Economy and Cycle Theory: Examining Key Assumptions, Origins, and Criticisms of Real Business Cycle Theory

The Real Business Cycle (RBC) theory, first introduced by Finn E. Kydland and Edward C. Prescott in 1982, offers a fresh perspective on the causes of economic fluctuations. Unlike traditional economic theories, RBC theory focuses primarily on real factors, such as technological advancements or resource price changes, as the primary cause of business cycles.

According to RBC theory, during the expansion phase, real GDP, capacity utilization, and employment increase, while the unemployment rate decreases, and income prospects improve. Conversely, during the contraction phase, there is a decrease in real GDP, businesses cut production, capacity utilization decreases, unemployment rate rises, and the outlook for household income deteriorates.

However, the RBC theory has faced criticism for underestimating the influence of fluctuations in aggregate demand on business cycles. Some economists argue that the assumption of full employment in RBC theory is unrealistic, as people may remain unemployed during a recession despite lowering their wage reservation.

Moreover, RBC theory rejects the ideas of Keynesianism and Monetarism, arguing that fiscal and monetary policies do not contribute to influencing the economy. However, it's important to note that fiscal policy (government spending and taxation) and monetary policy (interest rates and money supply) can influence aggregate demand, and governments can use them to mitigate the negative effects of business cycles, even if they don't directly address real shocks.

A real shock, such as a massive technological breakthrough, disrupts the economy's production capacity and triggers business cycles in RBC theory. However, psychological factors like consumer sentiment and business confidence can play a significant role in economic activity and may not be fully accounted for by RBC theory. For instance, a sudden drop in consumer confidence due to a financial crisis wouldn't be considered a real shock in RBC theory but could significantly impact aggregate demand, leading to a recession.

The new classical economists proposed the model and considered fluctuations in the aggregate supply to be the cause of business cycles. Over time, the economy adapts to the real shock, leading to a new long-run equilibrium with a higher or lower level of production, depending on the nature of the shock.

In conclusion, while RBC theory provides a valuable contribution to our understanding of economic fluctuations, it might not capture the full complexity of business cycles. Other factors like changes in aggregate demand and psychological factors can also play a significant role. Nevertheless, RBC theory offers a useful framework for analysing the economy's response to real shocks and understanding the short-run effects of these shocks on output and employment.

Economy and Cycle Theory: Examining Key Assumptions, Origins, and Criticisms of Real Business Cycle Theory