Real business cycle theory : definition, features, assumptions, criticisms

Real business cycle theory definition

What is real business cycle theory (RBC model)?

Real Business Cycle theory emphasizes the role of actual, exogenous shocks to the economy in explaining economic fluctuations. These shocks include adjustments in technology, shifts in labor productivity, and adjustments in the supply of resources. According to real business cycle theory, these shocks cause changes in macroeconomic indicators, including employment and economic production. RBC theory emphasizes the relevance of real variables in generating economic cycles, in contrast to other models that emphasize monetary factors or market imperfections. It indicates that the real business cycle theory emphasizes the supply side of the economy.

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Features of real business cycle theory

1. Real Shocks

Business cycle fluctuations typically arise because of the real shocks. The real business cycle theory emphasizes the role of real shocks as the main causes of economic fluctuations, such as shifts in technology or productivity. These shocks alter the economy’s capacity for production, changing the level of output.

2. Rational Expectations

The real business cycle theory argues that people and businesses make decisions based on all available information and have realistic expectations for the state of the economy in the future. Their decisions on consumption, investment, and production are influenced by this presumption.

3. Efficient Markets

RBC models presuppose efficient markets, in which prices and wages quickly adjust to clear markets. This means that even in the face of genuine shocks, resources are allocated efficiently because supply and demand are equal in all markets.

4. Market Clearing

RBC models are based on the idea of market clearing, according to which supply and demand are equal in all markets, including the labor and goods markets. To ensure that markets establish equilibrium and enable effective resource allocation, prices and wages adapt.

Real business cycle theory assumptions.

• Flexible Prices and Wages: Real business cycle theory assumes that prices and wages are adaptable and rapid to alter in response to shifts in supply and demand. This adaptability enables markets to settle quickly, ensuring that resources are distributed effectively. You may be interested in to read more, What is the difference between demand and quantity demanded? Market Equilibrium – With Examples & Graph What is the difference between supply vs quantity supplied?
• Rational Expectations: The RBC theory makes the premise that expectations are rational. This indicates that people and businesses have unbiased, correct expectations regarding the state of the economy. Economic agents base their decisions on all the information at their disposal and develop expectations that are congruent with the actual makeup of the economy. Decisions about consumption, investment, and output are influenced by rational expectations.
• Perfect Competition: According to RBC theory, perfect competition exists in every market. There are numerous buyers and sellers in perfectly competitive markets, and no one party can control the prices or output of the market. This presumption guarantees that markets function effectively and that forces of supply and demand determine prices and wages. You may interested in to read more, Perfectly Competitive Market Meaning, Characteristics, & Examples Perfect Competition Graph in Short Run and Long Run

Real Business Cycle Theory Criticisms

RBC theory has come under fire on numerous occasions. Its reliance on unrealistic assumptions is a major criticism. The complexity of real-world economies is at odds with the premise of perfectly competitive marketplaces and immediate price and wage changes. In actuality, markets are frequently flawed and prices and wages may not respond immediately, which can create circumstances where the economy may not return to equilibrium quickly after a shock.

The theory’s limited application to policy is another point of contention. According to RBC models, changes in the economy are effective reactions to actual shocks, negating the need for government intervention to keep things stable. However, detractors contend that government action is necessary to stop protracted periods of high unemployment and financial suffering during severe recessions, especially those brought on by financial crises.

Furthermore, RBC theory frequently finds it difficult to account for the length and severity of economic downturns. RBC models fail to effectively account for aspects that can exacerbate economic crises, such as investor confidence, banking sector instability, and government policy. These additional elements cast doubt on the theory’s capacity to adequately explain the intricacies of fluctuating real-world economic conditions.

Furthermore, the RBC hypothesis has come under fire for its disregard for the financial industry. During the financial crisis of 2007–2008, it became clear how intertwined the financial sector and actual economy are. The explanatory capacity of RBC models is constrained in the context of contemporary economic fluctuations because they do not sufficiently represent the role of credit markets, financial institutions, and systemic threats.

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