UNIT 6 REAL BUSINESS CYCLES 

Structure
12.0 Objectives
12.1 Introduction
12.2 New Classical View on Business Cycle
12.3 Real Factors vs. Monetary Factors
12.4 A Baseline RBC Model
12.5. Inter-temporal Substitution in Labour Supply
12.6 Impact of Supply Shocks to the Economy
12.7 New-Keynesian View on Business Cycle
12.8 Let Us Sum Up
12.9 Answer/Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After going through this unit you would be in a position to
 describe the salient features of new-classical economics;
 outline the assumptions and methodology adopted by new-classical
economics on analysis of business cycles;
 bring out the important features of real business cycle theory;
 explain the inter-temporal substitution in labour supply;
 assess the role of supply shocks; and
 discuss the new-Keynesian approach to business cycle.

12.1 INTRODUCTION
In the previous Unit we mentioned that business cycles are synchronic in the
sense that the state of recession or boom is prevalent in most industries at the
same time. Further, certain variables are pro-cyclical while some others are
counter-cyclical. Examples of pro-cyclical variables are output, employment,
wages and consumption expenditure. Examples of counter-cyclical variables are
unemployment, company profits, and stock market prices.


Dr. Jagannath Mallick, Independent Researcher, Delhi and Prof. Kaustuva Barik, IGNOU
There is no consensus among economists about the reasons behind business Real Business Cycles

cycles. According to Keynes (1936) fluctuations in investment (and therefore

employment) is caused by ‘animal spirit’, a sort of human emotion. Fluctuation
in output gets amplified due to the effect of ‘investment multiplier’. Samuelson
(1939) showed that the interaction of multiplier and accelerator leads to business
cycles. According to Austrian economist Joseph A. Schumpeter (1961), business
cycles are an outcome of the process of innovation and technological change; a
process called ‘creative destruction’. Schumpeter emphasises on the role of
entrepreneurs, who undertake innovation – they bring in new technology which
disrupts existing production processes. Such disruptions in an economy lead to
substantial fluctuations in employment and output. There have been several other
theories of business cycles which we have not included in the previous Unit.
Richard Goodwin (1967), another heterodox economist, ascribes business cycles
to the fluctuations in the share of workers in total output. During the boom phase
of business cycle, rising employment leads to higher wages, rise in bargaining
power of workers, and increase in the share of wages in revenue. This leads to
decrease in profit share, decrease in accumulation of capital, and consequent
decline in employment. Eventually the rise in unemployment leads to fall in the
share of wages in revenue, consequent recovery of profits, and increase in
accumulation. In sharp contrast to Keynes, Milton Friedman considered the
changes in money supply to be the major reason behind business cycles.
According to Friedman, a free market economy is inherently stable. The
fluctuation in money supply causes business cycles in an economy.
New classical economists followed the monetarist tradition and emphasized on
monetary factors. They introduced rational expectations and microfoundation in
macroeconomic analysis. According to them monetary shocks causes business
cycles in an economy. The real business cycle theory, however, brings back the
importance of real factors such as productivity shocks to explain business cycle.
In this Unit we begin with new-classical view on business cycle and subsequently
move on to real business cycle theory. We will conclude the Unit with a note on
new-Keynesian view on business cycle.

12.2 NEW-CLASSICAL VIEW ON BUSINESS CYCLE

During the 1950s and 1960s Keynesian economics was very popular – its policy
prescription was acceptable to researchers as well as policy makers. Milton
Friedman, however, challenged Keynesian economics during that time.
According to Friedman, changes in aggregate income are explained mostly by
monetary policy. Had the government taken recourse to open market operations
and redeemed bonds and securities during the Great Depression, money supply
would have increased and the adverse impact would have been lesser. Further,
Friedman disagreed with the inflation-unemployment trade-off as suggested by
the Phillips Curve. He introduced expectations into the analysis, and pointed out
that the Phillips curve is vertical in the short-run. The trade-off is possible only in

