© Sanjay K. Chugh
Real Business Cycle Theory
Real Business Cycle (RBC) Theory is the other dominant strand of thought in modern
For the most part, RBC theory has held much less sway amongst
policy-makers than has New Keynesian theory.
Among theoretical macroeconomists,
however, RBC theory is very well-known and well-understood and even provides the
foundations for some of New Keynesian theory.
Although there are a number of ways
in which RBC theory differs from New Keynesian theory, we will focus on two
The most important difference by far is that RBC theory eschews the idea of
sticky prices, while New Keynesian theory embraces it.
RBC theory views prices as fully
flexible – that is, all prices can be and are re-set very frequently.
Even more precisely,
RBC theory supposes that perfect competition in all markets is a good starting point for
analyzing the macroeconomy.
Second, RBC theory does not view exogenous shifts of
consumption demand as a good description of data, but rather “shifts in supply” as the
predominant reason for macroeconomic fluctuations.
The basic mechanics that we will use to sketch out the main elements of RBC theory are
the theory of the representative firm, the simple consumption-savings model, and the
consumption-leisure model, rather than the simple consumption-savings model and the
static consumption-leisure model in tandem.
As we saw earlier, though, the algebra
becomes quite messy and graphical tools become difficult to use.
RBC theorists do in
fact use the intertemporal consumption-leisure model in their workhorse models, but we
will be able to develop the basic results using the two models together.
The RBC Technology Shock
Recall from our discussion of the aggregate production function
that we could
augment it with a technology parameter
, so that total output is given by
This technology parameter is usually identified with the Solow Residual, which is a
measure constructed from data on output, capital, and labor.
We describe how to
compute Solow Residuals soon.
This way of measuring technology has the virtue that it
does not require taking a stand on what constitutes “technology” – i.e., it does not require
identifying the state of “technology” of an economy with, say, the number of computers it
uses or with the number of Ph.D.’s it employs or with how many people use wireless
contributions to the understanding of macroeconomics despite never having taken center stage in policy
The pioneering work of Ed Prescott and Finn Kydland, widely viewed as the “fathers” of RBC
theory, was finally widely-recognized in 2004 when