Real Business Cycle Theory
Real business cycle theory explains aggregate fluctuations as the efficient response of the economy to real shocks, particularly shocks to technology. It applies the methods of general equilibrium analysis and rational expectations to the study of the business cycle, and it contrasts with theories that attribute fluctuations to monetary disturbances or demand shocks.
Core Model
The core model features a representative household that maximises expected utility over consumption and leisure, subject to a budget constraint, and a representative firm that produces output using capital and labour with a technology subject to random shocks. The economy is assumed to be competitive and to clear continuously.
Fluctuations in this model arise from shocks to technology, which change the productivity of inputs. A positive technology shock raises output and the returns to working and investing, leading households to work more and to invest. A negative shock has the opposite effects. The resulting co-movement of output, consumption, investment, and hours worked resembles the patterns observed over the business cycle.
Properties and Predictions
The model predicts that technology shocks generate fluctuations in output and employment, with the magnitudes depending on the parameters of preferences and technology. It implies that fluctuations are efficient responses to changes in the economic environment, and that there is no role for demand management.
The model's predictions have been compared with the data, with mixed results. The model can replicate some features of the cycle, including the procyclicality of productivity and the volatility of investment, but it has difficulty matching the volatility of employment and the behaviour of real wages.
Criticisms
Criticisms of real business cycle theory include the plausibility of the technology shocks required to generate observed fluctuations, since measured productivity changes are often small and may reflect measurement error or factor utilisation rather than genuine technological change. The assumption of continuous market clearing is also questioned, given the evidence of unemployment and of the role of demand.
The model's treatment of labour supply has been criticised for failing to account for the observed behaviour of hours and employment. Extensions incorporate labour market frictions, indivisible labour, and other features, improving the match with the data while retaining the emphasis on real shocks and optimisation.
Legacy
Real business cycle theory has had a substantial influence on macroeconomics, particularly through its insistence on microfoundations, its use of dynamic optimisation, and its emphasis on the role of shocks. Modern dynamic stochastic general equilibrium models, used widely in policy analysis, incorporate many of its methods while also including nominal rigidities and other features that real business cycle models exclude.
The theory has thus contributed to the methodological transformation of macroeconomics, even where its substantive conclusions are not accepted. It also informs the analysis of the sources of fluctuations and of the appropriate role of stabilisation policy.
Calibration and Evaluation
Real business cycle models are typically calibrated rather than estimated, with parameters chosen to match long-run features of the data and the model simulated to examine its properties. The simulated moments are compared with the moments of the actual data, and the model is assessed by its ability to replicate key features of the cycle.
The methodology of calibration was a significant innovation, allowing the evaluation of models with complex dynamics that are difficult to estimate with conventional techniques. It has since been widely adopted in macroeconomics, including in the analysis of policy questions.
Extensions of the Framework
The basic model has been extended in many directions. Extensions incorporate indivisible labour, which improves the match with employment data; variable capital utilisation, which allows the model to generate larger fluctuations; and multiple sectors, which allows for differential responses to shocks.
Other extensions incorporate nominal rigidities, combining real and monetary elements in the analysis of fluctuations. These models, sometimes called New Keynesian, retain the dynamic optimisation and rational expectations of the real business cycle approach while allowing for the frictions that give monetary policy real effects.
Policy Analysis
Real business cycle theory has been used to analyse a range of policy questions, including the effects of tax changes, of government spending, and of structural reforms. The analysis emphasises the response of households and firms to changes in incentives and the resulting effects on economic activity.
The approach implies that policy should focus on the determinants of long-run performance, including the efficiency of the tax system, the quality of institutions, and the incentives for innovation and investment. It has contributed to the analysis of the effects of fiscal policy on labour supply and investment, and to the assessment of the costs of taxation.
Criticisms and the Broader Debate
Criticisms of real business cycle theory centre on the assumptions of market clearing and on the nature of the shocks required to generate fluctuations. The theory has also been criticised for neglecting the role of demand, of financial factors, and of the distribution of income in shaping economic outcomes.
The broader debate between real business cycle and New Keynesian approaches has shaped modern macroeconomics. The synthesis that has emerged combines elements of both, incorporating real shocks and market clearing in the long run with nominal rigidities and demand effects in the short run. This synthesis informs the models used for policy analysis by central banks and international institutions.