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

CHAPTER 27 Business cycles
lntertemporal substitution: a key to persistence
Real business cycle theories need to combine rapid market adjustment to equilibrium with sluggish
behaviour of aggregate output over the business cycle. Intertemporal substitution means making trade-offs
over time, postponing or bringing forward actions in the sophisticated long-run plans of households and
firms. This behaviour can cause effects to persist and look like part of a business cycle.
Suppose the productivity genie visits while we are all asleep. When we wake up, our productivity has
doubled. But only for a year. We know that by next year our productivity will have returned to normal. We
face a temporary productivity shock, a blip in our technology. What should we do?
We are definitely wealthier after the genie's visit. We are pleased it happened. We could simply behave as
before, working just as hard and investing just as much. In that case, our extra productivity would make
extra output this year, but it is output that we would blow entirely on consumption this year. We would get
little extra utility out of the hundredth bottle of champagne, and we would be making no provision for the
future. There must be a better way.
We could put in a temporary spurt of extra work while we are superproductive, but in itself that would only
exacerbate the problem: even more champagne today, still nothing extra for tomorrow. In fact, because leisure
is a luxury and because we are better off than before, we may feel like taking it easy and doing less work.
We need a way of transferring some of our windfall benefit into future consumption. The solution is
investment. A sharp rise in the share of output going to investment will provide more capital for the future,
thereby allowing higher future consumption even after our productivity bonus has evaporated. Once we
get to the future, being then richer than we would have been without the genie, we may in consequence
work less hard than we would have done, since leisure is a luxury.
The point of this example is to show that even a temporary shock can have effects that persist well into the
future. Persistence occurs both through investment (in human as well as physical capital) and through
intertemporal labour substitution - deciding when in one's life to put in the effort.
Real business cycle theories still need to be worked out fully. Apart from optimism about the speed of
adjustment, they have been criticized on two grounds. First, they are usually theories of persistence not
cycles. Shocks have long drawn out effects, but rarely are these cyclical. To 'explain' business cycles, so far
real business cycle theorists have had to assume a cyclical pattern to the shocks themselves. The theory is
therefore incomplete.
Second, and related, since the most widely researched example involves shocks to technology, a cyclical
pattern of shocks implies that in some years technical knowledge actually diminishes: we forget how to do
things. Not just once, but regularly every few years. This may be a bit hard to swallow.
However, this can be given a more plausible interpretation. In the dotcom bubble of the late 1990s, investors
made extravagant projections about future productivity growth and associated profits from the new
technologies. By 2000 evidence was accumulating that previous estimates, necessarily guesses in a new
situation, were too optimistic. In 2001 investment collapsed, particularly in the US where dotcom optimism
had been greatest.
Thus, the adverse shock was not a fall in existing technology - which is indeed implausible - but in
estimates of future technology, which affects current behaviour since firms, households and governments
all make long-term plans.
Policy implications
Research on real business cycles has much still to accomplish, but it does have a vital message for macroeconomic
policy. If the theory is right, it destroys the case for trying to stabilize output over the business cycle.
Fluctuations in output are fluctuations in an equilibrium output that efficiently reconciles people's desires.
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