Real%20Business%20Cycle%20Theory

1
Real Business Cycle Theory

• Theory developed by Edward Prescott and Finn
  Kydland (Nobel laureates 2004)

2
Real Business Cycle Theory

• This theory argues that productivity shocks to
  the economy are the primary cause of business
  cycles.
• Productivity shocks propagate throughout the
  economy and affect the production function,
  employment, investment, as well as the spending
  and saving decisions of consumers.
• They are also referred to as real shocks or
  supply shocks.

3
Deviations from trend in TFP

• TFP may slowdown when no significant discoveries
  that affect production take place.
• Measured TFP can also slowdown as a result of bad
  weather, or other exogenous events.
• Changes in TFP growth are recurrent, and not
  necessarily predictable. (TFP deviations from
  trend are well described by a Markov process with
  persistence.)

4
Is the theory consistent with the data?

• Qualitatively yes, but the RBC impulse (TFP
  changes) falls short of accounting for changes in
  GDP.

5
Propagation mechanism amplifies the impact of a
shock to TFP growth

• Two immediate effects follow from a change in
  productivity
• Investment demand changes (which affects
  interest rates, capital accumulation, and
  ultimately GDP).
• Capital utilization may also be affected
  (although capital utilization is also affected by
  other factors like energy price changes)
• The demand for labor labor force utilization-
  changes (which affects wages, hours worked, and
  ultimately GDP).

6
Propagation mechanism Impact on GDP larger than
original TFP shock

• Capital and labor markets in a real business
  cycle recession.

7
Real Business Cycle Theory

• A decrease in productivity lowers firms profit
  expectations and decreases both investment demand
  and the demand for labor.

8
Real Business Cycle Theory

• The interest rate falls.

9
Real Business Cycle Theory

• The lower the real interest rate lowers the
  return from current work so the supply of labor
  decreases.

10
Real Business Cycle Theory

• Employment falls by a large amount and the real
  wage rate falls by a small amount.

11
Summary of RBC theory

• Shocks to productivity growth are the main force
  driving business cycle fluctuations (accounting
  for 2/3 of the total volatility).
• Expansions and recessions are not necessarily
  caused by market failures.
• Policy implications The role of the government
  is to provide an environment that promotes TFP
  growth. Direct government interventions to smooth
  the cycle may be counter productive.