The real business cycle school

Introduction: The Demise of New Classical Macroeconomics
Mark I
The dramatic statement by Lawrence Summers concerning real business
cycle theory is no exaggeration. The reason has to do with the striking
implications of developments in business cycle theory associated with the
real business cycle school that initially took place in the early 1980s. We
have already seen in the previous two chapters how the influence of both
monetarism and new classical economics called into question the desirability
and effectiveness of activist discretionary stabilization policies. Such
policies were founded on the belief that aggregate demand shocks were the
main source of aggregate instability. But rather than advocate the persistent
use of expansionary aggregate demand policies in an attempt to achieve
some target rate of (full) employment, both Friedman and Lucas advocated
the use of supply-side policies in order to achieve employment goals (Friedman,
1968a; Lucas, 1978a, 1990a). During the 1960s and 1970s, both
Friedman and Lucas, in their explanation of business cycles, emphasized
monetary shocks as the primary impulse mechanism driving the cycle. The
real business cycle theorists have gone much further in their analysis of the
supply side. In the model developed during the early 1980s by Kydland and
Prescott (1982) a purely supply-side explanation of the business cycle is
provided. This paper marked the launch of a ‘mark II’ version of new
classical macroeconomics. Indeed, the research of Kydland and Prescott
represented a serious challenge to all previous mainstream accounts of the
business cycle that focused on aggregate demand shocks, in particular those
that emphasized monetary shocks.
Particularly shocking to conventional wisdom is the bold conjecture advanced
by real business cycle theorists that each stage of the business cycle
(peak, recession, trough and recovery) is an equilibrium! As Hartley et al.
(1998) point out, ‘to common sense, economic booms are good and slumps
are bad’. This ‘common sense’ vision was captured in the neoclassical syn
thesis period with the assumption that ‘full employment’ represented equilibrium
and that recessions were periods of welfare-reducing disequilibrium
implying market failure and the need for stabilization policy. Real business
cycle theorists reject this market failure view. While recessions are not desired
by economic agents, they represent the aggregate outcome of responses
to unavoidable shifts in the constraints that agents face. Given these constraints,
agents react optimally and market outcomes displaying aggregate
fluctuations are efficient. There is no need for economists to resort to disequilibrium
analysis, coordination failure, price stickiness, monetary and financial
shocks, and notions such as fundamental uncertainty to explain aggregate
instability. Rather, theorists can make use of the basic neoclassical growth
model to understand the business cycle once allowance is made for randomness
in the rate of technological progress (the neoclassical growth model is
discussed in Chapter 11). In this setting, the business cycle emerges as the
aggregate outcome of maximizing decisions made by all the agents populating
an economy.