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Theories of the short-run; in the long-run, unemployment cannot be brought down below the
Business Cycles
natural rate of unemployment.
The onset of stagflation during the 1970s further consolidated the dissent on
Keynesian economics. New-classical economics, led by Robert Lucas and
Thomas Sargent, brought in a revolution in macroeconomics. New-classical
economists revived the classical ideas; the analytical tools however were
different. Thus, new-classical economics is completely opposed to the Keynesian
policy prescriptions.
New-classical economics is based on three assumptions: (i) rational expectations
hypothesis, (ii) continuous market clearing, and (iii) the aggregate supply
hypothesis. People have rational expectations; they can correctly anticipate the
effect of government actions; and they take counter-measures to neutralise the
impact of government policy. A major inference drawn by new-classical
economics is that policy measures taken by the government are ineffective. Only
unexpected policy shocks lead to temporary deviations in output and employment
from their natural levels. The second assumption states that markets clear at any
point of time. An implication of the above is the equality between demand and
supply, and the economy is in a state of equilibrium always. New-classical
economics assumes flexibility in wage rate and prices. Further, adjustments in
prices and wages are instantaneous. You may be wondering how the labour
market can clear (i.e., there is no unemployment)! This in fact is a debatable
assumption of new-classical economics – according to new-classical economists,
unemployment is a voluntary phenomenon. At the ongoing wage rate anybody
who is willing to work gets employed. The third assumption states that the supply
of labour by workers and the supply of output of firms depend upon relative
prices. This is the famous Lucas supply function discussed in Unit 7.
Three prominent features of new-classical economics are as follows: (i)
microfoundation, (ii) dynamic stochastic general equilibrium, and (iii)
quantitative calibration of the economy. Microfoundation means that
macroeconomic phenomena are explained through the behaviour of
microeconomic agents such as households and firms. For example, the decision
of a household is based on its utility function while that of a firm is based on a
production function. New-classical models are based on dynamic stochastic
general equilibrium (DSGE). As the name suggests, these are ‘general
equilibrium models’ in the sense that they pertain to the whole economy. The
word ‘dynamic’ reflects the idea that these are inter-temporal models and
economic agents optimise on their decision-variables over time. Thus, DSGE
models involve the issue of ‘dynamic optimisation’ (See MEC-203, Block 7). As
you know, the economy receives various types of shocks, viz., demand shocks,
supply shocks and policy shocks, which are exogenous. These shocks are
assumed to be random in nature; thus these models are ‘stochastic’. In simple
186 DSGE models there are three inter-related blocks (set of equations), viz., (i) a
demand block, (ii) a supply block, and (iii) a monetary policy equation (for Real Business Cycles

example, policy rule). The equations included in these blocks are derived from
micro-foundations.
In order to describe the economy, new-classical economists use the method of
calibration. The DSGE models require solution to a set of inter-related dynamic
optimisation problems. Here households and firms make decisions on the basis of
current and expected future paths for prices and policy variables. This is a
challenging task as data are not easily available for longer time periods.
Therefore, in DSGE models researchers make extensive use of numerical
iteration, so as to replicate the economy. The researcher chooses (from past
studies) a set of parameters to describe the utility function and production
function. In the process, they rely on model simulation and take parameter values
that best fit the empirical data. Such a procedure of comparing the model output
with empirical data is called calibration. Remember that calibration is different
from estimation used in econometrics.
A question arises at this point: Why do employment and output fluctuate in an
economy, if there is market-clearing all the time? In other words, why do
business cycles occur? According to new-classical economics, there are two basic
reasons: (i) inter-temporal substitution between labour and leisure, and (ii) Lucas
supply function. If the actual real wage rate is higher than the expected real wage
rate, the household substitutes leisure by labour – thereby working for higher
number of hours in a day. In the process it supplies more labour. Thus, there is an
increase in supply of labour, which leads to an increase in output (higher than the
potential output). As pointed out above, changes in employment are treated as
voluntary choices of workers – the amount of labour supplied by households
depends upon their rational expectations about real wages. The ‘Lucas Supply
Function’ suggests that firms suffer from signal extraction problem and mistake a
general price rise as a relative price rise. When there is a general price rise, there
is no relative increase in prices of the products produced by a firm, as the cost of
production also has gone up. However, firms often see that there is an increase in
the prices of their products and they increase their production. Thus, there is a
(positive) deviation in employment and output from their natural levels. This
leads to a boom or expansion phase in the economy.
Let us take the opposite scenario. Suppose, households perceive that the actual
wages they receive is less than expected wage. As a response, households will
work less (enjoy more leisure) and supply less labour to the market. Decrease in
supply of labour will result in a (negative) deviation in output from its natural
level. If the firms perceive that there is a relative decrease in prices of their
products, they will decrease their output level. Such decline in output will lead to
a recession in the economy. Thus, while the economy is in equilibrium, there
could be fluctuation in employment and output.

