Real Business Cycle Theory - Literature review Example

Compare and Contrast Real Business Cycle theory with Theories of the Business Cycle which assume that Demand Shocks cause the Cycle Introduction This discussion is based on the analysis of the real business cycle models and distinguishes between traditional models of business cycles and theories and more contemporary Real Business Cycle theories and the changes affected by Prescott and Kydland who showed how demand shock models would gave way to the real business cycle models. An explanation and description is provided for the real business cycle model and this is then compared with the demand shocks model and the contrasting approaches of these two models are then put forward. The demand shocks model show how the markets change in accordance with demands of services and how business cycles could be interpreted in terms of consumer demands. This is completely different form the supply shocks model in which technological or supply shocks would be the major driving force of the cycle. Real business cycle show growth in economic activity and Real Business cycle helps in explaining economic boom time as also recessions. This discussion draws out a comparison between Real Business Cycle theory and Theories of Business Cycle which highlights that demand shocks cause the cycle. The various aspects of the economy such as effects of wage hikes, productivity, and employment resources are also discussed in terms of business cycle models. Real Business Cycle Theory and Demand Shocks Cycle Real Business Cycle theory explored by Muth (1961) and Lucas and business cycles were studied with the assumption that they were driven by technological rather than monetary shocks and changes in expectations. In real business cycle model, shocks in government purchases are also taken into consideration. Real Business Cycle Theory or RBC holds that the business cycle is caused by random fluctuations in productivity and recessions and periods of growth are seen as responses of output. The RBC theorists argue that the level of national output indicates that the government should not intervene through fiscal or monetary policy that could either minimize effects of recession or that of a rapidly growing economy. Business cycles, according to Real Business Cycle theory are considered as real and reflect the most efficient operation of the economy. This is different from Keynesian economics and Monetarism which consider recessions as the failure of some markets to clear. Some examples of the business cycles would be graphical representation on how advanced economies exhibit sustained growth over time and also depict higher levels of economic activity. There may even be random fluctuation in the growth trend and this would show how the latter economic activity could predict the earlier ones. The time series of an economy's output and gross national product or GNP indicating value of goods and services produced by a country would be useful for determining economic behavior. The first part of the discussion is about defining Real Business Cycle theory. Recessions are seen as a condition of market failure by mainstream macroeconomists. There is lack of demand, of workers and income and there is an adjustment of output but not the prices. The economy in certain cases is driven away from equilibrium and the output adjusts although if markets are in equilibrium, how are fluctuations in business activity explained' When people's marginal productivity drops, the real wage also drops and shifts work decisions. The real business cycle shows that a certain cyclical pattern of economic activity could hold over a longer period and when there is a technological shock that raises real wage, people work more and output increases and when technological shock lowers real wage, people tend to withdraw from work and output falls. Economic booms and recessions are explained with Real Business Cycle models although many economists do not endorse the real business cycle theory as technological shocks may not even be observable. The mathematical models are however seen as adequate representation of patterns in the real world. Real business cycle models are characterized by neglect of demand shocks and highlight technological productivity shocks that are the primary source of economic fluctuations. The strong assumptions of supply driven dynamics and demand determined influences are considered as in accordance with real business cycle theory. According to Entorf (1992), 'the backward propagation mechanism of demand shocks dominates the forward propagation of supply disturbances'. In certain cases, business cycles are hit by productivity shocks that in turn affect consumer expectations and this has all the features of an aggregate demand shock that increases output, employment and inflation. Productivity shock tends to have a temporary negative effect on inflation and employment (Lorenzoni, 2006). A demand shock is captured by a shift in consumer expectations and a disruption in market equilibrium or market adjustment that leads to a demand detriment and shifts in the demand curve. A demand shock can represent demand increase or demand decrease and an increase in demand is seen as a shift of the demand curve resulting in either increase or decrease of equilibrium quantity and price. According to Lorenzoni (2006), demand shocks can be related to changes in public sector expectations and productivity shocks can be associated with aggregate supply shocks. In certain traditional Keynesian description and business cycle theories and models, the demand shocks or sudden growth in demand of products and services actually drive growth and business cycle and bring about changes in the market ad economy. For the real business cycle model which is seen as different and quite opposed to the demand shock cycle, the focus is on supply rather than demand and real business cycle highlights the