REALBUSI
NESSCYCLEMODEL
Thedomi
nantnewcl
assi
calt
heor
yoft
hebusi
nesscy
cledur
ingt
heper
iod
1972–82wast
hemonet
arysur
pri
semodeli
nit
ial
l
ydev
elopedbyLucas(
1975,
1977)
.Si
ncet
heear
ly1980st
hel
eadi
ngnewcl
assi
calexpl
anat
ionofaggr
egat
e
i
nst
abi
l
ityhasf
ocusedonr
ealr
athert
hanmonet
aryshocks.Thet
ransi
ti
onf
rom
monet
aryt
orealt
heor
iesoft
hebusi
nesscy
clewasst
imul
atedbyt
woi
mpor
tant
dev
elopment
s.Fi
rst
,thesuppl
yshocksassoci
atedwi
tht
het
woOPECoi
lpr
ice
i
ncr
eases dur
ing t
he 1970s made macr
oeconomi
sts mor
e awar
e of t
he
i
mpor
tance ofsuppl
y-
side f
act
orsi
n expl
aini
ng macr
oeconomi
cinst
abi
l
ity
.
Second,t
her
ealshocksmaybef
armor
eimpor
tantt
hanmonet
aryshocksi
n
ex
plai
ningt
hepat
hofaggr
egat
eout
putov
ert
ime.Theev
idencei
sconsi
stent
wi
tht
hepr
oposi
ti
ont
hatout
putf
oll
owsapat
h,whi
chcoul
dbestbedescr
ibedas
a‘
random wal
k’
.
Ther
ealbusi
nesscy
clet
heor
yhasbeenev
olv
edoutoft
heAmer
icannew
cl
assi
calschoolof1980s.I
tist
heout
comeofr
esear
chmai
nlybyFi
nnKy
dland
andEdwar
dPr
escot
t,Rober
tBar
roandRober
tKi
ng,JohnLongandChar
les
Pl
osser
.Realbusi
nesscy
clet
heor
yasser
tst
hatt
hef
luct
uat
ionsi
nout
putand
empl
oymentar
ether
esul
tofav
ari
etyofr
ealshocks.Thi
swi
l
lhi
ttheeconomy
wi
th mar
ketadj
ust
mentr
api
dly and r
emai
ning al
way
sin equi
l
ibr
ium.Real
busi
ness cy
cle t
heor
ist
s di
sti
ngui
sh bet
ween i
mpul
se and pr
opagat
ion
mechani
sms.Ani
mpul
semechani
sm i
sthei
nit
ialshockwhi
chcausesav
ari
abl
e
t
odev
iat
efr
om i
tsst
eadyst
atev
alue.A pr
opagat
ionmechani
sm consi
stsof
t
hosef
orceswhi
chcar
ryt
heef
fect
soft
heshockf
orwar
dthr
ought
imeand
causet
hedev
iat
ionf
rom t
hest
eadyst
atet
oper
sist
.
FEATURESOFRBC
1|
, 1.Economi
cagent
sli
ke/
househol
d/f
ir
m ai
mst
omaxi
mizet
hei
rut
il
it
yorpr
ofi
ts,
subj
ectt
opr
evai
l
ingr
esour
ceconst
rai
nts.
2.Agent
sfor
m expect
ati
ons r
ati
onal
l
y and do not suf
fer i
nfor
mat
ional
asy
mmet
ri
es.
3.Pr
icef
lex
ibi
l
ityensur
escont
inuousmar
ketcl
ear
ingsot
hatequi
l
ibr
ium al
way
s
pr
evai
l
s.Ther
ear
enof
ri
cti
onsort
ransact
ioncost
s.
4.Fl
uct
uat
ionsi
naggr
egat
eout
putandempl
oymentar
edr
ivenbyl
arger
andom
changes i
nthe av
ail
abl
e pr
oduct
ion t
echnol
ogy
.Exogenous shocks t
o
t
echnol
ogyactast
hei
mpul
semechani
sm i
nthesemodel
s.
5.Av
ari
etyofpr
opagat
ionmechani
smscar
ryf
orwar
dthei
mpactoft
hei
nit
ial
i
mpul
se.
