1. Real Business Cycle Theory Theory developed by Edward Prescott and Finn Kydland (Nobel laureates 2004)

2. Real Business Cycle Theory • This theory argues that productivity shocks to the economy are the primary cause of business cycles. • Productivity shocks propagate throughout the economy and affect the production function, employment, investment, as well as the spending and saving decisions of consumers. • They are also referred to as real shocks or supply shocks. 29

3. Deviations from trend in TFP • TFP may slowdown when no significant discoveries that affect production take place. • Measured TFP can also slowdown as a result of bad weather, or other exogenous events. • Changes in TFP growth are recurrent, and not necessarily predictable. (TFP deviations from trend are well described by a Markov process with persistence.)

4. Is the theory consistent with the data? • Qualitatively yes, but the RBC impulse (TFP changes) falls short of accounting for changes in GDP.

5. Propagation mechanism amplifies the impact of a shock to TFP growth • Two immediate effects follow from a change in productivity • Investment demand changes (which affects interest rates, capital accumulation, and ultimately GDP). • Capital utilization may also be affected (although capital utilization is also affected by other factors like energy price changes) • The demand for labor –labor force utilization- changes (which affects wages, hours worked, and ultimately GDP).

6. Propagation mechanism: Impact on GDP larger than original TFP shock • Capital and labor markets in a real business cycle recession.

7. Real Business Cycle Theory • A decrease in productivity lowers firms’ profit expectations and decreases both investment demand and the demand for labor.

8. Real Business Cycle Theory • The interest rate falls.

9. Real Business Cycle Theory • The lower the real interest rate lowers the return from current work so the supply of labor decreases.

10. Real Business Cycle Theory • Employment falls by a large amount and the real wage rate falls by a small amount.

11. Summary of RBC theory • Shocks to productivity growth are the main force driving business cycle fluctuations (accounting for 2/3 of the total volatility). • Expansions and recessions are not necessarily caused by market failures. • Policy implications: The role of the government is to provide an environment that promotes TFP growth. Direct government interventions to smooth the cycle may be counter productive.