Real Business Cycle Theory - Term Paper Example

Compare and Contrast Real Business Cycle Theory with Theories of he Business Cycle which Assume that Demand Shocks cause the Cycle Table of Contents I. Introduction ……………………………………………………………… 3 II. Abstract ………………………………………………………………….. 4 III. Sources of Demand Shocks in UK Market ……………………………… 5 IV. Point of Equilibrium in Real Business Cycle, New Classical & Supply-side Theory ……………………………………………………… 7 V. Fiscal Policy in Keynesian Theory and Other Business Cycle Theory …. 9 VI. Factors that Triggers Employment Opportunity Using the Business Cycle Theories ………………………………………………… 11 VII. Conclusion ………………………………………………………………. 15 References ……………………………………………………………………….. 16 Introduction Macroeconomic study focuses particularly on the external factors that affect the economic variables such as the Gross Domestic Product (GDP), unemployment rate, inflation rate, interest rate, the level of stock market, and exchange rate. (Waller, 2007) These variables are used in summarizing the macroeconomic performance of a country. Fiscal policy and monetary policy are few of the common strategies used by economists to influence the movement of the aggregate supply and aggregate demand of the macroeconomic variables. (Wood, 2006) Over the past decades, different ideas, perception and beliefs of macroeconomists have resulted to the development of different business cycle theories. Among the business cycle theories are the Keynesian Theory, Classical Theory, Monetarism Theory, the Aggregate supply-Side Theory, and the Real Business Cycle Theory. These theories are used by government officials and businessmen in analyzing the cause and consequences of a particular action on the movement of aggregate demand in a country’s economy. (Balls, 2003) Abstract The author aims to elaborate the differences between the Real Business Cycle (RBC) Theory versus the Keynesian Theory, Classical Theory, Monetarism Theory, the Aggregate supply-Side Theory by clearly stating the different political, environmental, and monetary interventions including the free-market forces as well as the individual beliefs of the economic theorists that influence the movement of the aggregate demand curve in each business cycle theories. In line with the business cycle theories, this paper will discuss about the different external factors which could directly create a demand shock or a sudden temporary increase or decrease of demand for goods and services in the business cycle. Analysis on the differences between the business cycle theories is very useful for the government as well as the multi-national companies in terms of evaluating a country’s economic performance and developing some strategies for businesses respectively. Sources of Demand Shocks in UK Market Open country like UK is highly susceptible to exogenous shocks. (Riley, 2006) As an open country, UK is greatly affected by the changes in the international market. For example, the export market is at its peak will eventually have a positive effect in UK economy. The increase in demand for export goods will create an opportunity for manufacturing companies to produce more goods and services and employment for UK citizens. (See Figure 1 below) In case the demand for export goods declines, there will be a loss of opportunity for UK workforce to create more production output and employment. (See Figure 2 on page 6) The movement of the aggregate demand curve is directly influenced by non-financial and financial factors. The non-financial factor includes the size of population, consumption, investment, government and export while the financial factor is caused by money supply and financial assets. Demand shocks based on industrial output can be measured. This enables us to prioritize and give importance to a particular type of demand shock. According to Lee, Pesaran and Pierse (1990), among the major sources of shock in the UK economy comes from oil prices, stock market, money aggregate supply and the foreign exchange market. Back in 1993, Lim (1993) uses the econometric techniques in investigating the influence of shocks coming from the housing market. Likewise, a study was done to measure the effects of productivity shocks in UK industry. It was stated that demand shocks have a significant effect in the economy of UK. (Fabiani, 1994) Lee, Pesaran and Pierse (1990) concluded that among the four types of demand shock, shocks coming from exchange rate have the biggest effect in the manufacturing industry. Shocks coming from oil prices and stock market also have a remarkable impact to the UK economy while the aggregate supply of money is considered the least important factor. Point of Equilibrium in Real Business Cycle, New Classical & Supply-side Theory All macroeconomic theories are used to ensure a stable growing economy. However, each theory is developed based on the beliefs of a particular or a group of economists. The Supply-side theory assumes the tendency that allowing the prices of goods to adjust will result to equilibrium. For example, the oil price shocks in 1970s causes the aggregate supply curve to move an inward shift so that the price of oil increases while the consumption of oil decreases. (See Figure 3 below) The same with the Supply-side theory, the Real Business Cycle (RBC) and