Real business cycle

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The model of Real Business Cycles (RBCs) is a macroeconomics model formulated principally by Robert Lucas Jr, Finn E. Kydland and Edward C. Prescott, building upon the ideas of John F. Muth. Its main purpose is to explain why business cycles happen; why does real output fluctuate if there are rational expectations?

The assumptions underlying this model are the presence of representative rational agents possessing rational expectations. The model is usually stated in terms of one intertemporally optimising agent (a person who tries to maximize his utility, given their constraints, across time), whose actions can be seen as representative of all agents, and thus of the economy as a whole. (See representative agent.) Other implicit assumptions include the neutrality of money (this is implied by rational expectations).

Lucas showed that under productivity shocks, business cycles would be generated within this model. This is because, if the productivity of an agent declines, their real income will also decline. Given intertemporal optimisation, the representative agent will optimally choose to postpone working until the next period (and instead consume leisure) when he rationally expects that the productivity shock will have disappeared and real wages will have risen again. Aggregation implies that a negative productivity shock will result in voluntary unemployment and a decline in economic activity and hence GDP.

Therefore, the main conclusion of this model is that business cycles are entirely consistent with the efficient workings of a market economy; the movements of the economy are always Pareto efficient. There is no involuntary unemployment in this model. Furthermore, fiscal or monetary intervention into the economy will always be futile because, first, any action arising from a policy rule will be perfectly anticipated by agents with rational expectations; and second, unless the government has information unavailable to individual agents, it cannot improve upon market outcomes (and even if it did, it could simply release this information and hence let agents arrive at a Pareto-efficient outcome).

Criticisms of Real Business Cycles

The real business cycle depends on assumptions of rational expectations and a full set of perfect markets.

Real business cycle theory also suffers from conclusions which most observers find unrealistic; denying the existence of involuntary unemployment and imposing neutrality of money, even in the short run. It is also argued that productivity shocks are not large enough, nor of sufficient duration, to explain the prolongued recessions that are witnessed in almost all economies around the world.

Several people have tried to add in a money component of real business cycles, but there has been little agreement. It is generally agreed upon that monetary policy can affect the economy at least in the short run.

Despite all these criticisms, the validity of the underlying modeling approach has become an accepted standard for theoretical academic economists. The assumptions underlying many Keynesian models are often felt to be even further from reality than those of the real business cycle.

See also

Lucas critiqueca:Cicles econòmics reals ja:リアルビジネスサイクル理論 no:Realkonjunkturteori nn:Realkonjunkturteori