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Book Name –Â Macroeconomics (HL Ahuja)
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1. Introduction
2. Real Business Cycle Theory
3. Real GDP and Price Level
4. Has Money any Role in Real Business Cycle Theory?
5. Critique of Real Business Cycle Theory
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Real Business Cycle Theory
Chapter – 27 C
Introduction
Earlier business cycle theories explained fluctuations mainly through changes in aggregate demand (AD), though the causes differed across schools such as Keynesian economics, Nicholas Kaldor, John Hicks, Milton Friedman (Monetarism), and Robert Lucas (New Classical Rational Expectations).
In the 1980s, several economists argued that cyclical fluctuations in output are mainly due to shifts in aggregate supply (AS) rather than shifts in AD, marking a shift from demand-side to supply-side explanations of business cycles.
This approach is known as the Real Business Cycles (RBC) Theory, as it emphasizes real (non-monetary) factors affecting production, such as technology, productivity, and resource availability, as the primary drivers of economic fluctuations.
The central proposition of RBC theory is that the same supply-side factors responsible for long-run economic growth also generate short-run cyclical movements in real GDP ((Y)) and employment ((N)).
In formal terms, output is determined by the production function \(Y = F(K, L, A)\), where \(K\) = capital, \(L\) = labour, and \(A\) = technology; fluctuations in \(A\) (technology shocks) cause shifts in AS and hence changes in \(Y\) and \(N\).
Thus, business cycles are viewed as natural responses of the economy to real shocks affecting productive capacity, rather than as consequences of monetary or demand disturbances.