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Real Business Cycle Theory

Real Business Cycle Theory

Ever wondered what really causes fluctuations in the economic performance of a country? Whenever we hear news about macroeconomic instability, the economists involved refer to business cycles and factors that cause business cycles. Real business cycle theory is one of the theories suggested by economists to explain the causes of macroeconomic instability. This theory suggests that economic instability is caused by "real" factors that affect aggregate supply. So, what are these real factors? And what does the real business cycle theory say? Read on, and let's find out!

Real Business Cycle Theory Definition

Among the modern views of the causes of macroeconomic instability is the real business cycle theory. By definition, the real business cycle theory is a theory that suggests that business cycles are a result of technological changes and the availability of resources, both of which influence productivity and cause changes in the long-run aggregate supply. Here, fluctuations in the economy are caused by technological changes and the availability of resources, which means that the real business cycle theory focuses on the supply side of the economy since technology and resources are used in production.

Real business cycle theory is a theory that suggests that business cycles are a result of technological changes and the availability of resources, both of which influence productivity and cause changes in the long-run aggregate supply.

Let's look at the example below to make things clearer.

Oil prices in the USA have increased rapidly. As a result, productivity decreases significantly for companies that operate heavy gasoline-fueled machinery. This decrease in productivity means that the economy experiences a decrease in its real output, which results in a decrease in the long-run aggregate supply of the USA.

Read our article on the Business Cycle to learn more.

Features of Real Business Cycle Theory

The defining feature of the real business cycle theory is that it focuses on the impact technological changes and resource availability have on aggregate supply. This is illustrated in Figure 1, which is based on a reduction in resource availability and shows a shift in the long-run aggregate supply to the left.

Real business cycle theory A decline in long-run aggregate supply StudySmarterFig. 1 - A decline in long-run aggregate supply

As seen in Figure 1, a reduction in the availability of resources results in a leftward shift of the long-run aggregate supply (LRAS) curve from LRAS1 to LRAS2. Real output reduces from Q1 to Q2 as a result, and this reduces money demand and money supply, shifting the aggregate demand curve to the left from AD1 to AD2. In the end, we have a recession where the price level remains the same.

Assumptions of Real Business Cycle Theory

There are some assumptions that accompany the real business cycle theory. These assumptions are mainly in terms of the expected behavior of economic agents as the long-run aggregate supply changes with a significant change in technology or resource availability. So, let's see what happens in the case of a reduction in resource availability using Figure 2 as a visual reference.

Real business cycle theory A decline in long-run aggregate supply StudySmarterFig. 2 - A decline in long-run aggregate supply

As the LRAS curve shifts from LRAS1 to LRAS2, the economy experiences a reduction in output from Q1 to Q2. As this happens, people have fewer things to buy, and they require less money. Therefore, there is a reduction in the demand for money. The resulting reduction in business activity means that businesses will borrow less from banks, and this reduces the money supply since banks will be giving fewer loans. The reduction in the money supply means that people have less money to buy things, and this reduces aggregate demand, as shown by the leftward shift from AD1 to AD2. As shown, the real output ends up declining while the price level remains unchanged.

So, what about an increase in long-run aggregate supply? Let's say newer, better technology emerges. Well, it is expected that output will increase, which means that people will demand more money, the businesses will borrow more from the banks, so they can produce more, and this will increase the money supply. The increase will cause aggregate demand to increase, increasing real output without changing the price level.

All in all, the real business cycle theory argues that macroeconomic instability emerges from changes in aggregate supply rather than from changes in aggregate demand.

Policy Implications of Real Business Cycle Theory

The real business cycle theory has two main macroeconomic policy implications. These macroeconomic policy implications include policy ineffectiveness and the need for fixed rules. Let's look at these in turn!

For policy ineffectiveness, the main argument is that systematic monetary and fiscal policies will be ineffective in reducing unemployment. This is because these policies would be predictable, which would prevent them from having the desired effect. Let's explain with an example.

