Explain how Real Business Cycle Theory seeks to explain the business cycle as the result of productivity shocks.
The theory of the Real Business Cycle was formulated by economists Finn Kydland and Edward Prescott in 1982. They aimed to explain those factors that influence and eventually bring changes to the decisions of the players in an economy. These economists attributed these changes to technological shocks. They argued that business cycles come about as a result of random changes in the growth rate of business sector productivity and also by random changes in technology which intern fluctuates the constant growth trend up or down. These shocks include an increase in imported petroleum products prices, unfavorable weather, and stricter environmental and safety regulations. Hansen, Gary D. 1985.
The theory explains that booms in an economy occur when productivity grows at a more than average rate. That is when a favorable technological shock is in effect, while a recession occurs when productivity in the economy grows at a less than average rate. That is when the unfavorable technological shock is in effect. Unfavorable technological shock directly reduces the effectiveness of capital or labor or both. Change in these factors of production affects the decisions of the firm to change the product it produces. It also affects the decision by workers of what they buy. These changes affect the level of output of both the firm and the workers. Hansen, Gary D. 1985.
Prescott argued that business cycles are not caused by monetary and financial changes. According to him, economic booms result from an unexpectedly fast increase in money supply while recessions result from an unexpected fall in the money supply. The theory uses changes in an economy’s productivity to explain its cyclical booms and recessions. Economies’ output productivity can be looked at as the sum of all the total value added by all the firms in an economy. An economy’s total productivity can be associated with the time taken by workers working in the firms and the quantity and quality of the capital goods such as buildings and machinery used in assisting the production process. Lucas, Robert E., Jr. 1977.
Productivity can change if the effectiveness of labor and capital equipment used in production changes. If the firms devise a means of producing a commodity that reduces on wastage of raw materials, i.e., the means allows the same amount of products to be produced using fewer raw materials, the value addition at any given amount of hours worked and capital used would be higher. This brings about a favorable change in total factor productivity. Total factor productivity changes are brought by improvement in the technology for producing commodities coupled with improvement in labor skills. Total factor productivity can also change due to the invention of new products by the firms or when the price of an important imported input such as oil rises or falls. It can also fall if the government puts into place strict environmental protection laws, or when the weather is unfavorably resulting in a reduction in crop yields. Lucas, Robert E., Jr. 1977.
According to the theory, a boom occurs when a more than average growth rate of total factor productivity results in more than usual gainful employment opportunities for workers and capital. To take this opportunity of expanded labor market makes the firm invest more than usual in capital assets and employ additional workers. The extra income as a result of more than average total factor productivity growth coupled with increased production of capital assets leads to increased consumption. This brings about an overall increase of variables such as total output, consumption, investment, and hours worked, above their respective long-term trends which continue for some time. Fisher, J., (1999).
Real business cycle theory explains a recession as that period when there is a technological shock lowering wage rate that results in less than average growth in total factor productivity as workers withdraw from work causing a fall in total output. When there is unfavorable technological shock, workers’ marginal productivity goes down, people’s marginal productivity drops. This intern decreases the real wage. The workers will respond to a decrease in real wage by increasing their leisure time to the expense of their working time i.e. changing their work and leisure decisions over time. The real business cycle maintains that the condition should hold over a long period of time. It also argues that where the technological shock raises the real wage rate, workers will work more increasing their productivity and hence causing the output to increase more than normal resulting in a boom. Plosser, Charles I. 1989.
The real business cycle also argues that an individual faces two sets of trade-offs. These are; consumption- investment decision and labor- leisure trade-off. Consumption- investment decision involves the trade-off between consumption and investment in real assets. During the economic boom, the output is high and people have more to consume. An individual has to decide whether to consume all of it then or to keep some for future consumption. The individual may decide to invest the extra output in machinery and buildings to enable production in the following periods and hence increase future consumption. Depending on this factor most households peg their spending decisions on expected lifetime income and postpone spending during the boom to periods of recession. This enables the household a constant consumption level over time. Plosser, Charles I. 1989.
In labor leisure trade-off, the theory argues that when a technological shock results in higher productivity workers will substitute current work for future work. This is because workers’ earnings are higher than will be in the future. People will opt to work long hours at the expense of their leisure time. This will result in higher output today, which intern will result in higher consumption and investment. The higher rate of investment means that the higher rate of consumption will be extended for a time. Similarly, due to higher earnings workers may not want to work more today and opt to work less and increase their leisure time. This in effect lowers productivity and hence output. Fisher, J., (1999).
From the argument above it can be concluded that the real business cycle model tries to explain that given a technological temporally shock, total factor productivity, consumption, and investment rise above their long-term trends formulating into a positive deviation. An increase in investments translates into increased future capital. A positive temporary shock may have a long-lived impact on the future. An above-average growth may continue for some time even after the shock disappears. A continuing series of such productivity shocks may result in above-average economical growth. Similarly, a continuing series of negative shocks will result in average economical growth. This brings about business fluctuation cycles. Long, J., and C. Plosser (1981).
Does the theory present a plausible explanation of how the UK economy has behaved over the past two decades?
Over the past two decades, the UK economy has had few fluctuations in its economic growth pattern. According to my view, the theory partly explains how the UK economy behaved. Fluctuations of growth rate in UK economy can also be explained by the use of the theory’s paradigm. The economy’s growth rate can be attributed to total factor productivity. Due to a prolonged increase in output, the economy has been growing steadily. This growth is a result of capital investment of the extra output in the economy. The UK economy is characterized by a high rate of labor productivity, consumption, investment, and output that is above-average growth. Due to the high rate of investment, capital is always available for the future Real Business Cycles” John B. Long, Jr., Charles Plosser 1983.
Real business cycle theory assumes the existence of a perfect market, where there is no government involvement in business operations. A perfect market is a hypothetical market situation UK economy is characterized by a partly imperfect market associated with series of laws, regulations, policies, and customs. It is also influenced by the impact of monetary policy on business cycles. These regulations water down the principles of the theory. The UK government has a considerable influence on the economy. It regulates the rate of investment, controls the monetary and fiscal policies, and sets the minimum wage rate. These factors in general have affected labor productivity, rate of capital formation, and subsequent investment. Long, J., and C. Plosser (1981).
From the above explanation, it can be concluded that the theory parse does not plausibly explain the behavior of the UK economy over the stated period. For it to effectively explain the behavior it requires modification to encompass macroeconomics concepts such as monetary and fiscal policies.
References
Cooley, Thomas. F. 1995. Frontiers of Business Cycle Research. Princeton University Press.
Hansen, Gary D. 1985. “Indivisible labor and the business cycle.” Journal of Monetary Economics, 16, 309-327.
Lucas, Robert E., Jr. 1977. “Understanding Business Cycles.” Carnegie-Rochester Conference Series on Public Policy, 1, 19-46.
Plosser, Charles I. 1989. “Understanding real business cycles.” Journal of Economic Perspectives, 3, 51-77.
“Real Business Cycles” John B. Long, Jr., Charles Plosser, Journal of Political Economy, 1983.
Long, J., and C. Plosser (1981) “Real Business Cycles”, Journal of Political Economy 91.
Fisher, J., (1999) “The new view of growth and business cycles”, Economic Perspectives 23, Federal Reserve Bank of Chicago.