the economy compensates. Downturns in the business cycle are often characterized by layoffs, hitting managers as well as front-line employees. Corbis. 70 The National Economy A decision by households to consume less does not decrease the total amount of demand because if people consume less, then they have more to save. If they are saving more, that means they have more to lend. More lending means lower interest rates. Lower interest rates mean more busi- nesses are able to invest in new capital. The increase in investment makes up for the original decrease in consumer demand.

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  Frontiers of Business Cycle Research

  • Thomas F. Cooley(Author)
  • 2020(Publication Date)
  • Princeton University Press

    (Publisher)

  Chapter 11 International Business Cycles: Theory and Evidence David K. Backus, Patrick J. Kehoe, and Finn E. Kydtand 1. Introduction In modern developed economies, goods and assets are traded across national borders, with the result that events in one country generally have economic reper-cussions in others. International business cycle research focuses on the economic connections among countries and on the impact these connections have on the transmission of aggregate fluctuations. In academic studies this focus is expressed in terms of the volatility and comovements of international time series data. Ex-amples include the volatility of fluctuations in the balance of trade, the correlation of the trade balance with output, the correlation of output and consumption across countries, and the volatility of prices of foreign and domestic goods. We consider international business cycles from the perspective of dynamic gen-eral equilibrium theory, an approach adopted in a large and growing number of studies in international macroeconomics. In closed-economy studies, models of this kind have been able to account for a large fraction of the variability of aggre-gate output and for the relative variability of investment and consumption. See, for example, Prescott's (1986) review. In public finance, similar models have been used to assess the impact of fiscal policy on aggregate output, employment, and saving. Auerbach and Kotlikoff (1987) are a prominent example. In international macroeconomics, this approach has been used to account for some of the notable features of international data: the time series correlation of saving and investment rates (Baxter and Crucini 1993; Cardia 1991; and Finn 1990), the countercyclical movements of the trade balance (Backus, Kehoe, and Kydland 1994; Glick and Rogoff 1992; and Mendoza 1991), and the relation between the trade balance and the terms of trade (Backus, Kehoe, and Kydland 1994; Macklem 1993; and Smith 1993).

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