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Theories of Check Your Progress 1
Business Cycles
1) What are the basic assumptions of new-classical economics?
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2) Explain the reasons put forth by new-classical economists for occurrence of
business cycles in an economy.
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12.3 REAL FACTORS VS. MONETARY FACTORS

Real business cycle (RBC) theory originated with the publication of a paper in
1982 by Kydland and Prescott entitled, “Time to Build and Aggregate
Fluctuations”. Kydland and Prescott stated that business cycle is not due to
fluctuation in monetary variables; rather it is caused by real shocks to the
economy. The RBC theory is a distinct class of new-classical macroeconomics.
Therefore, the basic assumptions and analytical tools of new-classical models are
applied in RBC models also. In fact, Kydland and Presott were the first to
characterise the general equilibrium of a full-fledged dynamic and stochastic
macroeconomic model.
There could be two types of shocks to the economy: (i) nominal shocks, and (ii)
real shocks. The nominal shocks (shocks to money supply or money demand)
affect the LM curve. The real shocks (shocks to the production function, real
government spending, or to savings and consumption decisions) affect the IS
curve. In other words, real shocks affect the goods market equilibrium and the
labour market equilibrium.
As the name suggests, the RBC models ascribe ‘real shocks’ as the prime reason
behind business cycles. The shocks to the production function are known as
supply shocks or productivity shocks. Supply shocks can arise due to the
following reasons:
(i) development of new products or production methods (production
technology)
(ii) changes in the quality of labour or capital
(iii) changes in the availability of raw materials (relative prices, oil crisis)
(iv) unusually good or bad weather (drought, flood, earthquake)

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 (v) changes in government regulations affecting production (tax rate, Real Business Cycles

subsidies, etc.)
The positive or beneficial productivity shocks result in economic booms,
whereas the negative or adverse productivity shocks cause recessions in an
economy. Let us discuss the effect of a temporary adverse supply shock on the
economy (see Fig. 12.1). There will be a decline in the marginal productivity
of labour, which will reduce the demand for labour. Consequently, there will a
fall in the real wage. Households will see that their real wage has declined and
they will supply lower quantity of labour. This will lead to a fall in the level of
output (consequently, a recession). A beneficial productivity shock, on the
other hand, would result in an economic boom. There would be temporary
hike in productivity in the economy. This will cause an increase in investment
and work effort in the current period. Consequently, both the real output and
consumption spending will be increased. Once the effect of the supply shock
dies down, the economy will be back to natural rate of employment and
output.

w
SL

w1
w2 D
D

L
L2 L1

Fig. 12.1: Effect of Temporary Adverse Supply Shock

The RBC theory is based on two basic principles: (i) money has little role to play
in business cycles, and (ii) business cycles occur as a response of rational
economic agents (firms and households) to real shocks. The economy is
continuously at equilibrium – the supply of labour and output are according to
rational expectations of economic agents.
The RBC theory has certain differences with new-classical economics. There are
at least three differences between the real business cycle theory and the new
classical school of thought: (i) the RBC theory does not distinguish between
short-run and long-run. It integrates theory of economic growth with business
cycle theory. (ii) Lucas advocated that households and firms get fooled – they
cannot extract correct signal from price changes in the economy. This results in
deviation of actual output from potential output. The RBC theory assumes that
households and firms have complete information. (iii) RBC theory assumes that
supply shocks arise from real factors while new-classical economics assumes that
shocks arise from monetary factors.
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Theories of The implications of RBC theory are as follows: (i) The government should not
Business Cycles
try to stabilise output level; it should try to stabilise prices (i.e., inflation should
be kept under control – inflation targeting). (ii) The government should not
influence aggregate demand through fiscal policy measures (taxes and subsidies),
as fiscal measures may not be effective (due to the issue of Ricardian
equivalence). (iii) The government should use fiscal policy to stimulate the
supply side of the economy (to provide positive supply shocks to the economy).
Real business cycle is criticised on certain grounds: Its assumption of
instantaneous market clearing is unrealistic. Prices and wages are rigid in an
economy. Further, there is little evidence of large aggregate technology shocks in
an economy.

