Business Cycles Explained: Real Business Cycle Theory

Business Cycles Explained: Real Business Cycle Theory


Economists call it real business cycle theory,
but maybe that’s a funny name for lay people. What it really means is that business cycles
are often caused by negative shocks to technology. Let’s make that more concrete. Let’s say
you’re back in the year 20,000 BC and there’s a bad harvest. A lot of people starve; a lot
of people die; a lot of people are a lot poorer. That’s a very simple example of what is
called real business cycle theory. Now today agriculture isn’t as important
for economies as it was back then, so typically it’s an increase in the price of oil that
causes a real business cycle. So if you go back to the 1970s, the OPEC cartel significantly
pushed up the price of oil. There was a big energy squeeze. A lot of companies started
producing less; as a result their workers spent less money. There was less economic
activity. That, too, is an example of real business cycle theory. [Real Business Cycle Shocks] In the simplest real business cycle model
you start with one negative event or one negative shock, like think of the recent earthquake
and tsunami in Japan. So that has an initial round of negative effects. Some people are
killed. Some homes are destroyed. Many people have less wealth. And then throughout the
economy, prices and work decisions and investment decisions, is a kind of spreading ripple effect
through which this initial negative shock becomes a negative shock to many other sectors
and even parts or economic sectors of Japan that were not hit by the earthquake and tsunami.
And the core mechanisms of real business cycle theory are to explain how the initial negative
shock spreads and propagates itself. That’s really what the theory consists of. [What Is a Technology Shock?] Economists use the word technology in a slightly
funny way. We call it a technology shock if some event happens and the economy can’t
produce the goods and services that it produced in the past. So it’s not that anyone has
forgotten how to make ice cubes, just like the old joke I heard when I was a kid. But
rather, if there’s an earthquake or an increase in the price of oil or maybe a bad harvest,
this restricts the economy’s ability to create a lot more goods and services. [Strengths & Weaknesses] Well, the biggest strength of real business
cycle theory is that it applies to 99 percent of all business cycles in human history. That’s
pretty good for a theory. How many other theories can say that? That said, starting from the
20th century onwards, real business cycle theory is in many cases less applicable than
an aggregate demand model, because you have to ask often, where are these negative technology
shocks? How big and how negative can the technology shock be? With Japan maybe it’s the earthquake in
the 1970s or maybe it was the higher price of oil. If we look at the recent recession,
what was it? Some people say it’s the banking crisis and the real estate crisis itself.
Maybe. In my opinion, the very worst business cycles are caused when Keynesian factors and
negative real shocks actually come together.

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About the Author: Oren Garnes

51 Comments

  1. Its not really a cycle, so much as resulting effects. Cycle just makes it sound like it will get better.

  2. They do get better. Prior to 1929 the US and World as a matter a fact had an economic downturn every decade on average and came out within about 1 – 3 years. Throughout those decades the economies boomed, new technologies were invented, and peoples lives improved. The downturns actually weed out weaker, less efficient, and outdated industries. The resources not used on them are then saved and later used to expand the necessary industries that survived and potentially new burgeoning industries.

  3. What has caused economies to stay in slumps for long periods of time like the Great Depression, or the mess were in now is government. Usually monetary policy that creates a false sense of wealth. This leads to out dated and weaker industries to consume more resources than necessary. This leads to larger bubbles and a false sense of security. Then an event causes people to realize things aren't as valuable as they are and causes a crash. The crash is then harder hitting and longer lasting.

  4. Another way government prolong downturns is direct government policy. They create new taxes, regulations, and laws. This hurts individuals particularly wealth creators by taking their wealth via taxes, creating restrictions, through rules and regulations, making goods and services more expensive via the first two. If government is changing the rules this also creates more uncertainty because no one knows how the rules have, or are going to change, there is less spending and expansion by business

  5. I cannot agree one can reasonably put all of what you said together. Most people will accept any one of those excuses. But if there are consequences every time the numbers are faked to begin with, then why do it? If its such a mystery, then preventive or standby action should be ready. But there is no mystery and its ridiculous to suggest that obvious results from clearly deliberate actions are some sort of uncontrollable formula. Financial struggles are not universal.

  6. So what happens when abundance and frugality shock the system? Consumer trends.

    I mean I would like to learn more about non-farm jobs and how they change during recessions.

  7. I mean besides increases in crime. Is it largely government hands off policy or do they tax more. That sort of thing?

  8. I don't know how many times I am going to have to watch these videos; learning macro economic theories with that background music pulls my shades closed.

    LearnLiberty, keep them coming. Knowledge is power.

  9. To all people stressing on monetary theory:

    Business cycles occurred before banks and money.

    That being said… I still support good and wise monetary policy.

  10. To say 'real business cycle theory' applies to 99% is misleading imo; there are plenty of natural disasters and technology shocks that don't cause a significant business cycle, so the effect of this shock, even if it applies everywhere, is minor compared to policy factors. In particular monetary policy, which effects the whole economy, all human action, through monetary supply and demand. Therefore, the Austrian BCT is much more conducive to understanding business cycles than this 'real' one.

  11. To follow up on my other reaction; We can therefore learn more from the ABCT, the mistakes made, than from the RBCT, which can hardly be prevented anyway. Stressing the importance of the RBCT therefore masquerades from the real policy mistakes made and the improvements that can made as a result of that.

