What’s it: Real business cycle is the economy’s fluctuation due to shocks from real factors instead of aggregate demand shocks. The new classical economists proposed this model and considered fluctuations in the aggregate supply as the cause of business cycles.
A fall in input prices or technical progress raises aggregate supply and shifts the curve to the right. Conversely, an increase in input prices lowers aggregate supply and shifts the curve to the left.
The new classical economists discouraged government intervention from influencing the economy through aggregate demand. For example, to drive technical progress, they suggest supply-side reforms, which help the economy be more efficient and flexible.
What is a business cycle
Before discussing any further, let us review the concept of the business cycle or economic cycle. Economists define it as the rising and falling phases of aggregate economic activity. It is divided into four periods:
Expansion is the period when economic activity increases. During this phase, real GDP and capacity utilization increase. Producers increase output and create more jobs. Thus, the unemployment rate decreases, and the income prospects improve. At the same time, inflation tends to increase due to high demand. Growth continues until it reaches a peak, a turning point before the cycle turns into contraction.
When the economy starts to decline, we call it the contraction phase. The trough is the lowest point of the business cycle before it recovers and moves towards expansion.
During the economic contraction phase, we will see a decrease in real GDP. Businesses cut production, resulting in reduced capacity utilization in the economy. They seek to streamline operations and reduce labor. As a result, the unemployment rate rises, and the outlook for household income deteriorates. Household demand weakens so that inflation also tends to fall.
The four phases take place repeatedly, with the duration of each phase varying. Also, the cycle does not only apply to certain sectors, but all sectors of the economy undergo business cycle stages at almost the same time.
Real business cycle assumptions
Real business cycle theory uses several important assumptions.
First, economic agents always act rationally. Individuals or households will maximize utility when buying goods and services. Likewise, businesses will maximize profits when producing goods and services. Households and businesses behave alike, subject to the resource and technological limitations they face.
Second, the new classical economists argue the economy is at full employment. Prices and wages are fully flexible and function in a competitive market. Economic fluctuations reflect the most efficient response to real shocks by economic agents.
Third, the model excludes money roles. Monetary variables, such as inflation, have no effect on economic output and unemployment.
Causes of real business cycles
Real business cycle represents an efficient response to external shocks. The shocks come from factors such as changes in technology and the relative prices of inputs.
For example, technology leads to technical advances and productivity in the economy for capital and labor. It increases potential GDP and shifts the long-run aggregate supply curve to the right.
The economy needs some time to adjust. Short-run aggregate supply will not immediately jump to a new equilibrium. Not all companies can adopt these new technologies simultaneously.
Critiques of the real business cycle
The real business cycle model provides another perspective on the business cycle. However, some of the arguments are unrealistic, such as wages, labor market, and government intervention.
Also, this model ignores the role of money in influencing economic activity. In fact, money plays a significant role, especially in capitalist economies. Changes in the money supply have a strong effect on economic output, as explained by the quantity theory of money.
View of the unemployment phenomenon
Real business cycle theory believes that unemployment is a short-run phenomenon. It views the market as working with full competitiveness and operating at the perfect competition. Households are fully informed about the labor market, including the equilibrium for labor wages, demand, and supply.
As a result, the labor market is highly flexible. Wages easily fall or rise to match supply and demand.
Individuals are unemployed only if they demand higher wages than the equilibrium wage. Then, if they lower their wage reservation, they can find an employer who is willing to employ them.
For critics, such views are unrealistic in the real world. For example, during a recession, people may remain unemployed as employment shrinks. They cannot find work even when they are looking for work and lower the wage reservation.
Another criticism is about wage flexibility. Wages do not necessarily decrease or increase following the demand and supply of the labor market.
In the real world, increasing wages may be easier than decreasing wages. Take a case during a recession. Even though the labor market faces an excess supply, businesses cannot reduce wages. They were bound by work contracts with employees when they first recruited.
Views on the role of government
Long story short, real business cycle theory rejects the ideas of Keynesianism and Monetarism. The new classical economists argue that fiscal policy or monetary policy does not contribute to influencing the economy. Both policies work through aggregate demand. Meanwhile, the source of the problem in the real business cycle is aggregate supply.
Thus, they view the government should not interfere in the economy. The economy will automatically reach a new equilibrium. For example, in technical progress, a new equilibrium will be reached when all firms can adopt new technology. This process often takes longer than the cycle described by Keynesianism.
Thus, the real business cycle model emphasizes the role of aggregate supply as a cycle causes. As a consequence, demand-side (fiscal and monetary) policies are ineffective.
And of course, when applied in the real world, such an explanation is incomplete. The business cycle can also take place due to aggregate demand shocks. The US Great Depression, for example, occurred because of a crisis in aggregate demand. Thus, Keynes’s view was more potent in this case.