12.4 A BASELINE RBC MODEL

Let us discuss how the fluctuations of aggregated macroeconomic variables can
be explained through a general equilibrium model. Recall from microeconomic
theory that the Walrasian model (a baseline general equilibrium model) is a
competitive model without any of the following: (i) asymmetric information, (ii)
externalities, (iii) missing markets, and (iv) other imperfections. If we can
explain macroeconomic fluctuations through a Walrasian model, there is no
fundamental departure from conventional microeconomic analysis. Real-
business-cycle theory aims to analyse how a Walrasian model provides a good
explanation of the nature and character of observed fluctuations.
The Ramsey model (see Unit 8) can be seen as a baseline general equilibrium
model. The model excludes market imperfections; and there is no heterogeneity
among households. It is based on microfoundation in the sense that it considers a
representative household and a representative firm. The representative household
consumes goods and services which are homogenous. Goods and services
produced in the economy are used for consumption by households as well as
investment by firms. The representative household supplies labour to the firm.
The household determines the quantity of labour to be supplied on the basis of a
utility function. Recall that in the Ramsay model an economy converges to a
balanced growth path and then grows smoothly.
Let us try to extend the Ramsey model to include aggregate macroeconomic
fluctuations. In the absence of shocks, the economy is on a steady state.
Therefore, we need to incorporate certain disturbance to the model.
Suppose that there is certain disturbance or shock to the economy. What will be
the impact of such shocks? Will the impact of the shock dissipate (die down)
after some periods or will it generate fluctuations in output in the economy? The
sources of shocks to an economy could be of two types: (i) there could be a shock
to the economy’s technology. The production technology of the economy
undergoes change. Such shocks will lead to a change in the production function
across periods. (ii) Change in government purchases also could be a source of
disturbance to the economy. These two types of shocks are real disturbances;
190 they are not monetary or nominal disturbances. The change in technology leads
to change in the amount of output produced from a given quantity of inputs. Real Business Cycles

Similarly, the change in government-purchases leads to change in the quantity of

goods that are available to the private economy for a given level of production.
Since the shocks to an economy are real factors, the models are known as real-
business-cycle (RBC) models.
We need to make a second modification in the Ramsey model – we allow for
change in employment. In the traditional business cycle theories, labour supply is
assumed to be exogenous; labour supply is either constant or growing smoothly.
As mentioned above, the RBC models are based on microfoundation such that
labour supply is determined by a utility function. Households allocate their time
between work and leisure – an increase in the time allocated to work implies an
increase in the supply of labour and a decrease in the quantity of leisure.
Let us assume that the economy consists of a large number of homogenous price-
taking firms and households. There are two inputs to the production function,
viz., capital (K) and labour (L). Let us assume that technology is exogenous and it
is given by 𝐴 for time period ‘t’. Further, let us assume that the functional form
of the production function is Cobb-Douglas.
Thus, output in period t is
𝑌 = 𝐴 𝐹(𝐾 , 𝐿 ) = 𝐾 (𝐴 𝐿 ) … (12.1)
where 0< α <1
We know that output is divided among consumption (C), investment (I), and
government purchases (G). If δ is the depreciation rate of capital in each period,
the capital stock in period (t + 1) is
𝐾 = 𝐾 + 𝐼 − 𝛿𝐾
= 𝐾 + 𝑌 − 𝐶 −𝐺 − 𝛿𝐾 … (12.2)
(Since 𝐶 + 𝐼 + 𝐺 = 𝑌 ; we have 𝐼 = 𝑌 − 𝐶 − 𝐺 )
Let us consider that labour and capital are paid their marginal products. Thus, the
real wage and the real interest rate in period t are
𝑤 = (1 − α) 𝐴 𝐾 (𝐴 𝐿 )
= (1 − α) 𝐴 (𝐾 /𝐴 𝐿 ) … (12.3)
and,
𝑟 = α (𝐴 𝐿 /𝐾 ) … (12.4)
(You can derive equation (12.3) and equation (12.4) from equation (12.1) by
taking partial derivatives with respect to L and K respectively)
The representative household maximizes the expected value of the utility
function
U=∑ 𝑒 𝑢(𝑐 , 1 − 𝑙 ) … (12.5)

