Real Business Cycle

New Keynesian
Theory Name: Bodhiswattwa Chakraborty
Semester: IV

C.U Reg No: 313-1111-0485-20

C.U Roll No: 203313-21-0091

 Index
Framen Q1 update

• Theory of Real Business Cycle Theory

• Explain RBC: Teach me like I'm five
• New Keynesian Economics
• Keynesian approach to Business Cycles
• Keynesian Business Cycle Theory
The Theory of Real Business Cycle

• All prices are flexible even in short run :

1. Therefore money is neutral in short run

2. Classical Dichotomy holds at all times

• Fluctuations in output, employment and other

variables are optimal responses to to exogenous
changes in the economic environment

• Productivity shocks are the primary cause of economic

fluctuations
ELI5: Real Business Cycle
The Economics of Robinson Crusoe

• Economy consists of a single producer - consumer, like Robinson Crusoe on a desert Island

• Mr Crusoe divides his time between

1. Leisure
2. Working: A) Catching Fishes (Production) B) Making Fishing nests (Investment)

• Crusoe optimizes given constraints he faces

Shocks in the Crusoe Island Economy: Part I

•
Big school of fish swims by the island

•
GDP rises:
Crusoe fishing productivity is higher

Crusoe 's employment rises as he decides to take some

leisure to fishing to take advantage of high productivity
Shocks in the Crusoe Island Economy: Part 2

• Big storm hits the island

•
GDP Falls:

• The storm reduces productivity, so Crusoe spend less

time fishing for consumption

• Investment falls as it doesn't make any sense for making

fishing nests in a storm

• Employment falls: Since he is not spending as much time

fishing or making nets, Crusoe decides to enjoy more
leisure time
Economic Fluctuations as optimal responses to shocks

In Real Business Cycle Theory fluctuations in our economy are similar to those in Crusoe's economy

The shocks are not always

desirable but once they occur,
fluctuations in output, employment
and other variables are optimal
responses to them
New Keynesian Economics
•
Most Economists believe that short-run fluctuations in output and
employment represent deviations from natural rate, and these
deviations occur because wages and prices are sticky

•
New Keynesian research attempts to explain the stickiness of wages
and prices by examining microeconomics of price adjustment

•
Attempts to build Keynesian arguments based on rational
expectations
Keynesian approach to
Business Cycle
•One of the central ideas of Keynesism is that wages and prices
are “rigid” or “sticky”.

•Wage and price rigidities imply the economy can be away

from its general equilibrium for significant periods of time.

•Keynesians: the stabilization policy is necessary to minimize

recessions.

New Keynesians: the stabilization policy is not necessary

•In developing their approach Keynesians heavily rely on wage

and price rigidities.

•Nominal-wage rigidity is a situation when nominal wages are

slow to adjust to changes in labour demand and supply.
Keynesian Business Cycle Theory
•Keynesians believe that a primary source of business cycle fluctuations is
unanticipated shifts in the aggregate demand curve – aggregate demand
LRAS
shocks.

SRAS0
•Keynesians attribute recessions to “not enough demand” for goods.

E
SRAS1
•The Keynesian theory accounts for several business cycle facts: P0

–recurrent fluctuations of Y in response to AD shocks P1

F
–employment fluctuates in the same direction as Y P2

–shocks to M are non-neutral, money is procyclical and leading. H

ADe

AD1
•Cyclical behaviour of durable and investment goods can be explained if
shocks to them are themselves a main source of cycles.

•Inflation tends to slow during or just after recessions because demand

pressure is low during recessions.
Thank You