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.