The genuine business-cycle perspective

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For the new classical macroeconomics school of thought, business-cycle fluctuations are explained by
real (as opposed to nominal) shocks; this school of thought is known as real business-cycle theory (RBC
theory).

[1] In contrast to competing business cycle theories,[citation needed] According to RBC theory, business
cycle variations are an effective reaction to shocks in the real economy caused by external factors.
Therefore, governments should focus on long-run structural policy adjustments rather than intervening
with discretionary fiscal or monetary policy to actively smooth out economic short-term volatility, since
the level of national production inevitably optimises expected utility.

Therefore, economic cycles are "real" according to RBC theory because they reflect the most efficient
operation of the economy feasible given the structure of the system and not a failure of markets to
clear.

It is in the field of freshwater economics that RBC theory finds its natural home (the Chicago School of
Economics in the neoclassical tradition).

Contents

Number of business cycles

Two Fashionable Factualities

2.1 Calibration

Structural Variables 2.2

3 Criticisms

Also see (4)

5 References

Six more resources

Trends in the economy

There is no way to predict how an economy will look like in the future just looking at pictures taken at
different times. There are two causes for this phenomenon:

Growth rates in many developed economies have been rather stable over time. In other words,
comparing two time periods separated by decades would show increased economic activity during the
latter.

There are oscillations around this increasing pattern, but they seem to occur at random. Given two time
snapshots, it is therefore extremely difficult to foretell the future using the past.

Fig. 1
Looking at GDP growth rates over time is a frequent technique to spot this kind of pattern in economic
activity (GNP). The value of the goods and services created by a country's enterprises and workforce.

The actual Gross National Product (GNP) of the United States from 1954 to 2005 is depicted in Figure 1.
While output is increasing, it is not growing steadily. Every economy has periods of rapid expansion and
contraction. In Figure 2, we see this data after it has been transformed into real GNP growth rates, from
which a smoother growth trend has been extracted. The Hodrick-Prescott filter is often used to generate
this pattern. Since long-term growth rate is unlikely to be exactly constant, the objective is to strike a
compromise between the degree to which the overall growth trend follows the cyclical movement and
the degree to which it is smooth. The HP filter sorts the more choppy swings into the cyclical component
and the smoother ones into the growth trend.

CONCEPTUAL DRAWING NO. 2

Take note of how the jerkier data contrasts with this component of increase. Business cycles are what
economists call these recurrent fluctuations around a trend. These variations are shown directly in
Figure 3. Take note of the zero point on the horizontal axis. If a given year falls exactly on this line, it
means that there was no significant change from the norm that year. Any other data points outside of
the specified range are considered outliers. Using log real GNP, the proportion of discordance from the
long-term growth trend is essentially equivalent to the distance between any point and the 0 line. Please
take note that the Y-axis has extremely tiny numbers. This suggests that variations in true GNP are
rather minor and might be the result of measurement mistakes rather than genuine changes.
CIRCUIT 3

Large positive deviations (those that lie above the 0 axis) are known as peaks. Large negative deviations
(below the 0 axis) are referred to be troughs. Booms are characterised by a string of positive deviations
followed by a peak, whereas recessions are the result of a string of negative deviations followed by a
trough.

To the untrained eye, the variations appear to be random and disorganised, like a collection of waves.
Because of these anomalies, it may seem hard to explain the underlying reasons of the variations. If we
look at other macroeconomic factors, though, we can see patterns in these deviations. Take Figure 4 as
an example; it shows how output and consumption expenditure (what individuals purchase and
consume) fluctuate over time. Look at how the peaks and valleys overlap and how the ups and downs
occur at roughly the same times.

Pictorial Representation No. 4

If we have similar data, we may speculate that it will have certain characteristics. For instance, (a)
labour, the number of hours worked, (b) productivity, the efficiency with which firms put such capital or
labour to use, (c) investment, the amount of money set aside for future endeavours, and (d) capital
stock, the market value of the machines, buildings, and other equipment used by businesses to make
their wares. Figure 6 demonstrates a different relationship with capital than Figure 5, which displays a
comparable tale for investment. We need a method to more precisely pinpoint the story, and one way
to achieve so is to examine the data.
SECTION 5

SITUATION 6

A presentation of the facts in a literary style

Several patterns, sometimes known as stylized facts, may be inferred just by looking at the data. One of
these is tenacity. It is quite likely that the following period will also be above the trend if we pick any
point in the series that is above the trend (the x-axis in figure 3). This doggedness, though, eventually
wanes. That is, short-term economic activity is very predictable, but long-term forecasting is extremely
challenging, if not impossible, due to the erratic nature of variations.