191
Theories of where, u(•) is the instantaneous utility function. Here, ρ is the discount rate,
Business Cycles
which represents time preference of utility (i.e., the rate at which future income is
discounted). Further, 𝑁 is population and H is the number of households. Then,
the average number of members in each household is 𝑁 ⁄𝐻 . If the exogenous
growth rate of population is n:
𝑙𝑛 𝑁 = 𝑁 + 𝑛𝑡, ... (12.6)
where n<𝜌
Thus, the level of 𝑁 is given by 𝑁 = 𝑒
Notice that u(•) has two factors in equation (12.5): (i) consumption per member
of the household (𝑐 ), and (ii) leisure per member (𝑙 ). Leisure is the difference
between the time endowment per member (normalized to 1 for simplicity) and
the amount each member works. As all households are homogenous, c = C/N, and
l = L/N.
Let us first discuss about the assumption on the technology shocks. To capture
trend growth, we assume the following functional form for technology:
𝑙𝑛 𝐴 = 𝐴̅ + 𝑔𝑡 ... (12.7)
where g is the rate of technological progress. Technology in the above
specification is not subjected to random shocks. In order to include random
disturbances in technology we consider the following functional form:
𝑙𝑛 𝐴 = 𝐴̅ + 𝑔𝑡 + 𝐴 ... (12.8)
where 𝐴 is the random disturbances. The term 𝐴 follows first-order
autoregressive process. That is,
𝐴 = 𝜌 𝐴 +𝜀 , , −1 < 𝜌 < 1 ... (12.9)
where, the 𝜀 , is a stochastic error term (white noise). It means that 𝜀 , has zero
mean and zero correlation with other variables in the equation. Hence, equation
(12.9) indicates that the random component 𝐴 is a fraction 𝜌 of the previous
period’s value and a white noise error. The effect of a shock to technology
disappears gradually over time.
We follow a similar functional form for government purchases: It has a trend
component and a white-noise component. There is a trend growth rate of per
capita government purchases, but over time government purchases may become
arbitrarily large or arbitrarily small relative to the economy. Thus,
𝑙𝑛 𝐺 = 𝐺̅ + (𝑛 + 𝑔)𝑡 + 𝐺 , −1<𝜌 < 1, ... (12.10)
𝐺 =𝜌 𝐺 +𝜀 , , −1<𝜌 < 1, ... (12.11)
where the 𝜀 , is white noise. This completes the description of the RBC model.

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12.5 INTER-TEMPORAL SUBSTITUTION IN Real Business Cycles

LABOUR SUPPLY
We noted in the previous section that major differences between RBC model and
the Ramsey model are: (i) the inclusion of leisure in the utility function, and (ii)
the introduction of randomness in technology and government purchases as the
sources of macroeconomic aggregate fluctuations.
Let us focus on the introduction of leisure in the utility function. For simplicity
assume that the household lives only for one period and has only one member,
which has no initial wealth. Now, the objective function of the household is
ln 𝑐 + 𝑏 ln(1 − 𝑙) and its budget constraint is 𝑐 = 𝑤𝑙 . Hence, the Lagrangian
maximization problem is:
𝜁 = ln 𝑐 + b ln(1 − 𝑙) + 𝜆(𝑤𝑙 − 𝑐) ... (12.12)
The first-order conditions for c and 𝑙 are as follows:
− 𝜆 = 0, ... (12.13)

− + 𝜆𝑤 = 0, ... (12.14)

From equations (12.13), we find that 𝜆 = = (since 𝑐 = 𝑤𝑙 as per the budget

constraint).
Now, substituting the value of 𝜆 in equation (12.14), we obtain
− + 𝑤=0

That is,
− + =0 ... (12.15)

The labour supply that satisfies equation (12.15) is independent of the wage rate
as wage rate is not included in this equation. The reason is that utility is
logarithmic in consumption and the household has no initial wealth. The income
effect and substitution effect of a change in the wage rate offset each other. This
is the static case, as we assumed that the household lives for one period.
If we consider the case where the household lives for two periods or more than
two periods, then the wage variations do affect labour supply. Let us continue to
assume that household has no initial wealth with one member who lives for two
periods. Also, assume that there is no uncertainty about the interest rate or the
second-period wage.
The household’s lifetime budget constraint is now
𝑐 + 𝑐 =𝑤 𝑙 + 𝑤 𝑙 ... (12.16)

where r is the real interest rate. The Lagrangian maximization problem is:
𝜁 = ln 𝑐 + b ln(1 − 𝑙 ) + 𝑒 [ln 𝑐 + b ln(1 − 𝑙 )]
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Theories of
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+𝜆[𝑤 𝑙 + 𝑤 𝑙 −𝑐 − 𝑐 ] ... (12.17)

In equation (12.17), the choice variables of the household are 𝑐 , 𝑐 , 𝑙 and 𝑙 .