Let's say with elections approaching, the government deliberately reduces taxes to influence the voting decisions of the people. This should result in a change in the economic behavior of the people; for example, an increase in demand. However, after several years of pulling the same trick, people may realize the trend and not act as expected. If demand does not increase as a result of a tax cut, then aggregate demand does not increase, and the policy does not have the desired effect.

Now, let's look at the need for fixed rules. The real business cycle theory, as one of the modern views of macroeconomic instability, supports the idea that economic policy has predictable and unpredictable (discretionary) parts.

The predictable parts are considered the "rule," and the real business cycle theory works based on these fixed rules. The theory suggests that both the policymakers and the private sector make the same economic predictions, and policymakers (the government) have no room to make unpredictable changes to remedy the consequences of business cycle fluctuations.

Let's explain using an example.

Let's say resource unavailability emerges in the economy, which means aggregate supply is about to decrease. This means that, ultimately, unemployment will rise with it. As the policymakers make this observation, the private sector would have also made the same observations, and buyers and sellers would have already adjusted themselves to reach a new efficient market equilibrium.

Therefore, it is essentially impossible for the government to do something to improve the economic instability that the private sector can predict. However, it is possible for policymakers to do something unpredictable to make matters worse by distorting the behavior of the economic agents and causing inefficiencies. Therefore, predictable macroeconomic policies are preferred under the real business cycle theory.

Real business Cycle tTheory Criticisms

The real business cycle theory is only one of the views concerning the causes of economic instability. There are other views that argue differently and, in effect, are criticisms of the real business cycle theory. These other views are the mainstream view, the monetarist view, and the view of coordination failures. Let's briefly explain each one, so we can see how they differ from the real business cycle theory.

First, let's explain the mainstream view. The mainstream view is the most popular view, as the majority of economists hold this view. According to the mainstream view, economic instability emerges as a result of price stickiness and unexpected fluctuations in either aggregate demand or aggregate supply.

Learn more on price stickiness in our article - Sticky Prices!

The mainstream view of macroeconomic instability is the view that macroeconomic instability is caused by price stickiness and unexpected fluctuations in either aggregate demand or aggregate supply.

For changes in aggregate demand to cause macroeconomic instability, mainstream view economists look at the components of aggregate expenditure, which are after-tax consumption, gross investment, net exports, and government spending.

Read our article on the Aggregate Expenditures Model to learn more!

If any of the components of aggregate expenditure, for example, investment spending, increases or decreases, aggregate demand will increase or decrease accordingly. As a result, the real equilibrium output and the price level will change.

For changes in aggregate supply to cause macroeconomic instability, mainstream view economists consider external shocks such as wars or pandemics that can cause input scarcity and increase the cost of production. As a result, aggregate supply decreases, and this leads to cost-push inflation.

Read our article on the Types of Inflation to learn more!

Now, let's look at the monetarists' view of macroeconomic instability. Here, the proponents of this view argue that inappropriate monetary policy is the primary cause of macroeconomic instability.

The monetarist view of macroeconomic instability is the view that macroeconomic instability is primarily a result of inappropriate monetary policy.

Here, an increase or decrease in money supply causes an increase or decrease in aggregate demand. If the economy is at full employment, an increase in aggregate demand will result in an increase in the price level. Firms will momentarily increase real output since an increase in price is accompanied by an increase in supply. The unemployment rate will reduce below the natural unemployment rate until real wages increase to match the increase in prices. This increase in real wages will restore the economy back to full employment as real output is restored to the level of full employment. The inappropriate monetary policy, in this case, an increase in money supply, results in inflation and destabilizes both employment and real output.

Finally, the view of coordination failures is based on the inability of firms and households to agree on spending decisions. Let's explain this one with an example.

  • The coordination failures view of macroeconomic instability is based on the inability of firms and households to agree on spending decisions that will restore the economy back to full employment.

