Question

Discuss the main ideas and assumptions underlying the basic theory of real business cycles (RBC). Explain and discuss the arguments for and against the RBC approach

Answer 1

Ideas and assumption of basic theory of RBC:

• Real business cycle theory says that business cycles are created by the real shocks such as change in technology and productivity. Nominal changes in economic variables do not affect or cause business cycles.
• According to RBC theory, market forces work most efficiently and market failures are not witnessed.

Arguments for:

• It created micro foundation. All movements at micro level are motivated by micro decisions.
• Money does not matter. Only real factors account for changes in output.

Argument against:

• Proposition of ineffectiveness of monetary policy does not match with current empirical evidences that suggest effectiveness of monetary policy in dealing with economic misfortunes.
• This model is guided by the sudden changes in production and technology but it does not provide informed and rational explanation for economic downturn.