The Keynesians attribute business cycle fluctuations to what they regard as the fundamental instability of private spending--especially investment and consumer durable goods expenditure.

The New Classical view holds that unanticipated changes in monetary growth are the primary cause of deviations from the “natural rate” of output and employment.

Real Business Cycle theorists claim business cycles can be explained as an optimizing response of economic agents to random productivity shocks.

This is a tough model to explain

to non-economists

Households

Maximize consumption and leisure subject to constraints.

Constraints include the number of hours in a day and the resource prices (such as the wage).

Firms

Maximize profits subject to constraints

Constraints include prices of outputs and inputs, and productivity.

0

1

0

])1()),([)]1,([t

ttttttttt

t

t KKCNKFNCu l

Where:L is the LaGrangean functionCt is consumption in period tNt is work in period t1- Nt is leisure in period tKt is the capital stock in period t is the depreciation rate per periodt is a “shift factor” that alters total factor productivity in period t. is the time preference parameter, where 0< < 1; andt is the LaGrangean multiplier in time t.

Constrained optimization problem for an infinitely-lived “representative” consumer-producer.

Charles Plosser. “Understanding Real Business Cycles,” Journal of Economic Perspectives, Summer 1989, pp. 51-73.

If t increases, thatmeans you can getmore output from

the same stockof capital and work effort

When productivity rises,the opportunity cost of

leisure (measured in forgoneoutput) rises, which induces the

representative agent to substitute work for leisure.

Hence the random productivity shock brings about

an expansion of real output.

The intertemporal substitution of work for leisure (and vice versa) in reaction to technology shocks is the principal force underlying business cycle expansions and contractions

The problem for Plosser, Finn Kydland, and other Real Business Cycle theorists is to provide plausible estimates of t or “total factor productivity.”

Annual productivity growth

0

Per

cen

tage

rat

e of

ch

a ng e

2

-2

-4

-6

4

6

1955 1965 1970 19751960 1980 1985

The methods used to perform these

estimates have been

widely criticized

Policy implications of Real Business Cycle Policy implications of Real Business Cycle theorytheory

Some economists take the theory to mean that countercyclical aggregate demand management is doomed to ineffectiveness--since, after all, they claim that 70 percent of the deviation of real output from trend in the postwar era is explained by productivity shifts.

Technological change is a factor that policy makers cannot control.

Chatterjee explains that the Central Bank (the “FED” in the U.S.) should nevertheless exercise its stabilizing function in financial markets.