Let's say that firms and consumers in the USA expect a reduction in the investment and consumption spending of other firms and consumers. Since such a reduction hints at a reduction in aggregate demand, firms will reduce their investment spending, whereas consumers will reduce their consumption spending. This is because firms must be careful not to overproduce, and consumers must be careful not to spend too much since firms will not be employing them as much (firms employ less as they produce less). This will result in a reduction in the USA's aggregate demand. The situation results in an aggregate demand that is below the full employment aggregate demand.

In the situation described above, both firms and consumers could increase their investment spending and consumption spending at the same time to remedy the aggregate demand deficiency, which has fallen below the full-employment level. This would be ideal for both firms and consumers. However, since there is no real way for firms and consumers to agree to such an increase, the situation creates a coordination failure, where the economy remains outside full-employment equilibrium.

Real Business Cycle Theory - Key takeaways

  • Real business cycle theory is a theory that suggests that business cycles are a result of technological changes and the availability of resources, both of which influence productivity and cause changes in the long-run aggregate supply.
  • Policy ineffectiveness, as an implication of the real business cycle theory, argues that systematic monetary and fiscal policies will be ineffective in reducing unemployment.Also, it argues that discretionary monetary and fiscal policy cannot correct macroeconomic instability; hence, predictable policies are ideal.
  • The mainstream view of macroeconomic instability is the view that macroeconomic instability is caused by price stickiness and unexpected fluctuations in either aggregate demand or aggregate supply.
  • The monetarist view of macroeconomic instability is the view that macroeconomic instability is primarily a result of inappropriate monetary policy.
  • The coordination failures view of macroeconomic instability is based on the inability of firms and households to agree on spending decisions that will restore the economy to full employment.

Frequently Asked Questions about Real Business Cycle Theory

Real business cycle theory is a theory that suggests that business cycles are a result of technological changes and the availability of resources, both of which influence productivity and cause changes in long-run aggregate supply.

The defining feature of the real business cycle theory is that it focuses on the impact technological changes and resource availability have on aggregate supply.

The real business cycle theory argues that macroeconomic instability emerges from shocks to the economy's aggregate supply due to changes in technology and resource availability.

The other views concerning the causes of macroeconomic instability are the mainstream view, the monetarist view, and the view of coordination failures.

The real business cycle theory assumes significant changes in technology and resource availability which cause shocks to the long-run aggregate supply.

Final Real Business Cycle Theory Quiz

Question

What is the real business cycle theory?

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Answer

Real business cycle theory is a theory that suggests that business cycles are a result of technological changes and the availability of resources, both of which influence productivity and cause changes in long-run aggregate supply.

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Question

What is the mainstream view of macroeconomic instability?

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Answer

The mainstream view of macroeconomic instability is the view that macroeconomic instability is caused by price stickiness and unexpected fluctuations in either aggregate demand or aggregate supply.

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Question

What is the monetarist view of macroeconomic instability?

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Answer

The monetarist view of macroeconomic instability is the view that macroeconomic instability is primarily a result of inappropriate monetary policy.

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Question

The coordination failures view of macroeconomic instability is based on the ability of firms and households to agree on spending decisions that will restore the economy back to full employment.

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Answer

False

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Question

Changes in resource availability is one of the assumptions of the real business cycle theory.

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Answer

True

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Question

Long run aggregate supply increases when technology improves.

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Answer

True

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Question

Real output decreases when technology improves under the real business cycle theory.

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Answer

False

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Question

The real business cycle theory argues that macroeconomic instability emerges from changes in aggregate ____.

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Answer

Supply

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Question

The real business cycle theory argues that macroeconomic instability emerges from changes in aggregate supply, rather than ___.

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Answer

Aggregate demand

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Question

As a policy implication of the real business cycle theory, systematic macroeconomic policies may not be effective because they are ___.

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Answer

Predictable

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Question

Which of these is not a component of aggregate expenditure?

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Answer

Income Tax

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Question

For changes in aggregate demand to cause macroeconomic instability, mainstream view economists look at the components of ___.

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Answer

Aggregate expenditure

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Question

Under the monetarist view, ___ is the cause of macroeconomic instability.

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Answer

Inappropriate monetary policy

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