Real Business Cycle Theory Theory developed by Edward Prescott and Finn Kydland (Nobel laureates 2004)

Real Business Cycle Theory This theory argues that productivity shocks to the economy are the primary cause of business cycles. Productivity shocks propagate throughout the economy and affect the production function, employment, investment, as well as the spending and saving decisions of consumers. They are also referred to as real shocks or supply shocks. 29

Deviations from trend in TFP TFP may slowdown when no significant discoveries that affect production take place. Measured TFP can also slowdown as a result of bad weather, or other exogenous events. Changes in TFP growth are recurrent, and not necessarily predictable. (TFP deviations from trend are well described by a Markov process with persistence.)

Is the theory consistent with the data? Qualitatively yes, but the RBC impulse (TFP changes) falls short of accounting for changes in GDP.

Propagation mechanism amplifies the impact of a shock to TFP growth Two immediate effects follow from a change in productivity Investment demand changes (which affects interest rates, capital accumulation, and ultimately GDP). Capital utilization may also be affected (although capital utilization is also affected by other factors like energy price changes) The demand for labor –labor force utilization- changes (which affects wages, hours worked, and ultimately GDP).

Propagation mechanism: Impact on GDP larger than original TFP shock Capital and labor markets in a real business cycle recession.

Real Business Cycle Theory A decrease in productivity lowers firms’ profit expectations and decreases both investment demand and the demand for labor.

Real Business Cycle Theory The interest rate falls.

Real Business Cycle Theory The lower the real interest rate lowers the return from current work so the supply of labor decreases.

Real Business Cycle Theory Employment falls by a large amount and the real wage rate falls by a small amount.

Summary of RBC theory Shocks to productivity growth are the main force driving business cycle fluctuations (accounting for 2/3 of the total volatility). Expansions and recessions are not necessarily caused by market failures. Policy implications: The role of the government is to provide an environment that promotes TFP growth. Direct government interventions to smooth the cycle may be counter productive.