Intermediate Macroeconomics: The Neoclassical Business Cycle Model

We previously studied equilibrium in a particularly simple world – an endowment economy. This was useful for getting intuition about what determined the real interest rate, but lacked realism. In this section we endogenize supply. The concept of equilibrium is identical to before, but the set up is more interesting. Now we have firms that produce output using capital and labor, and households that consume, save, and supply labor. In addition to the goods market that must clear, we have another market – the labor market. We have several different exogenous variables and can examine how changes in these variables affect the endogenous variables of the model. The model we are going to study is sometimes called the Neoclassical model of the business cycle. It alternatively goes by the name of the “Real Business Cycle Model” (RBC) because it emphasizes “real” (as opposed to nominal) supply-side forces as the chief cause of short run economic fluctuations (the principal business cycle driving force in the model is changes in productivity). The model is capable of producing movements in endogenous variables that bear some resemblance to what we observe in the data. The model has the implication that business cycles are the efficient response to changing productivity and as such stabilization policies (either monetary or fiscal) are undesirable. We will later study Keynesian models which do not share this implication.