Our aim is to show the responsiveness of the relative labour supply due to the
variation in relative wage in the two periods. Hence, we need to find out the first-
order conditions for 𝑙 and 𝑙 from equation (12.17). These conditions are:
= 𝜆𝑤 ... (12.18)

= 𝜆𝑤 ... (12.19)

In order to simplify the above two equations, we divide both sides of (12.18) by
𝑤 and both sides of (12.19) by 𝑤 /(1 + r). Thus, we obtain

= 𝜆 and = 𝜆 ... (12.20)

Now, =

The relative labour supply in the two periods is:

= = ... (12.21)
( ) ( )

In the two-period case, the wage rate enters into the labour supply function.
Equation (12.21) implies that there is a relation between the relative labour
supply and the relative wage. This is to note here that (1 − 𝑙 ) means the
household releases 𝑙 that means the remaining (1 − 𝑙 ) refers to the leisure in the
first period. If 𝑤 rises relative to 𝑤 , then 𝑙 has to be increased or (1 − 𝑙 ) has
to be decreased to satisfy equation (12.21). That means if the wage rate increases
in the first period relative to the second period, labour supply has to increase in
the first period relative to the second period (or leisure has to decrease in the first
period relative to the second period). The elasticity of substitution between
leisure in the two time periods is 1 (due to its logarithmic functional form).
Let us consider the case of a rise in r in equation (12.21). It indicates that there is
an increase in the labour supply in the first period relative to second-period. A
rise in interest rate in the first period raises the incentive to work more (hence,
earn more and save more) in the first period relative to the second period. You
might have observed that the effect of interest rate is crucial to fluctuation in
employment in an economy. The effect of relative wage and interest rate on the
labour supply (or employment or leisure) is known as intertemporal substitution
in labour supply.
Check Your Progress 2
1) Give four examples of negative real shocks to an economy?
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2) Explain the concept of intertemporal substitution of labour. Real Business Cycles

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3) Explain how relative labour supply is dependent upon relative wage.
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4) In an intertemporal utility function, what is the impact of a rise in interest rate
on labour supply?
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12.6 IMPACT OF SUPPLY SHOCKS TO THE

ECONOMY
Now let us discuss the impact of the productivity shocks or technology shocks
through our RBC model as we discussed in the previous section. Assume that
there is an exogenous and temporary (lasting for one time period) favourable
shock to technology in a given time period (t). This is reflected in our model by a
rise in the 𝐴 term as in equation (12.1). Let us denote the initial level technology
as 𝐴 which increased to 𝐴 due to the shock. The growth in technology will
cause a rise in the income 𝑌 at the given levels of 𝐾 and 𝐿 .
The effect of this shock is illustrated in Fig. 12.2. Initially, at the level of
technology 𝐴 the corresponding production function is 𝐾 (𝐴 𝐿 ) . Let us
assume that L is the optimal amount of labour at this level of technology and
corresponding equilibrium output is 𝑌 . The beneficial productivity shock (or
technology shock) shifts the production function upward to 𝐾 (𝐴 𝐿 ) . In
addition to this upward shift, the nature of the shock is assumed to be such that
the production function becomes steeper for any level of labour input. We know
from microeconomics that the slope of the production function is the marginal
product of labour. Thus, the positive technology shock increases marginal
productivity also. Hence, at the same level of labour input (L ), we have higher
output 𝑌 due to the increase in productivity. That means the favourable shock
has changed the production possibilities as well. If we increase the labour input
to L , the corresponding higher output is Y due to the increased productivity.
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𝑌

𝐴 𝐹(𝐾 , 𝐿 )

𝑌
𝐴 𝐹(𝐾 , 𝐿 )

