The Real Business Cycle Theory

analytical Essay
1495 words
1495 words

The Real Business Cycle theory was first initiated by Kydland and Prescott in 1982, which concentrate on explaining the economic fluctuations driven by the “real” exogenous technology shocks. It described the general philosophy of any New Classical approach to business cycle analysis. This essay is going to explore their main successes and drawbacks by firstly providing an overview of the historical background of the model. Then it will discuss some general achievements, extensions to, and criticisms before concluding.
The Historical Background
The dominating Keynesian paradigm seemed particularly successful in explaining the macroeconomic fluctuations before the mid-1970s while it became more apparent that later development in the real world revealed serious shortcomings of the earlier analysis which could not be seen as a proper interpretation for understanding the business cycles. According to Plosser (1989), the view that Keynesian economics was an empirical success even if it lacked sound theoretical foundations could no longer be taken seriously. The essential flaw in the Keynesian interpretation of macroeconomic phenomenon was the absence of a consistent foundation based on the choice-theoretic framework of microeconomics. With this emerging stagflation phenomenon in mind, the quiet different approaches to the explanation of business cycles fluctuations have been pursued. And the revival of business cycle theory is brought by the development of New Classical macroeconomics. Friedman (1968) and Lucas (1976) critically posed a challenge to the Keynesian model. Friedman argued that the long-run Phillips Curve should be vertical and the sustained inflation is compatible with any level of real demand of goods. Lucas...

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...planation of the monetary transmission mechanism.”
All in all, the Real Business Cycle theory has been very controversial and there are many devastating criticisms toward its advocates, as there exist many unresolved problems. However, even if the final consensus is that RBC theory has many imperfections, it indeed changes the way macroeconomics modelled. As what Stadler(1994) praises, “ It has introduced into macroeconomics computable general equilibrium models that can replicate certain characteristics of real data sets.” The incorporation of more features of reality into these models can be achieved when the technical frontier moves outwards. Thus, the contributions of RBC theory not only altered our conventional views of business cycles significantly but also brought in creative methods for macroeconomic research and revolutionary policy appraisal.

In this essay, the author

  • Introduces kydland and prescott's real business cycle theory, which focuses on explaining the economic fluctuations driven by exogenous technology shocks.
  • Argues that keynesian economics was an empirical success even if it lacked sound theoretical foundations. the revival of business cycle theory is brought by the development of new classical macroeconomics
  • Explains that the rbc theory has brought about a remarkable improvement in our understanding of the reasons and mechanisms of business cycles' formation.
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