The Real-Business-Cycle (RBC) Theory is an influential macroeconomic framework that provides insights into the causes of economic fluctuations.

The Real-Business-Cycle (RBC) Theory is an influential macroeconomic framework that provides insights into the causes of economic fluctuations. RBC theory offers four basic arguments to explain these fluctuations.

Exogenous Shocks

RBC theory posits that economic fluctuations primarily result from exogenous shocks to the economy. These shocks can be technological innovations, changes in government policies, or external factors like oil price shocks. When these shocks occur, they affect the supply side of the economy, leading to changes in productivity, production, and employment. For instance, a positive technological shock can increase productivity and lead to economic expansion, while negative shocks can lead to contractions.

Market-Clearing Mechanism

RBC theory emphasizes the role of competitive markets in clearing and adjusting the economy. It assumes that wages and prices are flexible, adjusting quickly to maintain equilibrium between labor supply and demand and between goods and services supply and demand. When a positive shock occurs, firms increase production, which drives up wages and prices. This, in turn, encourages more people to enter the labor market, leading to full employment and a new equilibrium. Similarly, negative shocks lead to wage and price decreases.

Consumption and Savings

RBC theory highlights the importance of rational and forward-looking behavior by households. It assumes that individuals make consumption and savings decisions based on their expectations of future income and wealth. When facing positive shocks, households may increase consumption and reduce savings, whereas negative shocks lead to decreased consumption and increased savings. This behavior helps to smooth consumption over time.

Limited Role of Demand Management Policies

RBC theory is critical of the effectiveness of demand management policies, such as monetary and fiscal policy, in stabilizing the economy. It argues that these policies are less effective because they focus on demand-side factors and tend to be destabilizing when applied to an economy driven by real, supply-side shocks. Instead, RBC theory suggests that the focus should be on creating a stable economic environment through structural reforms and minimizing government intervention.

In summary, the Real-Business-Cycle Theory attributes economic fluctuations to exogenous shocks, underscores the role of market-clearing mechanisms, highlights the importance of rational consumption and savings decisions, and questions the effectiveness of demand management policies. While this theory has been influential in shaping macroeconomic thought, it is not without its criticisms, particularly in its treatment of the role of demand and the assumption of perfectly flexible prices and wages.

Reference

Business cycles: Theory, evidence and policy implications - JSTOR. (n.d.-a). https://www.jstor.org/stable/3440773 

Cerra, V., Fatas, A., & Saxena, S. C. (2020). Hysteresis and Business Cycles, IMF Working Papers, 2020(073), A001. Retrieved Oct 19, 2023, from https://doi.org/10.5089/9781513536996.001.A001

Hemming, R., & Kochhar, K. (1990). "4 The Role of Fiscal and Monetary Policy in the Growth Process". In Strategies for Structural Adjustment. USA: International Monetary Fund. Retrieved Oct 19, 2023, from https://doi.org/10.5089/9781557751478.071.ch004

Interaction between business cycles and economic growth - 日本銀行. (n.d.-b). https://www.boj.or.jp/en/research/wps_rev/wps_2018/data/wp18e12.pdf 

International Monetary Fund - IMF. (n.d.-c). https://www.imf.org/external/pubs/ft/wp/2004/wp04234.pdf