David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

27 .3 Real business cycles
provides a more frequent and more reliable picture of the eurozone business cycle - helpful information for
the monthly meetings of the European Central Bank at which interest rate decisions are made.
The figure shows that, like other independent central banks, the European Central Bank had been fairly
successful up to 2007 in stabilizing output. There was not much of a business cycle. The monthly EuroCOIN
indicator shows a slowdown beginning to happen even during 2007 and then rapidly during 2008. The
indicator dates early 2009 as the cyclical bottom for output growth, even though the growth indicator did not
climb above zero until later in 2009, and did not deliver two successive quarters of positive growth - the
official definition of the end of the recession - until the end of 2009.
Source: http://www.cepr.org/Data/eurocoin.
Real business cycles
So far our analysis of business cycles focuses on demand shocks and cyclical movements in output gaps.
This is compatible with our earlier analysis of sluggish wage adjustment in the short run. This view of
cycles is consistent with a model that is Keynesian in the short run, but classical or monetarist in the long
run.
Not all economists share our assessment of how the economy works. In particular, there is an influential
school, known as the New Classical economists, whose intellectual leader is the Nobel Laureate Robert
Lucas of the University of Chicago. Although we discuss competing views of macroeconomics more fully
in the next chapter, one implication of the New Classical view should be discussed immediately.
A key assumption of the New Classical school is that all markets clear almost instantaneously. Effectively,
output is almost always at its full-employment level. 1
Proponents of the theory argue that macroeconomics should base theories of firms
and households in a microeconomic analysis of choice between the present and
the future. For example, this approach would view each household as making a
plan to supply labour and demand goods both now and in the future in such a way
that lifetime spending was financed out of lifetime income plus any initial assets.
Real business cycle
theories explain cycles as
fluctuations in potential output
itself.
Such plans would then be aggregated to get total consumption spending and total labour supply. An
equivalently complex story would apply to firms and investment.
One implication of this approach is that it is no longer helpful to distinguish between supply and demand.
Iflabour supply and consumption demand are part of the same household decision, things that induce the
household to change its consumption demand also induce it to change its labour supply.
For this reason, real business cycle theorists simply discuss what happens to actual output, which reflects
both supply and demand and, by assumption, equates the two at potential output. In this view, the economy
is then bombarded with shocks (for example, breakthroughs in technology, changes in government policy),
which alter these complicated plans and give rise to equilibrium behaviour that looks like a business cycle.
Why is this approach called the real business cycle approach? In the classical model, nominal money only
affects other nominal variables. Output and employment depend only on real variables. Since real business
cycle theorists believe in the classical model, they take it for granted that the source of business cycles must
be in real shocks. Fancy dynamics can then explain why shocks last and have convoluted effects.
1 For an accessible introduction to these issues, see the lively exchange between Charles Plosser and Greg Mankiw in 'Real
business cycles: a new Keynesian perspective: Journal of Economic Perspectives, 3 (3): 79-90.
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