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By Adrienne Moore

Carmen A. Olivier

Adrienne J. Moore

Carmen A. Olivier

2007

This paper is an attempt to provide comparative analysis by presenting brief comparison analysis of the classical view, the Keynesian Revolution, the Monestarist Counterrevolution, the New Classical School, real business cycle theory, and the New Keynesiasism. The study also aims to give a detailed account of real business cycle theory development.

Modern macroeconomic literature employs the term EBCT as the preclude the very developments within the New Classical school that are most closely related to ABCT.

Business Cycle Theory characterizes by cyclical movements of macroeconomic variables. These are characterized by both market clearing and Pareto optimality, is sometimes designated as the only true equilibrium construction.

The Theory of Real Business Cycles

  • all prices remain to be flexible, even in short run

–     implies money is neutral, even in short run

–     classical dichotomy holds at all times

  • The economy lives through fluctuations in output, employment, and other variables. These are the responses to exogenous changes in the economic environment
  • productivity shocks the primary cause of economic fluctuations

The Business Cycle Phenomena

The use of the expression business cycle is unfortunate for two reasons. One is that it leads people to think in terms of a time series’ business cycle component which is to be explained independently of a growth component

Lucas (1977, p. 9) defines the business cycle phenomena as the recurrent fluctuations of output about trend and the co-movements among other aggregate time series. Fluctuations are by definition deviations from some slowly varying path. Since this slowly varying path increases monotonically over time, it is better to adopt the common practice of labeling it trend. This trend is neither a measure nor an estimate of the unconditional mean of some stochastic process. It is, rather, defined by the computational procedure used to fit the smooth curve through the data.

The business cycle

The business cycle has been a recurring phenomenon for many years past. Its course can be traced with more or less precision almost to the earliest beginnings of the present economic system. In other words, it is an accompaniment of a social scheme that involves specialized production, exchange, and a money-credit mechanism, that is, a banking system. Only in recent decades, however, especially during the present century, have there been comprehensive studies of the effects of the business cycle.

Equilibrium business cycles

To common sense, economic booms are good and slumps are bad. Economists have attempted to capture common sense in disequilibrium models: full employment is modeled as an equilibrium: that is, as a situation in which each worker’s and each producer’s preferences are satisfied. The real business cycle model is an extraordinarily bold conjecture in that it describes each stage of the business cycle—the trough as well as the peak—as an equilibrium (Prescott 21).

Real business cycle model & The limits of idealization

The real business cycle model does not present a descriptively realistic account of the economic process, but a highly stylized or idealized account. This is a common feature of many economic models, but real business cycle practitioners are bold in their conjecture that such models nevertheless provide useful quantifications of the actual economy. While idealizations are inevitable in modeling exercises, they do limit the scope of the virtues one can claim for a model.

In particular, the real business cycle program is part of the larger new classical macroeconomic research program. Proponents of these models often promote them as models that provide satisfactory microfoundations for macroeconomics in a way that Keynesian models conspicuously fail to do (Lucas and Sargent, 1979). The claim for providing microfoundations is largely based on the fact that new classical models in general, and real business cycle models in particular, model the representative agent as solving a single dynamic optimization problem on behalf of all the consumers, workers, and firms in the economy. However, the claim that representative agent models are innately superior to other sorts of models is unfounded. There is no a priori reason to accord real business cycle models a presumption of accuracy because they look like they are based on microeconomics.

A significant part of the rhetorical argument for using real business cycle methodology is an appeal to general equilibrium theory. However, because the models do not reach a microfoundational goal of a separate objective function for every individual and firm, the models are at best highly idealized general equilibrium models. Real business cycle theorists do not appear to be aware of the degree to which this undermines certain sorts of claims that can be made for their models. The fact that they do not provide genuine microfoundations essentially removes any prior claims that real business cycle models are superior to Keynesian or other aggregate models.

Real business cycle models, on the other hand, take the functions of the representative agent far more seriously, arguing that “we deduce the quantitative implications of theory for business cycle fluctuations” (Kydland and Prescott 211). However, for the reasons described above, these deductions are not the rigorous working out of microeconomic principles combined with a serious analysis of heterogeneity and aggregation.

Testing

Business cycle theory has thus traditionally tried to explain what causes output to fall and then rise again. To be sure, this is not just a matter of output declining: when output declines, one expects employment, income, and trade to decline as well, and these declines to be widespread across different sectors. Even before the first real business cycle models, new classical macroeconomics shifted the focus to the comovements. (Sargent 256)

Real business cycle models view the business cycle in precisely the same way as Sargent and Lucas. The things to be explained are the correlations between time series, and the typical assessment of the success or failure of a model is to compare the correlations of the actual time series to those that result from simulating the model using artificially generated series for the technology shock (Z).

Works Cited

Lucas, Robert E., Jr. (1972) “Expectations and the Neutrality of Money, ” Journal of Economic Theory , 4(2), April: 103-24, reprinted in Lucas (1981): 66-89.

Prescott, Edward C. (1986a) “Theory Ahead of Business Cycle Measurement, ” in Federal Reserve Bank of Minneapolis Quarterly Review, 10(4), Fall: 9-22, reprinted here in Chapter 4.

Prescott, Edward C. (1986b) “Response to a Skeptic, ” Federal Reserve Bank of Minneapolis Quarterly Review, 10(4), Fall: 28-33, reprinted here in Chapter 6.

Sargent, Thomas J. (1979) Macroeconomic Theory, New York: Academic Press.

Kydland, Finn E. and Edward C. Prescott (1997) “A Response [to Milton Friedman], “Journal of Economic Perspectives, 11(1), Winter: 210-11.