fact that shocks or economic variations are driven by technological changes and technological or supply shocks in which there are rapid fluctuations of supply driven by changes in technology. Economic theories tend to deal with economic fluctuation rather than business cycle and economic fluctuations could be modeled in terms of aggregate demand although in real business cycle models the fluctuation considered are technology shocks rather than demand shocks. An economic cycle could be explained or triggered with the aid of a demand shock which provides an explanation on how an increase in demand of products and services by consumers would actually drive the market and economy and as against how the supply shocks or technology shocks on the other hand can bring about changes in the economy through the real business cycle model. Jerger and Michaelis (2003) suggest that wage hikes affect production costs and are considered as supply shocks although demand effects of wage variations are controversial. Wage variations tend to affect aggregate demand and also affect aggregate employment and demand effects are particularly strong in certain cases. Lin and Duan (2007) define the business cycle of a commodity using the concepts of demand supply shocks and showed that the convenience yield for crude oil tend to exhibit seasonal behavior. Convenience yields tend to explain price issues although in this particular study, oil prices are considered as highly volatile. When good markets clear and individuals optimize in terms of work and there is a strict wage with rational expectations, there are heterogeneous preferences on resource endowments (Holmes and Hutton, 2005). Asymmetric monetary policy, changing relationship between wage and employment can result in optimizing behavior using a wage setting, monopsonistic, price uncertainty, supply of employees and wage behavior. Disequilibrium at times occurs at the level of individual firm's labor market. Gomes (2006) discuss the routes to chaos in economic theory and identifies several models dealing with the interpretation of business cycle models. In business cycles and models, fluctuations are duet to deterministic reasons and imply that governments are able to change the qualitative nature of economic dynamics. Gomes (2006) presents a nonlinear dynamics of macroeconomics and shows the link between business cycle models and economic growth, asset pricing, and consumption decisions etc. Conditions for indeterminacy in RBC models highlight the fact that the economic mechanism for indeterminacy has to be explored (Wen, 2001). An alternative framework for understanding technical conditions would determine indeterminacy in RBC models and in deriving the conditions of indeterminacy the role of structural perturbations in preferences, technologies and market structures are also determined (Wen 2001). Prescott and Kydland (2004) worked on time consistency and business cycle models using optimal control theory in a rational expectations model and changed the concept of central banking and general macro economy considerably (Hartley, 2006). The demand shock cycle is the more traditional Keynesian model that shows how demand of products could actually affect the business cycle model and general economy. Most of the traditional business cycle theories were however also real and focused on agriculture and a decline in the real rate of return would cause entrepreneurs to contract economic activity. Monetary expansion and Keynesian focus on liquidity gave ay from real business cycle theories to more demand oriented models. For clear markets however, real theories of business cycle would be related to persistence and comovement and Kydland and Prescott emphasized on the relationship between production and an initial negative shock that cause lowered inputs and outputs over a longer period of time (Tabellini, 2005; Hartley, 2006). However the real approach to business cycles would show that wage and price issues play a role in all real business cycle theories. However the more popular theory in economics is the hybrid theory, which also focuses on real business cycles and involves monetary shocks, real shocks and adjustment mechanisms (Hartley, 2006). Conclusion: In conclusion the real business cycle model is a drastic change in how macroeconomics is studied and Kydland and Prescott could be given full credit for bringing about major change in the perspectives with which economic theories are considered. The changes from a demand shock model to a technological supply shock model shows a shift from an importance on demands placed by customers to an importance to technological changes, market forces and supply issues that define the real business models and show how they are different from traditional ones. Bibliography Bierens H.J.;'Swanson N.R. (2000) The econometric consequences of the ceteris paribus condition in economic theory - Suggestions on quantitative business cycle theory Journal of Econometrics, Volume 95,'Number 2, pp. 223-253(31) Entorf, Horst, (1992). Real Business Cycles: Is Neglecting Demand Shocks Justified' Empirical Economics, Springer, vol. 17(4), pages 463-84. Erturk, Korkut A. 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Ram (2007) Evaluating sustainability practices in terms of stakeholders' satisfaction International Journal of Business Governance and Ethics, Volume 3,'Number 1, pp. 56-76(21) Sieg, Gernot (2006) A MODEL OF AN OPPORTUNISTIC-PARTISAN POLITICAL BUSINESS CYCLE Scottish Journal of Political Economy, Volume 53,'Number 2, pp. 242-252(11) Tabellini, Guido (2005) Finn Kydland and Edward Prescott's Contribution to the Theory of Macroeconomic Policy Scandinavian Journal of Economics, Volume 107,'Number 2, June pp. 203-216(14) Wen Y. (2001) Understanding self-fulfilling rational expectations equilibria in real business cycle models Journal of Economic Dynamics and Control, Volume 25,'Number 8, pp. 1221-1240(20) Read More