the New Classical theory attains equilibrium through flexible wages and prices. (See Figure 4 on page 8) When the wage falls below the original wage, the supply of labour will shift to the right such that it increases the number of employment. Point B is the new equilibrium when wage falls and the supply of labour increases. RBC promotes the idea that the business cycle can be triggered by the productivity output of a country. (Bilbiie et al., 2006) It means that increasing the number of employees will generate an increase in the quantity of products and services. Thus, economic growth is achieved. In the case of Keynesian theory, it is the aggregate demand shifts in order to find its equilibrium along the aggregate supply curve. (Auburn, 2007) For example, there is a demand shock for cars, the aggregate demand curve will move along the aggregate supply of cars in order to meet the equilibrium point. This results to an increase in both the number of cars in the market as well as the price of cars. (See Figure 5 on page 9) Fiscal Policy in Keynesian Theory and Other Business Cycle Theory Government intervention plays a major role in the Keynesian Economic theory. In order to create a successful economy, theorists of Keynesian believe that the government should intervene in the monetary policy and the marketplace in order to stimulate the economy. Excessive government intervention may result to a long-term inflation. (See Figure 6 on page 10) Inflation can be prevented by simply increasing and decreasing the tax rate and government spending in times of a good and bad economy respectively. (Investopedia, 2007) There are two ways in which the government could control inflation. In case of recession, the government should cut on taxes or increase government spending. When the economy is running well, the government may increase taxes or cut down on government spending to slow down the real GDP. In doing so, the ‘New short-run Phillips Curve’ will shift to the left resulting to a decrease in inflation rate. Other business cycle theories such as Real Business Cycle (Wikipedia, 2007 a), Classical, Monetarism, Supply-side, and Laissez-Faire does not agree with government intervention as much as Keynesian Theory does. Theories like the Classical, Supply-side, and Laissez-Faire relies more on allowing the market and private sector to operate on its own rather than allowing the fiscal policies to manipulate the economy while the Monetarism follows a monetary rule wherein money supply is the main determinant of the economic activities and growth. (Wikipedia, 2007 b) Classical Theory considers fiscal policy or government intervention as an external factor which could increase the demand for labour as well as increasing wages. However, increasing the wages could eventually hurt the businesses. The fiscal policy aiming to increase stocks of government bonds is simply not a good decision to make because it will only reduce the market price of the bonds and would only result to an increase the interest rates. (Wikipedia, 2007 b) In times of recession, higher interest rates will make financing a business more expensive. It may even cause bankruptcy to some of the entrepreneurs. In worst cases, too much government intervention would only take away the resources and productivity of the private sector. Intensive use of fiscal policy often results to an imbalanced wealth between the government and the business sector because of some ‘special group’s’ personal interests. Another theory that opposes the use of fiscal policy is the Monetarism. Theorists of Monetarism believe that inflation can be controlled by monitoring the growth of the nation’s supply of money and that fiscal policy such as the controlling of taxes and government spending has a minimal effect on the business cycle. (Britannica Encyclopedia, 2007) They trust the monetary authority to focus on maintaining the price stability by managing the excessive supply of money which is the main cause inflation. (Davies, 2002) Factors that Triggers Employment Opportunity Using the Business Cycle Theories Government intervention in the Real Business Cycle and Keynesian Theory shows a huge impact on job opportunity for the job seekers. In case the government would temporarily increase the government expenditures, there will be an increase in the supply of labour resulting to a decrease in the real wage while creating more employment opportunities. (Abel & Bernanke, 2007) Government intervention at this point proves that fiscal policy can create jobs for the local citizens. (See Figure 7 on page 12) The increase of government expenditure would shift the IS curve up as national saving declines. At this point, the IS curve is bigger than the shift of the FE line. Therefore, prices would also increase in a way that the LM curve moves up to restore its equilibrium. Despite the fact that new jobs are created for the citizens, according to Classical economists, government intervention does not make the economic situation any better since the prices and wages would eventually adjust quickly to restore its equilibrium. (Abel & Bernanke, 2007) In fact, the fiscal policy is giving the workers the burden of having to pay higher taxes. In Classical Theory, adjustment in prices of goods and wages will create a