Real business cycle theory (RBC theory)

Real business cycle theory (RBC theory)

L

- A variant of New Classical macro

- Aims to show how macroeconomic fluctuations can arise in neoclassical general equilibrium

- Business cycle is an optimal response to shocks

- No role for government policy

L – Key idea

- The economy does not move rapidly back to equilibrium, as in classical economics

- Macroeconomics aggregates display autocorrelation

- This can be explained by auto-correlated shocks

o Technology

o Preferences for leisure

o Terms of trade.

W

RBC theory is a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real (in contrast to nominal) shocks. Unlike other leading theories of business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility, and government should therefore concentrate on the long run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations.

According to RBC theory, business cycles are therefore “real” in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy. RBC theory differs in this way from other theories of the business cycle such as Keynesian economics and Monetarism that see recessions as the failure of some market to clear.

RBC theory is associated with freshwater economics (the Chicago school of economics in the neoclassical tradition). It is rejected and harshly criticized by other schools within mainstream economics, notably Keynesians.