Answer to Question #171381 in Microeconomics for Julie

Question

Please explain in three well-structured paragraphs the basic arguments stated by the Real-Business-Cycle (RBC) Theory, regarding economic fluctuations.

Answer 1

Solution:

Real Business Cycle (RBC) theory is a class of new classical macroeconomics models in which the business cycle fluctuations to a wide extent can be accounted for by real shocks.

 

Real Business Cycle theory assumes that the economy experiences fluctuations in its ability to inputs into outputs and that these fluctuations in technology cause fluctuations in output and employment. When the available production technology improves, the economy produces more output with the same inputs. According to this theory, output and employment fall during recessions since the available production technology deteriorates reducing output and the motivation to work.

 

Real Business Cycle theory assumes that fluctuations in employment reflect changes in the amount people want to work. On the other hand, it assumes that the economy is always on the labor supply curve. Changes in wage rates and interest rates contribute to the inter-temporal substitution of labor.

 

Real Business Cycle theory assumes that wages and prices adapt swiftly to clear markets. Advocates of this theory believe that the stickiness of wages and prices is not important for understanding economic fluctuations. They also believe that the assumption of flexible prices is methodologically superior to the assumption of sticky prices since it connects microeconomic theory to macroeconomic theory more closely.