Real Business Cycle Theory

1. Introduction

Business cycle theories have evolved over centuries and have always been a topic of debate.  They provide valuable insight into the economic mechanism and therefore the importance to continually improve the theories (Reijnders, 2007).

The 1970’s can be regarded as a turning point for business cycle theory.  Taking Lucas insights into consideration Kydland and Prescott gave a new perspective on business cycles in 1982, referred to as real business cycle (RBC) theory.  It incorporated growth theory into business cycle theory and also provided the platform for quantitative analysis by constructing the “artificial economy” Lucas identified as needed to help guide policy (Rebelo, 2005).

Unfortunately this model, some argues, may have become too “artificial” to be applicable on reality and it creates a dangerous illusion of knowledge (Caballero, 2010).  On the positive side, RBC-models became a point of departures for further research, taking into account microfoundations and forward-looking expectations, and provided valuable methodology insights.

The recent financial crisis challenges the general consensus which the “Great Moderation” has brought to the economic field.   The role of financial markets is central.  Financial intermediaries were largely ignored before the crisis and it is critical that interactions in real economies be better understood.  

The purpose of this paper is to evaluate the RBC-theory, specifically after the International Financial crisis.  Firstly an overview of the crisis and RBC theory is given.  The second part highlights the shortages of the RBC-theory and lastly, given the shortages, the future prospects of the theory are considered.

1. The crisis in brief and the role for economists

The origin of the financial crisis can be traced back to misaligned incentives, that created the real estate bubble, and leveraged speculation.  Financial innovations (like MBS and CDO), designed to reduce risks, ironically integrated the financial system and created systemic risks that amplified the crisis throughout the world economy.  Moral hazard was present.  Complex financial instruments sketched a risk-free investments picture causing the balance sheets of financial institutions to be skewed.  After the fall of Lehman Brothers in September 2008, turmoil erupted and spread through the global financial markets.  Uncertainty led to credit-markets freezing.  Lost in confidence was a huge impediment for banks, individuals and firms that now faced liquidity constraints.  High unemployment and output losses followed (Siegel, 2009).  

Criticism was raised on why economist did not see the crisis coming.  This seems unfair.  Caballero argues that a crisis causes so much damage for the very reason that it is unpredictable (2010).  Criticism concerning the failure to forsee the possibility of the crisis and to fully comprehend its effects to provide a good response-framework for policy, may be validated (Krugman, 2011).

1. RBC-theory definition

According to The RBC-theory rational agents respond optimally to exogenous real shocks to the economy by adjusting consumption and labour supply.  The shocks are supply-side (production) shocks, with technology shocks being the most prominent.  Business fluctuations must not be seen as market failures, for they are Pareto efficient.  Since every stage of the business cycle is an equilibrium, there is no role for government interventions and efforts to reduce the business cycle would create a welfare loss (De Vroey & Malgrange, 2011).  

1. The shortcomings of RBC-theory

The crisis showed that the financial sector is important and financial fragility and financial intermediation should be considered in models (Boyer, 2010).   Problems with the assumptions of the RBC-theory, especially the representative agent assumption, make this very difficult.  Further the role of behaviour economics and monetary policy is evaluated and the problem with the model explaining the high unemployment is considered.

1. Representative agents

The choices of Robinson Crusoe are assumed to be representative of the billions heterogeneous individuals.  Without heterogeneity the welfare effects of shocks cannot be fully comprehended.  Asymmetric information and coordination between the heterogeneous agents are ignored even though both issues are fundamental.   This makes it difficult to incorporate financial intermediaries in the models and bank heterogeneity is a central to financial fragility (Du Plessis, 2011).

Arguably this is the biggest shortcoming of the DSGE-models and RBC-theory   Within a representative agent framework there is no scope for redistributive effects, the financial sector and default risk is ignored (Stiglitz, 2011).

1. Finance

Some literature have stated that the shock to the economy is endogenous (Keen, 2011).  Better integration of finance and economics are central.  The Walrasian logic, which if n-1 markets are in equilibrium/disequilibrium the nth market should also be in equilibrium/disequilibrium, implies that once one market is in disequilibrium, other markets will also not be in equilibrium and cannot be ignored.  

1. Efficient Market Hypothesis

Advocates of the RBC-theory also believe in the assumption of efficient market hypothesis.  The financial market follows a random walk and cannot be beaten.  Further, the market perfectly reflects the underlying fundamentals and asset prices change with the availability of new information.  The existence of “bubbles” is ruled out by this hypothesis (Roubini & Mihm, 2010:41-43)  

The assumption of complete markets is flawed Critics explain that stock prices reveal much more volatility than what the EMH predicts and the market is not fully efficient.  Optimistic overreaction and panics are present and speculation is driven by psychology instead of fundamentals.  Behavioural economics should be considered as an explanation for the market’s inefficiency and the rise of a bubble (Roubini & Mihm, 2010:41-43).

The bubble alone does not create a crisis.  Debt and easy extra credit does.  If only a few firms fail, general distrust leads to a crisis.  The crisis confirms that imperfections are important and may be an explanation for the slow recovery (Stiglitz, 2011).  

Financial market imperfection stresses a role for financial intermediaries.

1. Financial intermediaries: Bank credit and stock markets needs to be incorporated

Analysing and incorporating financial intermediation has received a lot of recent research (See Kiyotaki, 2011 & Goodhart et al., 2006).  The crisis emphasized the importance of including the banking sector and to focus more on the financial sector.  These sectors are guilty of financing the real-estate bubble and the facilitating the geared financial innovations.  The credit crisis and borrowing constraints that followed accelerated the financial crisis throughout the whole world (Kiyotaki, 2011).  Keen (2011) found that increase in debt has macroeconomic significance and also plays a role in asset prices.  Introducing credit markets, and their imperfections, are central.