Real Business Theory

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Dictionary of Economics

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Real Business Theory

This is "Game of Theories: Real Business Cycle" from our Principles of Economics: Macroeconomics course.

So far in our business cycles deep dive, we’ve covered two of the four main theories: Keynesian and monetarist. Now, we’re going to move away from aggregate demand and monetary policy to check out the supply side of things in real business cycle (RBC) theory.

In RBC, the “real” part refers to real shocks to an economy. Specifically, it refers to supply shocks.

Think about what might happen if the price for oil suddenly increased dramatically. We rely on oil a ton. Not only is oil crucial for travel, but also for the production of many everyday goods. That steep price increase would be a negative supply shock and put a damper on many sectors of the U.S. economy. A recession could follow.

This is exactly what happened in the U.S. in 1973 when the price of oil quadrupled for American buyers.

Okay, so RBC is useful for a complex supply shock. But it can also explain many of the economic downturns throughout human history. For instance, in ancient times when economies relied primarily on agriculture, a drought would be truly awful for the economy. It’s a much simpler example, but it’s still a negative supply shock.

What are the solutions to a downturn in RBC? Basically, try to avoid over-reliance on the supply of any particular good. In the case of an oil shock, be prepared by investing in alternative energy solutions. And try to make your economy flexible so that it can quickly respond to a negative real supply shock and limit the cost.

Like the theories we’ve discussed in previous videos, there are limitations to what RBC can explain. For instance, it’s not as useful in explaining recessions that are caused by monetary policy, banking, and credit in a modern economy. Check out our video for more on where RBC can, and can’t, shed light.

Teacher Resources


Real business cycle theory is about negative supply shocks. That word "real" in the name—don't contrast it with the word "phony," but rather contrast it with "monetary." Real business cycles are not about monetary policy—mostly they're about negative supply shocks. Now, the nice thing about real business cycle theory is that it actually explains most business cycles in the history of the human race.


Consider earlier economies where, say, 80% of GDP was agriculture. What then could be the negative shock? Well, imagine a whole year of bad rainfall, and then a very bad harvest. That would mean lower output for almost all of the economy. It would mean people have less to eat. It might even mean more malnutrition, and that would be a very bad macroeconomic event. That's just the simplest example of real business cycle theory.


Real business cycle theory needs to be modified for more modern economies, which are more diversified. So, what would be an example? Consider America in the year 1973. What was the negative shock then? A much higher price of oil. OPEC, the oil-exporting cartel, raised the price of its oil to American buyers. Now, oil is an input into the production of many goods and services—like airplane trips, or building automobiles, or bathtub rubber duckies. So, you have higher production costs. That means less will be produced, probably fewer workers will be hired, and, overall, incomes will be lower. Those initial negative shocks will work their way through the American economy, and that will mean successive negative shocks for other parts of the economy even if they don't use oil, and that ends up leading to a recession.


Real business cycle theory also can apply to the present day. Consider the economy of Brazil, where GDP has declined by more than 5% over the last two years. What have been the negative shocks? First—falling commodity prices. Brazil exports a lot of commodities, commodities like soybeans, and cotton, and coffee, and minerals. Those commodities are bringing in lower prices on world markets, and that means lower incomes for a lot of Brazilians. Second—bad policy. The behavior of the Brazilian government has been erratic and unpredictable, and this has increased the level of perceived risk in the Brazilian economy.


So to graph a real business cycle, what does that look like? Well, in our basic aggregate demand-aggregate supply model, it's pretty simple. The long-run aggregate supply curve is shifting to the left, and you can see that means a lower level of output. Over the medium term, due to propagation, it also may be that the aggregate demand curve shifts back and to the left, and that, of course, will make the problem worse. But again, the fundamental event is simply the shifting back and to the left of the aggregate supply curve.


So what are the solutions when you have a problem based in real business cycle theory? Well, first thing you can do is try to avoid the problem in the first place. If the risk is having an oil price which is too high, try to have invested in the first place in some energy alternatives. Second, ask yourself what can you do to make your economy more flexible so it can adjust to the negative supply shock more quickly. All of those responses will help limit the costs of having a negative real-business cycle.


So, what are the problems in real business cycle theory? There are at least two. First—it doesn't explain all business cycles. A lot of business cycles do have to do with monetary policy, banking, and credit, rather than the supply side of the economy. A second problem with real business cycle theory—it's not always good on explaining why unemployment is so high over the course of many business cycles. If you imagine a negative shock hitting the economy, well, why don't workers just take lower wages and stay at work? And to explain those employment effects, often we need to supplement real business cycle theory with other accounts of business cycles. So, to sum up, real business cycle theory is a really good theory for many cases, but it leaves many others fundamentally unexplained.


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