Real business cycle theory sheds light on the ups and downs of economies, focusing on how real-world changes trigger fluctuations. Unlike other theories that emphasize demand, the real business cycle perspective highlights how shifts in the supply side of the economy can cause periods of expansion and contraction. Let’s delve deeper into the core principles of real business cycle theory, exploring its explanations for economic booms and busts, as well as the criticisms it faces.
Understanding real business cycle theory
A 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 to be 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.
Understanding 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 theory vs. Keynesian economics
Real business cycle theory offers a unique perspective on economic fluctuations. Unlike Keynesian economics, which focuses on changes in overall spending (aggregate demand), RBC theory argues that shifts in the actual productive capacity of the economy (aggregate supply) are the primary cause of business cycles.
Imagine the economy as a giant production line. Real business cycle theory suggests that disruptions to this line, caused by factors like technological advancements or resource price changes, trigger economic booms and busts.
Meanwhile, Keynesian economics emphasizes the role of aggregate demand, which is the total amount of goods and services consumers, businesses, and governments purchase. According to Keynesians, fluctuations in aggregate demand can cause economic booms and busts. For example, a sudden drop in consumer spending could lead to a recession.
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. This assumption is crucial because it allows RBC theory to focus on changes in production capacity, without the added complication of unemployment affecting economic output.
Third is the limited role of money. Real business cycle theory downplays the influence of money on economic activity. It suggests that changes in the money supply have little impact on real factors like production and employment. In simpler terms, RBC theory argues that printing more money won’t magically increase the number of workers or factories in the economy.
Causes of business cycles in real business cycle theory
Real business cycle theory pinpoints changes in the real economy, not just consumer spending, as the driving force behind economic ups and downs. These changes, called real shocks, disrupt the economy’s production capacity and trigger business cycles.
Imagine a massive technological breakthrough in manufacturing that allows factories to produce more goods with less labor. According to RBC theory, this would be a real shock. New inventions and efficiency gains can significantly boost the economy’s productive capacity. This increase in potential output shifts the long-run aggregate supply curve to the right, leading to economic expansion.
Short-run vs. Long-run effects
Real business cycle theory acknowledges that the economy doesn’t magically jump to a new level of production following a real shock. There’s an adjustment period:
- Short-run effects: In the short run, businesses might not be able to adopt new technologies or adjust to price changes immediately. This can lead to temporary fluctuations in output and employment, like a slight economic slowdown after an oil price hike.
- Long-run equilibrium: Over time, however, the economy adapts to the real shock. Businesses invest in new technologies, and workers acquire new skills. This eventually leads to a new long-run equilibrium with a higher or lower level of production, depending on the nature of the shock.
Criticisms of real business cycle theory
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.
Unrealistic assumptions
Real business cycle theory rests on a set of core assumptions that shape its explanations for economic fluctuations. While these assumptions provide a clear framework, let’s delve deeper to see if they hold up entirely in the real world. We’ll examine the critiques surrounding two key assumptions: full employment and the limited role of money in influencing economic activity.
Full-employment fantasy
Real business cycle theory believes that unemployment is a short-run phenomenon. It views the market as fully competitive and operating at 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. If they lower their wage reservation, they can find an employer 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 concerns wage flexibility. Wages do not necessarily decrease or increase with the labor market’s demand and supply.
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 were first recruited.
Fiscal and money on the sidelines
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 as not necessary to 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 cause. As a consequence, demand-side (fiscal and monetary) policies are ineffective.
Of course, when applied in the real world, such an explanation is incomplete. The business cycle can also occur 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.
Limited explanatory power
Real business cycle theory faces criticism for potentially offering an incomplete picture of business cycles. While it effectively highlights the impact of real shocks on production capacity, some economists argue it underestimates the influence of fluctuations in aggregate demand.
Imagine a domino effect. A real shock, like a technological breakthrough, might be the initial push. However, RBC theory might not fully capture the subsequent dominoes that can trigger a recession. Here’s how:
- Demand-side shocks: A sudden drop in consumer confidence due to a financial crisis, for instance, wouldn’t be considered a real shock in RBC theory. Yet, it could significantly impact aggregate demand, leading businesses to cut back on production and hire fewer workers, ultimately causing a recession.
- Psychological factors: Consumer sentiment and business confidence can play a significant role in economic activity. RBC theory, with its focus on rational actors making optimal decisions, might not fully account for these psychological factors that can influence spending and investment decisions.
- Government intervention: Fiscal policy (government spending and taxation) and monetary policy (interest rates and money supply) can influence aggregate demand. RBC theory downplays the role of these policies, but critics argue that governments can use them to mitigate the negative effects of business cycles, even if they don’t directly address real shocks.
In essence, while real shocks are undoubtedly a key driver of business cycles, RBC theory might not capture the full complexity of these economic fluctuations. Other factors, like changes in aggregate demand and psychological factors, can also play a significant role.
