Real Business Cycle Theory

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Introduction to Real Business Cycle Theory

Real business cycle theory (RBC theory) is a class of macroeconomics models and theories that were first explored by American economist John Muth in 1961. The theory has since been more closely associated with another American economist, Robert Lucas, Jr., who has been characterized as “the most influential macroeconomist in the last quarter of the twentieth century.”  

Intro to Economic Business Cycles

Before understanding real business cycle theory, one must understand the basic concept of business cycles. A business cycle is the periodic up and down movements in the economy, which are measured by fluctuations in real GDP and other macroeconomic variables. There are sequential phases of a business cycle that demonstrate rapid growth (known as expansions or booms) followed by periods of stagnation or decline (known as contractions or declines).

  1. Expansion (or Recovery when following a trough): categorized by an increase in economic activity
  2. Peak: The upper turning point of the business cycle when expansion turns to contraction
  3. Contraction: categorized by a decrease in economic activity
  4. Trough: The lower turning point of the business cycle when contraction leads to recovery and/or expansion

Real business cycle theory makes strong assumptions about the drivers of these business cycle phases.

Primary Assumption of Real Business Cycle Theory

The primary concept behind real business cycle theory is that one must study business cycles with the fundamental assumption that they are driven entirely by technology shocks rather than by monetary shocks or changes in expectations. That is to say that RBC theory largely accounts for business cycle fluctuations with real (rather than nominal) shocks, which are defined as unexpected or unpredictable events that affect the economy.

Technology shocks, in particular, are considered a result of some unanticipated technological development that impacts productivity. Shocks in government purchases are another kind of shock that can appear in a pure real business cycle (RBC Theory) model.

Real Business Cycle Theory and Shocks

In addition to attributing all business cycle phases to technological shocks, real business cycle theory considers business cycle fluctuations an efficient response to those exogenous changes or developments in the real economic environment.  Therefore, business cycles are “real” according to RBC theory in that they do not represent the failure of markets to clear or show an equal supply to demand ratio, but instead, reflect the most efficient economic operation given the structure of that economy. As a result, RBC theory rejects Keynesian economics, or the view that in the short run economic output is primarily influenced by aggregate demand, and monetarism, the school of thought that emphasizes the role of government in controlling the amount of money in circulation. Despite their rejection of RBC theory, both of these schools of economic thought currently represent the foundation of mainstream macroeconomic policy.

Other Resources for Real Business Cycle Theory

Terms related to Real Business Cycle Theory:

  • Business Cycle Frequency
  • New Economy
  • Unemployment

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