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.