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JA7- Real-Business-Cycle (RBC) Theory

Statement

Please explain in three well-structured paragraphs the basic arguments stated by the Real-Business-Cycle (RBC) Theory, regarding economic fluctuations.

Answer

The Real-Business-Cycle (RBC) Theory is a macroeconomic theory that belongs to the new classical school of economics; it was developed in the 1980s by Finn Kydland and Edward Prescott (Chand, 2014). The theory provides a model that explains economic cycles with good accuracy; it also tries to explain economic situations and predict next cycles; the model in the theory can be calibrated with real-world data to ensure accuracy. The theory has a set of assumptions that urged criticism against it, along with the way it explained the recessions and its downplaying of the role of monetary policy in the business cycle.

The RBC theory has two main principles; “money is of little importance in business cycles and that business cycles are driven by real shocks” (Krauth, 2004). The shocks are usually due to fluctuations in productivity growth, government purchases, import prices and consumer preferences. Labor input, productivity, and expenditures are pro-cyclical variables; that is, they increase during expansions (booms) and decrease during contractions (recessions). On the other hand, capital and wages are acyclical variables; they do not change much during the business cycle. Unemployment is a counter-cyclical variable; it increases during recessions and decreases during expansions (Krauth, 2004).

The RBC theory argues that business cycles are the results of shocks caused by changes in technology, as opposed to changes in monetary, fiscal, and oil prices which was believed to be the cause of fluctuations before RBC (Rebelo, 2005, p.7). RBC theory attributes expansions to technology advancements and recessions to technology setbacks. An initial shock of a positive technology advancement leads to an increase in productivity, which leads to an increase in output, employment, investment, and consumption marking the expansion phase of the cycle. While RBC downplays the role of monetary policy in the expansion phase, it does not completely deny it (Pettinger, 2018).

The recession phases of the cycle include a negative technology shock that may include innovations, bad weather, stricter regulations, wars, strikes, and other factors that reduce productivity (The Economic Times, 2024). The negative shock leads to a decrease in output, employment, investment, and consumption. The RBC theory argues that this phase -in the short run- indicates the market returning to equilibrium after the output increase due to the positive shock is stabilized; it sees the recession as a natural and efficient response and not a point of concern0 until the next positive shock occurs that will lead to the next expansion phase (QuickOnoMics, n.d.).

The RBC theory downplays the role of aggregate demand/supply, monetary, and fiscal policies in the business cycle, and instead focuses on shocks in output as the main drivers of economic fluctuations. Thus, RBC asks policymakers to focus more on the long-run growth of the economy and ensuring enough flexibility to counter negative shocks as opposed to trying to stabilize the short-run natural fluctuations which it sees as non-concerning (QuickOnoMics, n.d.). Policies that promote human capital such as education and training should be the main focus of economies as human capital is the main driver of technological advancements and productivity growth.

Word Count: 507.

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