full employment. Increasing wages and demand for goods and services will increase the demand for factories to produce more goods. In other words, the increase in investment will also create job opportunities for people who prefer to work. It is the free-market that the number of employed and unemployed. (See Figure 8 on page 13) Keynes strongly objects on Classical theorists’ belief that minimum wages and unions be abolished. This is because of the fact that when aggregate demand falls, automatically the prices and wages will drop. Union will always be present in cases when employees are no longer earning enough money for their daily needs. (The Short Run, 2007) In Monetarism, it is the supply of money that affects production output, employment, and price level of goods and services. In other words, money supply is used to determine the changes in the prices and the real GDP. The monetary rule states that ‘the money supply should expand at the expected rate of growth of real GDP.’ (Scottsdalecc, 2007) Interest plays a huge role in the supply of money. When the interest rate is high, people tend to invest their money into a business venture or somewhere else. Thus, employment opportunity, productivity is created. (See Figure 9 below) On the other hand, when the money supply becomes excessive, the interest rate will automatically drop. This will lessen the supply of money in the market. (See Figure 10 on page 15) Conclusion Keynes’ Theory could cause a short-term depression, economic fluctuation and high unemployment rate due to insufficient consumer spending and high taxes. Government can resolve the short-term issue by increasing the government spending in order to promote the smooth flow of local business transactions. If left unmanaged, this theory could cause a long-term problem such as inflation, slow economic growth and an increase in the number of unemployed especially in situation of a demand or supply shock. These problems can be resolved by controlling the tax rate and government spending. The Classical, Real Business Cycle, Monetarism and other Business Cycle theories also has its own weak points. It is important for policy makers and economists to search for a better solution in case an economic problem would arise. Analyzing the differences between each theory will help boost our economy by improving the unemployment rate in our country. *** End *** References: 1 Abel & Breanne (2007) ‘Chapter 10: Classical Business Cycle Analysis: Market-Clearing Macroeconomics’ Macroeconomics 4th Ed. Retrieved: March 21, 2007 from http://edwardmcphail.com/intermediatemacro/chapter_10_online.htm 2 Auburn (2007) ‘Chapter 26: Public Policy and Economic Regulations’ Auburn University. Retrieved: March 21, 2007 from http://www.auburn.edu/~bernsra/poli_1090_ch26_p.html 3 Balls, E. (2003) ‘Preventing Financial Crises: The Case for Independent IMF Surveillance’ Speech & Testimony at the Institute for International Economics. Dated: March 6, 2003. Retrieved: March 21, 2007 from http://www.iie.com/publications/papers/paper.cfm?researchid=244 4 Bilbiie F., Ghironi F. and Melitz M. (2006) ‘Endogenous Entry, Product Variety, and Business Cycles’ Dated: June 9, 2006. Retrieved: March 21, 2007 from http://www.princeton.edu/~mmelitz/BGMRBC.pdf 5 Britannica Encyclopedia (2007) ‘Monetarism’ Retrieved: March 21, 2007 from http://www.answers.com/topic/monetarism 6 Davies, R. (2005) ‘Inflation – The Pendulum Meta-theory Quality vs. Quantity of Money’ based on the book of Glyn Davies ‘A History of Money from Ancient Times to the Present Day’ 3rd ed. Cardiff: University of Wales Press, 2002. Retrieved: March 21, 2007 from http://www.ex.ac.uk/~RDavies/arian/metatheory.html 7 Investopedia (2007) ‘Keynesian Economics’ Retrieved: March 21, 2007 from http://www.investopedia.com/terms/k/keynesianeconomics.asp 8 Lee, K.C., Pesaran, M. H. and Pierse, R.G. (1990) ‘Testing for Aggregation Bias in Linear Models’ Economic Journal, 100, 137-50. 9 Lim, C.H. (1993) ‘Persistence of Housing Market Shocks to UK Output Growth’ Mimeo, Cambridge. 10 Riley, G. (2006) ‘Macroeconomics/International Economy: Cyclical Fluctuations – Demand and Aggregate supply-side Shocks’ tutor2u Retrieved: 20 March, 2007 from http://www.tutor2u.net/economics/revision- notes/a2-macro-cyclical-fluctuations.html 11 Scottsdalecc (2007) ‘Chapter 16: Monetary Policy’ Retrieved: March 22, 2007 from http://www.scottsdalecc.edu/dept/sbscience/division/faculty/pflanz/ECN111/Mod ule03/Monetary_Policy.ppt#310,1,Slide 1 12 The Short Run (2007) ‘Classical Economics’ Retrieved: March 22, 2007 from http://www.theshortrun.com/classroom/doctrines/classicals.html 13 Waller, S. (2007) ‘The Basics of Fundamental Analysis’ Retrieved: March 21, 2007 from http://www.bizfun.cc/articles/tbofa.html 14 Wikipedia (2007 a) ‘Real Business Cycle Theory’ Wikipedia Encyclopedia Retrieved: March 21, 2007 from http://en.wikipedia.org/wiki/Real_business_cycle 15 Wikipedia (2007 b) ‘Keynesian Economics’ Wikipedia Encyclopedia Retrieved: March 21, 2007 from http://en.wikipedia.org/wiki/Keynesian_economics 16 Wood, G. (2006) ‘364 Economists on Economic Policy’ Econ Journal Watch, Volume 3, Number 1, January 2006, pp. 137 – 147. Retrieved: March 21, 2007 from http://www.econjournalwatch.org/pdf/WoodCharacterIssuesJanuary2006.pdf Read More