The word “real” means the real term in contract with the word “monetary”. Therefore, the real business cycle is not about the monetary policy, but about the negative supply shock. The RBC theory explains most of the business cycle in human history.
Examples
For example. in the early agriculture society, agriculture consists most of GDP. If extreme weather condition happens (the real shock), then there are bad harvests and bad outputs for almost all economy. People have less to eat, and an economic recession emerges. In the modern economy, outputs are more diversified. Another is that in the 1973 oil crisis, the OPEC oil embargo induced the oil price increase. The increase in oil prices made production costs increase for other goods and services, and led to an overall recession. A recent example is a crisis in Brazil. A decrease in commodity prices hugely reduced incomes (net export). Also, the Brazilian government became erratic and unpredictable (no clear target and no credible), bringing further risks to the Brazilian economy.
Shocks
Examples of shocks are,
- Technology schoks
- Policy shocks: Fiscal policy & Monetary shocks
- Political shocks: changes in polical party
- Expectations shocks: animial spirits
- Natural disaster
Propagation mechanisms
Two Propagation mechanisms are here, the labour propagation mechanism and the intertemporal one. See notes.
Potential Solutions
- Try to avoid the problem in the first place. For example, if the oil price is expected to increae, then invest in other alternative energy to decreae the effects of oil price increase on production costs. In other word, diversity the production costs and make the production process not rely too much on oil.
- Make the economy more flexible and can be adjustable to negative supply shocks quickly.
Problems
- It do not explain all business cycles, which are not caused by supply shocks. For example, a lot busienss cycles are about monetary polcy, banking, and credit.
- It does not explain why unemployment rate is so high in labour economics.
In short, before the RBC model, macroeconomic studies mainly focus on the IS-LM and AD-AS. The building up of RBC solves the problem that macroeconomic study did not have a solid microeconomic background.
RBC model is like a new classical model with shocks, based on the key assumption that markets are perfectly competitive. Then, market players maximise their utility subject to certain constraints. Through the RBC model, we can get the co-movement of outputs, labours and capitals. Market fluctuations are caused by shocks. Without shocks, the markets are in equilibrium condition over time, because markets are competitive. Meanwhile, money is not included in the RBC model, so all factors are in real terms.