Real Business Cycle theory

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Real Business Cycle theory

• The Keynesians attribute business cycle
  fluctuations to what they regard as the
  fundamental instability of private
  spending--especially investment and consumer
  durable goods expenditure.
• The New Classical view holds that unanticipated
  changes in monetary growth are the primary cause
  of deviations from the natural rate of output
  and employment.
• Real Business Cycle theorists claim business
  cycles can be explained as an optimizing response
  of economic agents to random productivity shocks.

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This is a tough model to explain to
non-economists
Optimizing agents

• Households
• Maximize consumption and leisure subject to
  constraints.
• Constraints include the number of hours in a day
  and the resource prices (such as the wage).

• Firms
• Maximize profits subject to constraints
• Constraints include prices of outputs and inputs,
  and productivity.

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Constrained optimization problem for an
infinitely-lived representative
consumer-producer.
Charles Plosser. Understanding Real Business
Cycles, Journal of Economic Perspectives, Summer
1989, pp. 51-73.
If ?t increases, thatmeans you can getmore
output fromthe same stockof capital and work
effort
WhereL is the LaGrangean functionCt is
consumption in period tNt is work in period t1-
Nt is leisure in period tKt is the capital stock
in period t? is the depreciation rate per
period?t is a shift factor that alters total
factor productivity in period t. ? is the time
preference parameter, where 0lt ? lt 1 and?t is
the LaGrangean multiplier in time t.
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When productivity rises,the opportunity cost of
leisure (measured in forgoneoutput) rises,
which induces therepresentative agent to
substitute work for leisure.Hence the random
productivity shock brings aboutan expansion of
real output.
The intertemporal substitution of work for
leisure (and vice versa) in reaction to
technology shocks is the principal force
underlying business cycle expansions and
contractions
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The problem for Plosser, Finn Kydland, and other
Real Business Cycle theorists is to provide
plausible estimates of ?t or total factor
productivity.
The methods used to perform theseestimates have
been widely criticized
Annual productivity growth
6
4
2
Percentage rate of change
0
-2
-4
-6
1955
1965
1970
1975
1960
1980
1985
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Policy implications of Real Business Cycle theory

• Some economists take the theory to mean that
  countercyclical aggregate demand management is
  doomed to ineffectiveness--since, after all, they
  claim that 70 percent of the deviation of real
  output from trend in the postwar era is explained
  by productivity shifts.
• Technological change is a factor that policy
  makers cannot control.
• Chatterjee explains that the Central Bank (the
  FED in the U.S.) should nevertheless exercise
  its stabilizing function in financial markets.