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 features of real business cycle theory? Read on, and find out the assumptions, policy implications and criticisms of this theory!

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 economy's supply side since technology and resources are used in production.

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

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.

Fig. 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.

Fig. 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.

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.

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 Theory 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.

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.

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.

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.

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.

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.