Real Business Cycle Theory

Real business cycle theory explains rises and falls in output and employment mainly as responses to changes in the economy's productive capacity, especially changes in technology. In its benchmark form, households and firms respond rationally to real shocks in competitive markets with flexible prices and wages, so fluctuations need not arise from a failure of aggregate demand.

The source of fluctuations

The central disturbance is a productivity shock, which changes how much output firms can produce from given quantities of labour and capital. Unlike a purely monetary disturbance, it changes real production possibilities.

• A favourable technology shock raises productivity and makes production more profitable, encouraging firms to expand output, employment and investment.
• An adverse productivity shock reduces productive capacity and the returns to production, leading to lower output and employment.
• In the benchmark model, monetary shocks are not the principal explanation of business cycles because prices and wages adjust rather than remaining persistently rigid.

How output and employment respond

Households choose consumption, saving and work over time, while firms choose labour and investment. Their responses transmit the initial shock through the economy.

• Higher productivity raises the marginal product of labour and, under competitive conditions, the real wage, increasing the reward from working.
• Intertemporal substitution of labour means that people shift work towards periods when its reward is relatively high and leisure towards periods when it is relatively low.
• Higher wages also make households wealthier, which can increase their demand for leisure; the employment response therefore depends on the balance between substitution and wealth effects.
• Investment changes the future capital stock, while persistent productivity shocks extend the initial disturbance, helping fluctuations continue over time.

Interpretation and policy implications

In the undistorted benchmark, fluctuations are equilibrium responses to changing opportunities and constraints, rather than necessarily evidence of market failure.

• Lower employment is explained through labour supply and demand adjustments, rather than primarily through involuntary unemployment caused by deficient spending.
• This weakens the case for routine demand-management policy aimed at eliminating every fluctuation.
• The explanation is contested because wage and price rigidities, involuntary unemployment and demand disturbances can also be important; real business cycle theory isolates a particular mechanism rather than explaining every downturn.