  12. Lots of government policies have the exact opposite effect from their official objectives. That's precisely the problem with central banking. Compare price stability under the gold standard with price 'stability' under central banking and you'll be more perplexed.

  13. Wars and natural disasters have a temporary effect on the economy. The real problem causing boom and bust cycles is speculation in land values. No matter how efficient and productive an economy becomes the end result is rising land values. As values rise more and more cash is withdrawn from the economy and directed toward land speculation. Investing in land does not create more land but it does starve the productive economy of cash. Solution: the rental value of land must first be recaptured.

  14. "Business cycles occurred before banks and money."

    That is mostly true. But before banks and money, they could pretty much always be explained by some specific event.

    After _paper_ money and banks (i.e. credit money) then we started to get business cycles that were hard to explain by pointing to some specific event.

  15. Exactly. The financial sector and credit plays an essential role in determining output, unemployment, inflation, etc in an economy. Real business cycle theory is, in fact, very unreal.

  16. OPEC didn't increase their prices because they wanted to, but because We fully decoupled from the gold standard.

    The combination of inflation (on our part) and fear (on theirs) was the result.

  17. Well yea, RBC theory is a load of crap–to say that nominal output always maximizes the expected utility is just absurd. Suppose you have an economy with 15 players that all interact with each other, the amount of possible interactions at any given point are 15!–the amount of complexity increases at a rate faster than an exponential curve. Ergo, the calculations required to allow everyone to maximize utility become impossible due to the complexity.

  18. Anytime you have some sort of theory that has some sort of utility maximization by either individuals or by the market as a whole, it is just garbage. Economies cannot work if they rely on people maximizing utility; the complexity blows up.

    The reason that business cycles occur, I think, has to do more with the changes in the amount of credit issued. I think people need to look to Minsky and Keynes more.

  19. I can agree with that. The model we have set up in the federal government is far from what Keynes envisioned, contrary to what the Austrians believe. At least we're out of this liquidity trap.

  20. When I say money, I'm specifically meaning legal tender officially backed by the government.

    Gold was a popular medium of trade because it was common and people universally understood the value of gold but it wouldn't be for awhile until it was legally backed by the government as a form of currency.

  21. Shocks are terrible, of course. However, boom-to-bust cycles occur every 18-20 years linked to property market dynamics. Easy and cheap credit accelerate and exacerbate the level of speculation in land markets. And, speculation is profitable because of the very low effective rate of taxation on the rent of land. Near the end of the cycle prices climb to heights that stress users of land in all its forms. See the writing of Mason Gaffney at UC for a full explanation.

  22. Actually it is not 15! in the case you described. The case you described, 15 people, each person having one interaction with all the others is described by a model called a complete graph in graph theory. A complete graph with N vertices (people) has [n(n-1)]/2 edges (interactions). The people-interaction complexity is O(n^2) not O(n!). A polynomial time algorithm is still infeasible for real time computation though.

  23. Keynes and the Austrians agreed a lot more than people give them credit. The focus is always on what is different. Keynes believed in the Austrian theory during times of full employment. (defined as unemployment rates below 5%) Some use Keynesian theory to justify wreck-less spending behavior.

  24. The one failure, IMO, with Keynesian economic theory, is that's focus is on the cure and not the vaccine. The solution, IMO, is to have a more restrictive lending policy during good economic times. The reason why, is that things like tech booms are often short lived and once the economy returns to normal, everything crashes because people were expecting those high rates of return to pay off their loans. I'm not recommending overly tigh lending practices, just tighter than under Bush/Clinton.

  25. Perhaps. I know Milton Friedman is considered a monetarist, however, and he distinctly disagreed with Keynes. Of course Friedman rejects the claim that he is or was a true monetarist. Friedman believed in a consistent monetary policy, where as Keynes was anything but consistent. He believed in doing much more in an economic crisis and much less when not in one. Friedman wanted to take the human element out of monetary policy by printing money either in fixed intervals or using economic triggers.

  26. True, we have to say Friedman is different from modern monetarist. And Keynes and the Austrians agreed on many things. Which is why Friedman disagreed with the Austrians as well (there are some other, methodological reasons of course).

  27. Definitely not a paleontologist. "Harvest" and "20,000 B.C." don't go together. Economic information seems solid though.

  28. to me this theory seems the least probable compared to the other-mentioned !!!
    The shock has to be pretty big one to disrupt society in a world wide scale !?

  29. 'Agriculture is not a key part of economies today'….rightttttt bit of a sweeping statement there but great video

  30. Of course, there are frequent shocks to production of good and services. Natural disasters and warfare are two of the major types of shocks. And yet, these shocks are really externalities to the systemic structure of the production AND DISTRIBUTION of wealth. As Joseph Stiglitz has tried to tell us repeatedly over the last four or five years, our systems of property law and taxation have created an entrenched rent-seeking elite able to claim as their own what others produce without producing anything in exchange.

  31. Some professions are going extinct because of advanced technology. As a result some people lose their jobs, got no money to cover their expenses like before and this will make aggregate demand lower. What do u think?

  32. Покажу, каким образом легко получать пару раз в день до 85 долларов на свою карту. Изучите вuдео у меня кaналe

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