How do real business cycle theorists go about explaining the sources Essay

How do real business cycle theorists go about explaining the sources of business cycles What are their main conclusions - Essay Example Under the technical innovation, RBC models were developed with the aid of a method called calibration. (Quiggin, 2009). Sources of Business Cycle In 1986, Edward Prsescott, argued in an article that business cycles in USA, after the World War II resulted from the random changes in the business sector productivity. He justified his argument by proving that upswings in economic activity resulted from an above average growth rate of productivity while downswings resulted from a below average growth rate of productivity. In doing so, Prescott openly challenged the then prevalent notion that business cycles were triggered by monetary and financial disturbances (Chatterjee, 1999). There are numerous ways of measuring total output and one such way is to measure the total value added in all the domestic firms. The total output tends to change when productivity of workers changes or the effectiveness of the equipments used increases. Thus an increase in the effectiveness of workers and equipm ent leads to the value-added and is known as total factor productivity (TFP). TFP increases majorly as a result of improvements in technology and increase in worker productivity. TFP can also change when the price of an imported raw material changes or when new products are developed through investments in Research and Development (R&D) or when natural calamities destroy agricultural output (Chatterjee, 1999). When the TFP increases, it signals to the firms that they can benefit immensely from hiring more labor and installing more equipment. To make good use of such opportunities, firms invest heavily in buildings, equipment and hire a lot of workers. Additional income is generated in the economy and the overall output rises and people tend to consume more. These favorable trends in macroeconomic variables such as consumption and investment are used by RBC theorists to explain a boom (Chatterjee, 1999). There are other sources of fluctuations in the RBC, such as changes in taxes and government spending, tastes, government regulation (such as laws to protect the environment and minimise wastage by factories), terms of trade and energy prices. When government spending increases such as expenditure on infrastructure and transfer payments, firms are encouraged to set up production plants and increase economic activity, and consumption of households also increases. Investment, government spending and consumption are the elements of aggregate demand and they are directly related to output: an increase in these elements results in an increase in the overall output of an economy. The graph below shows this as an outward shift of the aggregate demand (AD) curve from AD to AD1, with the corresponding increase in output from Q to Q1 (McGrattan, 2006). In RBC theory, technological distrubances are discussed at length because the fluctuations caused by technological disturbances resemble the actual economic fluctuations a lot. According to Kydland and Prescott’s mod el, when households respond optimally to changes in technology, fluctuations occur (McGrattan, 2006). In a traditional business cycle, consumption and leisure move in opposite directions: when one increases, the other decreases. During the boom period, consumption