𝐿 𝐿 𝐿

Fig. 12.2: Effect of Positive Technology Shock

Now, let us discuss about the distribution of such increased output. The increased
output is distributed between consumption and saving. One possibility is that the
increased output goes completely towards consumption. But, particularly in the
case of a temporary shock, we may not prefer to consume all, but we like to save
a portion of them for future higher consumption. If this is the case, equation
(12.2) suggests that the higher the saving higher will be the level of investment.
This will cause the capital stock to be higher in the next period as well as other
future periods. Thus, the exogenous and temporary technology shock leads to
increases in future capital stock.
Had the shock lasted for several periods or caused permanent effects, the
economy would have responded somewhat differently. A permanent shock
causes higher output for a longer period. Hence, the incentive to save would be
reduced and consumption would be increased. The other possibility in the
permanent shock case is that the increase in the labour input may not be high.
Nevertheless, a persistent productivity shock will cause an increase in output,
capital stock, and employment.
You should note that there is persistence of the effect of technology shocks.
However, this statement is criticized by Keynesian economists as it cannot
explain the persistence of real-world business cycles. The believers of RBC
196 model argue that as explained in the model, the dynamic responses of optimizing
agents to change in economic conditions will have sustained effects. Such Real Business Cycles

responses can explain periods of persistently high or low economic activity.

12.7 NEW-KEYNESIAN VIEW ON BUSINESS CYCLE

An important assumption of new-classical models is continuous market clearing,
which implies perfect competition and flexibility in wages and prices. Thus,
adjustments in prices and wages were instantaneous. Recall that classical
economics was based on the same assumptions. Keynes discarded such
assumptions and stressed on market imperfections. He advocated an activist role
for the government.
A major criticism of Keynesian economics by Robert Lucas was that Keynesian
economics does not have microfoundation. Further, expectations about future
prices are not taken into account in Keynesian economics. New-Keynesian
macroeconomics overcomes the above criticisms by including microfoundation
and rational expectations.
What will happen if the above two features is brought into Keynesian
economics? It implies that New-Keynesian economics also uses DSGE models.
However, New-Keynesian models retain market imperfections and rigidities in
prices and wages. Thus, there is not much difference between new-classical
macroeconomics and new-Keynesian macroeconomics so far as methodology is
concerned. The assumptions about market clearing are different however. New-
Keynesian economists see certain imperfections in the market, particularly
imperfect competition in the market and rigidities in prices and wages. In order to
bring in such imperfections to DSGE models, new-Keynesian economists include
various price-setting and wage-setting equations. These models take care of
adjustment costs (such as menu costs) in wage setting, mark-up in price setting
(as a measure of market imperfection) and some form of Taylor Rule for interest
rate setting (policy rule).
Check Your Progress 3
1) Explain the impact of a supply shock on the economy through a diagram.
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2) Sate the issues emphasised by new-Keynesian economics in dynamic
stochastic general equilibrium models.
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Theories of
Business Cycles 12.8 LET US SUM UP
Real business cycle (RBC) theory is based on microeconomic foundations in the
sense that it takes into account the behaviour of economic agents such as firms
and households. Thus, it considers the production function for analyzing changes
in behavior of firms during a business cycle. Similarly, it considers the
consumption function, particularly substitutability between labour and leisure on
the part of households. Further, RBC theory is based on rational expectations in
the sense that economic agents optimize on their objective functions by taking
into account all information available to them. The RBC models adopt a general
equilibrium framework for empirical estimation. The assumptions of RBC
models, particularly its assumption of continuous market clearing, are challenged
by new-Keynesian economics. The new-Keynesian economists, while adopting
microfoundation, rational expectations and general equilibrium framework,
incorporate market imperfections such as adjustment costs, staggered prices and
mark-up pricing in dynamic stochastic general equilibrium (DGSE) models.

12.11 ANSWER/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) There are three basic assumptions in new-classical models, viz., rational
expectations, continuous market clearing, and Lucas supply function. You
should discuss the implications of these assumptions. Refer to Section 12.2
for details.
2) There are basically reasons, viz., inter-temporal substitution between labour
and leisure, and Lucas supply function. According to new-classical
economics, business cycles are rational response of economic agents to
shocks to the economy. Refer to Section 12.2.
Check Your Progress 2
1) There could be several examples of real shocks. The negative shocks for
example could be decline in technology (i.e., technical regress), unexpected
rise in input prices (crude oil crisis), scanty rainfall (severe drought), and
large-scale increase in taxes on inputs. Refer to Section 12.3.
2) Refer to Section 12.4 and explain on the basis of equation (12.21).
3) Refer to equation (12.21). You can find that the ratio of labour supply in
both the periods is influenced by the ratio of wage rates.
4) Refer to Section 12.4 and explain on the basis of equation (12.21).
Check Your Progress 3
1) Refer to Fig. 12.2 and answer.
2) Refer to Section 12.7 and answer.

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