LOS 25g Describe mainstream business cycle theory and real business cycle RBC theory and distinguish between them including the role of productivity changes

There are two main schools of thought on the causes of business cycles. The mainstream view is that business cycles are caused by the variability of aggregate demand. Potential real GDP is believed to increase at a fairly stable rate over time. If aggregate demand increased at a steady rate as well, we would not observe business cycles of the magnitude that we do. In fact, however, aggregate demand sometimes grows more rapidly, and sometimes more slowly, than LRAS (potential GDP).

If aggregate demand grows more rapidly than LRAS, short-term equilibrium is along the short-run aggregate supply (SAS) curve at an output higher than potential full-eniployment GDP and a price level higher than the long-run equilibrium level. Unemployment is temporarily low, employment is temporarily over the full-employment level, and there is an inflationary gap. If aggregate demand grows more slowly than potential GDP, the new short-run equilibrium is at a level of output less than potential Ci!)l', unemployment rises, and there is a recessionary gap.

These two situations are illustrated in Figure 7. An increase in potential GDP to l.RAS. can be accompanied bv an increase in aggregate demand to AD,, in which case employment and output increase to the new long-run equilibrium level. GDP,. Alternatively, if the growth of aggregate demand is less (AD^), output and employment arc reduced and an economic contraction mav result. If the «rowth of asirresrate demand o DO O

is high (greater than the increase in potential GDP), as with ADH, the expansion in the economy is temporarily more rapid than the increase in potential GDP, and employment and output increase to the level labeled GDI',,.

Figure 7: Business Cycles, Mainstream View

"Why are there fluctuations in aggregate demand that lead to business cycles? Keynesian economists believe that these fluctuations are primarily due to swings in the level of optimism of those who run businesses. They overinvest and overproduce when they are tco optimistic about future growth in potential GDP, and undcrinvest and underproduce vvhen they are too pessimistic or fearful about the future growth of potential GDP.

Price Level

LRAS

SRS:

LRAS

SRS:

AD,

Not surprisingly, monetarist economists believe that the variation in aggregate demand that causes business cycles is due to variation in the rate of growth of the money supply, likely from inappropriate decisions by the monetary authority. To this supposition, we must add that wages, and possibly prices of other productive inputs, are "sticky" so that rapid shifts of the SAS curve do not occur as wages change in response to inflationary or recessionary gaps.

New classical economists believe that only unexpected changes in aggregate demand lead to economic cycles. New Keynesian economists stress the importance of workers' rational expectations (based on past inflation) about inflation rates in determining the position of the SAS curve. In their view, both expected and unexpected changes in aggregate demand fuel economic cycles.

An alternative school of thought with respect to business cycles is termed real business cycle theory and emphasizes the effect of real economic variables as opposed to monetary variables or variation in expectations about aggregate demand growth. Under this theory, due to improvements in technology, workers' productivity sometimes grows rapidly and sometimes more slowly. This leads to fluctuations in the growth rate of potential real GDP, as opposed to the assumption of a steady increase in potential real GDP underlying the mainstream business cycle theories explained above. Rapid increases in productivity lead to economic expansions and periods of slower increases in productivity lead to economic contractions.

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