Business Cycle


Real Business Cycle theory - Business cycles



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Real Business Cycle theory - Business cycles

  • Figure 1 shows the time series of real GNP for the United States from 1954-2005



Real Business Cycle theory - Business cycles

  • Economists refer to these cyclical movements about the trend as 'business cycles'



Real Business Cycle theory - Business cycles

  • We call large positive deviations (those above the 0 axis) peaks. We call relatively large negative deviations (those below the 0 axis) troughs. A series of positive deviations leading to peaks are booms and a series of negative deviations leading to troughs are recessions.



Real Business Cycle theory - Business cycles



Real Business Cycle theory - Business cycles

  • We might predict that other similar data may exhibit similar qualities



Real Business Cycle theory - Stylized facts



Real Business Cycle theory - Stylized facts

  • Another regularity is cyclical variability. Column A of Table 1 lists a measure of this with standard deviations. The magnitude of fluctuations in output and hours worked are nearly equal. Consumption and productivity are similarly much smoother than output while investment fluctuates much more than output. Capital stock is the least volatile of the indicators.



Real Business Cycle theory - Stylized facts



Real Business Cycle theory - Stylized facts

  • Observing these similarities yet seemingly non-deterministic fluctuations about trend, we come to the burning question of why any of this occurs. It’s common sense that people prefer economic booms over recessions. It follows that if all people in the economy make optimal decisions, these fluctuations are caused by something outside the decision-making process. So the key question really is: what main factor influences and subsequently changes the decisions of all factors in an economy?



Real Business Cycle theory - Stylized facts



Real Business Cycle theory - Stylized facts

  • But exactly how do these productivity shocks cause ups and downs in economic activity? Let’s consider a positive but temporary shock to productivity. This momentarily increases the effectiveness of workers and capital, allowing a given level of capital and labor to produce more output.



Real Business Cycle theory - Stylized facts

  • Individuals face two types of tradeoffs



Real Business Cycle theory - Stylized facts

  • The other decision is the labor-leisure tradeoff



Real Business Cycle theory - Stylized facts

  • Overall, the basic RBC model predicts that given a temporary shock, output, consumption, investment and labor all rise above their long-term trends and hence formulate into a positive deviation



Real Business Cycle theory - Stylized facts

  • It is easy to see that a string of such productivity shocks will likely result in a boom. Similarly, recessions follow a string of bad shocks to the economy. If there were no shocks, the economy would just continue following the growth trend with no business cycles.



Real Business Cycle theory - Stylized facts



Real Business Cycle theory - Stylized facts

  • It follows that business cycles exhibited in an economy are chosen in preference to no business cycles at all



Real Business Cycle theory - Stylized facts

  • A pre-cursor to RBC theory was developed by monetary economists Milton Friedman and Robert Lucas in the early 1970s. They envisioned the factor that influenced people’s decisions to be misperception of wages—that booms/recessions occurred when workers perceived wages higher/lower than they really were. This meant they worked and consumed more/less than otherwise. In a world of perfect information, there would be no booms or recessions.



Real Business Cycle theory - Calibration

  • Unlike estimation, which is usually used for the construction of economic models, calibration only returns to the drawing board to change the model in the face of overwhelming evidence against the model being correct; this inverts the burden of proof away from the builder of the model






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