Introduction to the classical real business cycle model

Reading: AB, chapter 11, sections 1 and 2.

Assumptions

Real shock: unexpected change in the production function, labor market or IS curve (saving and investment).
Nominal shock: unexpected change in money supply or money demand.

Real business cycle theory (RBC) focuses on productivity and government spending shocks as the main sources of business cycles.

Variable behavior	Jive with observed data?
Output (Y) is procyclical	Yes
Employment (N) is procyclical	Yes
Avg. labor productivity (Y/N) is procyclical	Yes
Real wage (W/P) is procyclical	Yes - but RBC predicts more variable W/P
Prices (P) are counter-cyclical	No - P appears to be procyclical.
Unemployment, u, is always at the natural rate u. Changes in u represent changes in u.	Not really - hard to justify relatively large changes in u*.
Monetary policy is neutral	No - money appears to lead the business cycle

Fed should not try to stabilize the business cycle - it should only use monetary policy to keep prices stable (inflation under control)
Government need not use fiscal policy (tax and spending policy) to influence aggregate demand to manage the business cycle.
Government should use fiscal policies to stimulate the supply-side of the economy - use policies to promote growth and increase productivity; make labor market more efficient (increase the matching between job seekers and employers).

Last updated on July 26, 1996 by Eric Zivot.