Real 

business cycle theory
Real business cycle theory (RBC theory) is a class of macroeconomic models and theories that
were first explored by American economist John Muth in 1961. The theory has since been more
closely associated with another American economist, Robert Lucas, Jr., who has been
characterized as “the most influential macroeconomist in the last quarter of the twentieth
century.”  

Intro to Economic Business Cycles

Before understanding real business cycle theory, one must understand the basic concept of
business cycles. A business cycle is the periodic up and down movements in the economy, which
are measured by fluctuations in real GDP and other macroeconomic variables. There are
sequential phases of a business cycle that demonstrate rapid growth (known as expansions or
booms) followed by periods of stagnation or decline (known as contractions or declines).

1. Expansion (or Recovery when following a trough): categorized by an increase in

economic activity
2. Peak: The upper turning point of the business cycle when expansion turns to contraction
3. Contraction: categorized by a decrease in economic activity
4. Trough: The lower turning point of the business cycle when contraction leads to
recovery and/or expansion

Real business cycle theory makes strong assumptions about the drivers of these business cycle
phases.

Primary Assumption of Real Business Cycle Theory

The primary concept behind real business cycle theory is that one must study business cycles
with the fundamental assumption that they are driven entirely by technology shocks rather than
by monetary shocks or changes in expectations. That is to say that RBC theory largely accounts
for business cycle fluctuations with real (rather than nominal) shocks, which are defined as
unexpected or unpredictable events that affect the economy. Technology shocks, in particular,
are considered a result of some unanticipated technological development that impacts
productivity. Shocks in government purchases are another kind of shock that can appear in a pure
real business cycle (RBC Theory) model.

Real Business Cycle Theory and Shocks

In addition to attributing all business cycle phases to technological shocks, real business cycle
theory considers business cycle fluctuations an efficient response to those exogenous changes or
developments in the real economic environment. Therefore, business cycles are “real” according
to RBC theory in that they do not represent the failure of markets to clear or show an equal
supply to demand ratio, but instead, reflect the most efficient economic operation given the
structure of that economy.

As a result, RBC theory rejects Keynesian economics, or the view that in the short run economic
output is primarily influenced by aggregate demand, and monetarism, the school of thought that
emphasizes the role of government in controlling the amount of money in circulation. Despite
their rejection of RBC theory, both of these schools of economic thought currently represent the
foundation of mainstream macroeconomic policy.

5 Main Phases of Business Cycle | Managerial Economics

The following points highlight the five main phases of business cycle.

The phases are: 1. Depression

2. Recovery or Revival

3. Prosperity or Full Employment

4. Boom or Overfull Employment

5. Recession.
Business Cycle Phase # 1 Depression:

This constitutes the first stage of a business cycle. It is a protracted period in which business
activity in the country is far below the normal.

It is characterized by a sharp reduction of production, mass unemployment, low employment,

falling prices, falling profits, low wages, contraction of credit, a high rate of business failures and
an atmosphere of all-round permission and despair.

A decline in output or production is accompanied by a reduction in the volume of employment.

All construction activities come to a more or less complete stand still during a depression.

The consumer goods industries such as food clothing etc., are not so much affected by
unemployment as the basic capital goods industries. The prices of manufactured goods fall to
low levels. Since the costs are “sticky” and do not fall as rapidly as prices, the manufacturers
suffer huge financial losses. Many of these firms have to close down on account of accumulated
losses.

The fall in prices distorts the relative price structure. The prices of agricultural commodities and
raw materials fall to greater extent than the prices of finished manufactured goods. The
agriculturists are hit more than the manufacturing classes.

For example:
The two longest depressions are U. S. depression of 1873—1879 (65 months) and 1929-1935 (44
months).

Business Cycle Phase # 2 Recovery or Revival:

It implies increase in business activity after the lowest point of the depression has been reached.
During this phase, there is slight improvement in economic activity to start with. The
entrepreneurs begin to feel that the economic situation was not as bad as it was in the preceding
stage. This leads to further improvement in business activity.

The industrial production picks up slowly and gradually. The volume of employment has steadily
increases. There is a slow but sure rise in prices accompanied by a small rise in profits. The
wages also rise, though they do not rise in the same proportion in which the prices rise.

Attracted by rising profits new investments take place in capital goods industries. The Banks
expand credit. The business inventories also start rising slowly. The possimism and despair of
the preceding period is replaced by an atmosphere of all-round cautious hope.

The recovery continues until business activity reaches approximately the same level that it had
achieved before the decline set in. The rate of recovery, it has been found is generally related
directly to that of the preceding depression. The recovery could be initiated by new innovations
government expenditure, changes in production techniques, investment in new regions,
exploitation of new sources of energy etc.

Business Cycle Phase # 3 Prosperity or Full Employment:

This stage is characterized by increased production, high capital investment in basic industries,
expansion of bank credit, high prices, high profits, a high rate of formation of new business
enterprises and full employment. There is a general enterprises and full employment. There is a
general feeling of optimism among businessmen and industrialists.

The longest sustained period of prosperity occurred in the U.S.A. between 1923 and 1929 with
some minor interruptions in 1924.

Business Cycle Phase # 4 Boom or Over-All Employment:

It is the stage of rapid expansion in business activity to new high marks resulting in high stocks
and commodity prices, high profits and over full employment. The prosperity phase of the
business cycle does not end up with a stable state of full employment; it leads to the emergence
of boom.