A further pattern is cyclical variation. There is a measurement of this in the form of standard deviations
listed in Column A of Table 1. Changes in both production and hours worked are very similar in size. The
fluctuations in investment are substantially larger than those in production, whereas consumption and
productivity are much more stable. The level of capital stock shows the least variation among the
metrics.

TABLE 1

The correlation between production and other macroeconomic indicators also tends to be true. The
connection was depicted in Figures 4–6. Correlations, as seen in Table 1, Column B, allow us to get a
better sense of this. Since procyclical variables often grow during expansions and shrink during
contractions, they tend to have positive correlations. In contrast, a negative correlation characterises a
countercyclical variable. An acyclical variable is one having a low association to the business cycle. The
production seems to be slightly procyclical. Because of this, it may be concluded that labour and capital
are most productive during times of economic expansion. When the economy is in a slump, they are not
quite as productive. Consumption and investment, which are highly procyclical, follow a similar logic.
Although capital appears to be acyclical, labour is procyclical.

The issue of why these parallels exist with seemingly random changes in trend emerges. If everyone in
the system makes the best judgments possible, then economic booms and busts must be produced by
factors other than people's preferences. So, the critical inquiry is this: what central factor primarily
impacts and subsequently modifies the decisions of all elements in an economy?

Numerous theories have been proposed by economists in an effort to address this subject. Finn E.
Kydland and Edward C. Prescott established the one that is presently dominant in the academic
literature on real business cycle theory[citation needed] in their 1982 book Time to Build And Aggregate
Fluctuations. They assumed that technology shocks, or unexpected changes in the rate of productivity,
would play a role in this. Innovations, severe weather, the rising cost of imported oil, new legislation for
environmental protection and worker safety, etc. are all examples of shocks that might occur.
Something happens that has an immediate and decisive impact on the efficiency of capital and/or
labour. Worker and company decisions are influenced, leading to shifts in consumption and production
patterns, which in turn affect output. Time series allocation for consumption, investment, etc. is
predicted by RBC models in light of these shocks.

The question is how these "productivity shocks" lead to cyclical increases and decreases in economic
activity. Think of a boost in productivity that is short-lived yet welcome. For a limited time, this boosts
the efficiency of both labour and capital, allowing the same amount of resources to generate greater
output.
There are two distinct compromises that people must make. The choice between spending and saving is
one example. When productivity rises, so does the amount of goods and services available to
consumers. Maybe you want to eat it all right now. All that extra output might not be worth it if he
places a high value on future consumption. Alternatively, he may save some of his income and put it
toward capital improvements that will boost output and income in future time periods. In light of this, it
seems sense that investment expenditure is more erratic than consumer spending. Households,
according to the life-cycle theory, "smooth" their spending over time because they take into account
their predicted lifetime income. Therefore, they will save (and maybe invest) during prosperous times
and put off spending during leaner times.

The choice between work and play is the other. Since employees will earn more per hour today than
tomorrow, higher productivity encourages replacement of present labour for future work. Today's
increased productivity is a direct outcome of people working more and having less free time. higher
expenditure and investment at the present time. Yet there is a countervailing influence: workers may be
less motivated to put in extra hours now and in the future if their wages have increased. Given the
cyclical character of the labour market, however, it appears that the substitution effect described above
has a greater impact on household income.

Under the assumption of a short-term shock, the fundamental RBC model forecasts an increase in
output, consumption, investment, and labour relative to their respective long-term trends. In addition, a
temporary shock may have long-term consequences since more investment implies more money is
accessible for the future. That is, the out-of-the-norm conduct may persist for a while after the shock
has faded. Investment in fixed assets is sometimes referred to as a "internal propagation mechanism"
since it can make output shocks more long-lasting.

The economy will likely flourish after a series of productivity shocks. Like booms, recessions occur after a
series of setbacks. Without unexpected events, economic development would continue unabated and
business cycles would be eliminated.
Calibration procedures were developed by Kydland and Prescott to bring tabular data into line with its
stylised representation in Table 1. The model successfully captures a number of characteristics of the
business cycle using this way. However, existing RBC models do not adequately account for all
behaviours, thus neoclassical economists continue to look for new and improved variants.