Real Business Cycles Theory

Research on economic fluctuations has progressed rapidly since Robert Lucas revived the profession’s interest in business cycle theory. Business cycle theory is the theory of the nature and causes of economic fluctuations The new Classical paradigm tried to account for the existence of cycles in perfectly competitive economies with rational expectations. It emphasized the role of imperfect information, and saw nominal shocks, in the form of monetary misperceptions, as the cause of cycles. The new Classical theory posed a challenge to Keynesian economics and stimulated the development of both the New Keynesian economics and RBC theory. Keynesian economics has generally accepted the idea of rational expectations, but emphasizes the importance of imperfect competition, costly price adjustment and externalities and considers nominal shocks as predominant impulse mechanism. RBC theory views cycles as arising in frictionless, perfectly competitive economies with generally complete markets subject to real shocks. RBC models demonstrate that, even in such environments, cycles can arise through the reactions of optimizing agents to real disturbances, such as random changes in technology or productivity. Coordination failures, price stickiness, waves of optimism or pessimism, monetary policy, or government policy generally are not needed to account for business cycles. Further more, such models are capable of mimicking the most important empirical regularities displayed by business cycles.