Real business-cycle theory

The model of Real Business Cycles (RBCs) is a macroeconomics model formulated principally by Robert Lucas Jr, building upon the ideas of John Muth. It is an example of New classical economics.

The assumptions underlying this model are the presence of representative rational agents possessing rational expectations. The model is usually stated in terms of one intertemporally optimising agent, whose actions can be seen as representative of all agents, and thus of the economy as a whole. (See representative agent.) Other implicit assumptions include the neutrality of money (this is implied by rational expectations). Lucas showed that under productivity shocks, business cycles would be generated within this model. This is because, if the productivity of an agent declines, their real income will also decline (this can be thought of in a Robinson Crusoe context - where the representative agent keeps all of their production - or within a perfectly competitive labour market, where workers are paid the value of their marginal product). Given intertemporal optimisation, the representative agent will optimally choose to postpone working until the next period (and instead consume leisure) when he rationally expects that the productivity shock will have disappeared and real wages will have risen again. Aggregation implies that a negative productivity shock will result in voluntary unemployment and a decline in economic activity and hence GDP. Therefore, the main conclusion of this model is that business cycles are entirely consistent with the efficient workings of a market economy; the movements of the economy are always Pareto efficient. There is no involuntary unemployment in this model. Furthermore, fiscal or monetary intervention into the economy will always be futile because, first, any action arising from a policy rule will be perfectly anticipated by agents with rational expectations; and second, unless the government has information unavailable to individual agents, it cannot improve upon market outcomes (and even if it did, it could simply release this information and hence let agents arrive at a Pareto-efficient outcome).

Criticisms of Real Business Cycles

The most obvious criticism is of the large number of heroic assumptions - those of rational expectations and representative agents (although the analysis will work equally well with perfectly competitive product and asset markets, assuming no missing markets - which is also a huge assumption). See the relevant pages for criticisms of these assumptions.

Real business cycle theory also suffers from conclusions which most observers find unrealistic; denying the existence of involuntary unemployment and imposing neutrality of money, even in the short run. It is also argued that productivity shocks are not large enough, nor of sufficient duration, to explain the prolongued recessions that are witnessed in almost all economies around the world.