Rational Expectations Equilibrium Approach

Real Business Cycle Theory

Real business cycle (RBC) theory argues that the business cycle is the natural and efficient response of the economy to changes in the available production technology. It distinguishes between nominal shocks (shocks to money supply or money demand) which only affect the LM curve and real shocks (shocks to the production function, real government spending, or to savings and consumption decisions) which affect only the IS or FE curves.

According to RBC theory, real shocks to the economy are the primary cause of business cycles. The theory focuses on shocks to the production function: supply shocks or productivity shocks.

Productivity shocks can be the result of

• • the development of new products or production methods

  • changes in the quality of labor or capital

  • changes in the availability of raw materials

  • unusually good or bad weather

  • changes in government regulations affecting production

Economic booms result from beneficial productivity shocks and recessions are caused by adverse productivity shocks

A beneficial productivity shock would cause an economic boom. Productivity would be temporarily high. So, there would be an increase in investment and work effort in the current period. The result would be an increase in real output and consumption spending. Once the shock wore off, people would consume more leisure.

Business Cycle Facts Explained by RBC Theory

• 1. employment is procyclical

  2. average labor productivity is procyclical

  3. real wage is procyclical

  4. investment is more volatile than consumption

Criticisms of RBC Theory

1. It is hard to identify the productivity shocks that have caused business cycle fluctuations.

2. To explain the large cyclical fluctuations in hours worked and the small cyclical fluctuations in the real wage observed in the real world, RBC theory needs a flatter aggregate labor supply curve than has been found by most studies.

3. RBC theory predicts that the price level will be countercyclical when it is, in fact, procyclical.

Fiscal Policy

Consider a increase in government spending which shifts up the IS curve. Workers know that this spending results in higher taxes in the future or the present. Either way, workers feel poorer so they consume less leisure and supply more labor. The FE curve also shifts to the right. The LM curve will adjust to restore equilibrium, and if the FE curve doesn't shift much, the price level rises. Fiscal policy can have real effects on the economy.

Monetary Policy

We've already seen that anticipated changes in the money supply are neutral, that is, they have no real effects on the economy. Unanticipated changes in the money supply can have real effects in the short run, but anticipated money is neutral in the long run.

The problem with claiming that money is neutral is that the money stock is a leading, procyclical variable. RBC theorists argue that the apparent relationship between money and output is one of reverse causation: anticipated changes in output lead to changes in the money supply in the same direction. But, historical research suggests that money is not neutral.