What is Real Business Cycle (RBC) theory

RBC theory belongs to the new classical macroeconomics models in which business-cycle fluctuates to a large extent and can be accounted for by real (in contrast to nominal) shocks. Unlike other leading theories of the business cycle, RBC theory sees business cycle fluctuations as the efficient response to exogenous changes in the real economic environment.
That is, the level of national output necessarily maximizes expected utility, and governments should therefore concentrate on long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations. Real business cycle theory categorically rejects Keynesian economics and the real effectiveness of monetary policy

Features of Real Business Cycle (RBC) theory

Technological Shock: A real business cycle is generated in a steady state economy when there is a positive exogenous and permanent technological shock. This leads to increase in productivity. As a result, the aggregate production function shifts upward. In this way, the economy continues to expand when consumption, investment and output increase gradually leading to a steady state.

Labour Market: The real business cycle theory emphasizes that there is inter-temporal substitution of labour in the labour market. When a technology advance leads to a boom, the marginal product of labour increases. There is increase in employment and real wage. In response to a high real wage, workers reduce leisure. On the contrary, when technology is unfavorable and declines, the marginal product of labour, employment and real wage rate are low. In response to a low real wage, workers increase leisure. Thus an important implication of real business theory is that the real wage is pro-cyclical.

Interest Rate: The real business cycle theory also takes into account the role of real interest rate in response to a technological shock. The real interest is equal to the marginal product of capital. When a favorable technological change leads to a boom, the marginal product of capital and the real interest rate rise. On the contrary, an unfavorable technical change leading to a recession reduces the marginal product of capital and the real interest rate. When the economy reaches the new steady state, the real interest rate eventually returns to its initial level.

Flexibility of Wages and Prices: The real business cycle theory assumes than wages and prices are flexible. They adjust quickly to clear the markets. There are no market imperfections. It is the “invisible hand” that clears the market and leads to an optimal allocation of resources in the economy.
Neutrality of Money: Money plays no role in the real business cycle theory. Money is neutral. It is a veil. Money does not affect such real variables as employment and output. The role of money is to determine the price level. The money supply is endogenous in the real business cycle theory. It is fluctuations in output that cause fluctuations in the money supply. For instance, when there is a favorable technological change, the output increases and the quantity of money demanded rises. The banking system responds by advancing more loans and the central bank increases the money supply. With the money supply increasing, prices rise.
Fiscal Policy: Fiscal policy has little role to play in the real business cycle theory. Since the “invisible hand” guides the economy, the government role is limited. In fact, business cycles are the natural and efficient response of the economy to favorable and unfavorable technological shocks. A fiscal policy measure such as a tax on income will adversely affect output and employment. An individual may choose more leisure to work leading to reduction in consumption, investment and output. To avoid tax distortions and meet its requirements, the central bank increases the money supply in the economy. So the government has no role in stabilization policy.

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