The continuance of investment even after the stage of full employment results in a sharp
inflationary rise of prices. This causes undue optimism among businessmen and industrialists
who made additional investments in the various branches of the economy.

This puts additional pressure on the factors of production which are already fully employed,
causing a sharp rise in their prices. Soon a situation develops in which the number of jobs
exceeds the number of workers available in the market. Such a situation is known as overfull
employment.

Profits touch a new height, attracted by the rising profits, the businessmen and industrialists
further increase their capital investments. Prices rise sky high. There is an atmosphere of over-
optimism all round. The cost calculations of the businessmen and the industrialists are
completely upset. Some new hastily set up firms collapse. A boom as it is said is inevitably
followed by a bust.
Business Cycle Phase # 5 Recession:

It should be remembered that recession brings cumulative effect in the market. Once a recession
starts it goes on gathering momentum and finally assumes the shape of depression. In this period
the feeling of over optimism of the earlier period is replaced now by over pessimism
characterized by fear and hesitation on the part of the businessmen.

The failure of some businesses creates panic among businessmen. The banks also got panicky
and begin to withdraw loans from business enterprises. More business enterprises fail. Prices
collapse and confidence is rudely shaken.

Building construction slows down and unemployment appears in basic capital expenditures.
Unemployment leads to fall in income, expenditure, prices and profits. For example—In 1957-58
the recession in U.S.A. was a severe one.

Features of Business Cycles:

Though different business cycles differ in duration and intensity, they have some common
features which we explain below:

1. Business cycles occur periodically. Though they do not show same regularity, they have some
distinct phases such as expansion, peak, contraction or depression and trough. Further the
duration of cycles varies a good deal from minimum of two years to a maximum of ten to twelve
years.

2. Secondly, business cycles are synchronic. That is, they do not cause changes in any single
industry or sector but are of all-embracing character. For example, depression or contraction
occur simultaneously in all industries or sectors of the economy.

Recession passes from one industry to another and chain reaction continues till the whole
economy is in the grip of recession. Similar process is at work in the expansion phase, prosperity
spreads through various linkages of input-output relations or demand relations between various
industries, and sectors.

3. Thirdly, it has been observed that fluctuations occur not only in level of production but also
simultaneously in other variables such as employment, investment, consumption, rate of interest
and price level.

4. Another important feature of business cycles is that investment and consumption of durable
consumer goods such as cars, houses, refrigerators are affected most by the cyclical fluctuations.
As stressed by J.M. Keynes, investment is greatly volatile and unstable as it depends on profit
expectations of private entrepreneurs.
These expectations of entrepreneurs change quite often making investment quite unstable. Since
consumption of durable consumer goods can be deferred, it also fluctuates greatly during the
course of business cycles.

5. An important feature of business cycles is that consumption of non-durable goods and services
does not vary much during different phases of business cycles. Past data of business cycles
reveal that households maintain a great stability in consumption of non-durable goods.

6. The immediate impact of depression and expansion is on the inventories of goods. When
depression sets in, the inventories start accumulating beyond the desired level. This leads to cut
in production of goods. On the contrary, when recovery starts, the inventories go below the
desired level. This encourages businessmen to place more orders for goods whose production
picks up and stimulates investment in capital goods.

7. Another important feature of business cycles is that profits fluctuate more than any other type
of income. The occurrence of business cycles causes a lot of uncertainty for businessmen and
makes it difficult to forecast the economic conditions.

During the depression period profits may even become negative and many businesses go
bankrupt. In a free market economy profits are justified on the ground that they are necessary
payments if the entrepreneurs are to be induced to bear uncertainty.

8. Lastly, business cycles are international in character. That is, once started in one country they
spread to other countries through trade relations between them. For example, if there is a
recession in the USA, which is a large importer of goods from other countries, it will cause a fall
in demand for imports from other countries whose exports would be adversely affected causing
recession in them too. Depression of 1930s in USA and Great Britain engulfed the entire capital
world.

Limitations:

The real business cycle theory relies on three assumptions which according to economists such
as Greg Mankiw and Larry Summers are unrealistic:

1. The model is driven by large and sudden changes in available production technology.
Summers noted that Prescott is unable to suggest any specific technological shock for an actual
downturn apart from the oil price shock in the 1970s. Furthermore there is no microeconomic
evidence for the large real shocks that need to drive these models. Real business cycle models as
a rule are not subjected to tests against competing alternatives which are easy to support.
(Summers 1986)

2. Unemployment reflects changes in the amount people want to work. Paul Krugman argued
that this assumption would mean that 25% unemployment at the height of the Great Depression
(1933) would be the result of a mass decision to take a long vacation.
3. Monetary policy is irrelevant for economic fluctuations. Nowadays it is widely agreed that
wages and prices do not adjust as quickly as needed to restore equilibrium. Therefore most
economists, even among the new classicists, do not accept the policy-ineffectiveness proposition.

Another major criticism is that real business cycle models cannot account for the dynamics
displayed by U.S. gross national product. As Larry Summers said: "(My view is that) real
business cycle models of the type urged on us by [Ed] Prescott have nothing to do with the
business cycle phenomena observed in the United States or other capitalist economies." —
(Summers 1986)