6.Fl
uct
uat
ionsi
nempl
oymentr
efl
ectv
olunt
arychangesi
nthenumberofhour
s
peopl
e choose t
o wor
k.Wor
k and l
eisur
e ar
e assumed t
o be hi
ghl
y
subst
it
utabl
eov
ert
ime.
7.Monet
arypol
i
cyi
sir
rel
evant
,hav
ingnoi
nfl
uenceonr
ealv
ari
abl
es,t
hati
s,
moneyi
sneut
ral
.
8.Thedi
sti
nct
ionbet
weent
heshor
trunandt
hel
ongr
uni
ntheanal
ysi
sof
economi
cfl
uct
uat
ionsandt
rendsi
sabandoned.
RBC t
heor
yis bui
l
ton t
he assumpt
ion t
hatt
her
e ar
elar
ge r
andom
f
luct
uat
ionsi
nther
ateoft
echnol
ogi
calpr
ogr
ess.Thesesuppl
ysi
deshockst
o
t
he pr
oduct
ion f
unct
ion gener
ate f
luct
uat
ions i
n aggr
egat
e out
put and
empl
oyment
. Rat
ionali
ndi
vi
dual
srespondt
otheal
ter
edst
ruct
ureofr
elat
ive
pr
icesbychangi
ngt
hei
rlaboursuppl
yandconsumpt
ionf
unct
ion.
2|
NESSCYCLEMODEL
Thedomi
nantnewcl
assi
calt
heor
yoft
hebusi
nesscy
cledur
ingt
heper
iod
1972–82wast
hemonet
arysur
pri
semodeli
nit
ial
l
ydev
elopedbyLucas(
1975,
1977)
.Si
ncet
heear
ly1980st
hel
eadi
ngnewcl
assi
calexpl
anat
ionofaggr
egat
e
i
nst
abi
l
ityhasf
ocusedonr
ealr
athert
hanmonet
aryshocks.Thet
ransi
ti
onf
rom
monet
aryt
orealt
heor
iesoft
hebusi
nesscy
clewasst
imul
atedbyt
woi
mpor
tant
dev
elopment
s.Fi
rst
,thesuppl
yshocksassoci
atedwi
tht
het
woOPECoi
lpr
ice
i
ncr
eases dur
ing t
he 1970s made macr
oeconomi
sts mor
e awar
e of t
he
i
mpor
tance ofsuppl
y-
side f
act
orsi
n expl
aini
ng macr
oeconomi
cinst
abi
l
ity
.
Second,t
her
ealshocksmaybef
armor
eimpor
tantt
hanmonet
aryshocksi
n
ex
plai
ningt
hepat
hofaggr
egat
eout
putov
ert
ime.Theev
idencei
sconsi
stent
wi
tht
hepr
oposi
ti
ont
hatout
putf
oll
owsapat
h,whi
chcoul
dbestbedescr
ibedas
a‘
random wal
k’
.
Ther
ealbusi
nesscy
clet
heor
yhasbeenev
olv
edoutoft
heAmer
icannew
cl
assi
calschoolof1980s.I
tist
heout
comeofr
esear
chmai
nlybyFi
nnKy
dland
andEdwar
dPr
escot
t,Rober
tBar
roandRober
tKi
ng,JohnLongandChar
les
Pl
osser
.Realbusi
nesscy
clet
heor
yasser
tst
hatt
hef
luct
uat
ionsi
nout
putand
empl
oymentar
ether
esul
tofav
ari
etyofr
ealshocks.Thi
swi
l
lhi
ttheeconomy
wi
th mar
ketadj
ust
mentr
api
dly and r
emai
ning al
way
sin equi
l
ibr
ium.Real
busi
ness cy
cle t
heor
ist
s di
sti
ngui
sh bet
ween i
mpul
se and pr
opagat
ion
mechani
sms.Ani
mpul
semechani
sm i
sthei
nit
ialshockwhi
chcausesav
ari
abl
e
t
odev
iat
efr
om i
tsst
eadyst
atev
alue.A pr
opagat
ionmechani
sm consi
stsof
t
hosef
orceswhi
chcar
ryt
heef
fect
soft
heshockf
orwar
dthr
ought
imeand
causet
hedev
iat
ionf
rom t
hest
eadyst
atet
oper
sist
.
FEATURESOFRBC
1|
, 1.Economi
cagent
sli
ke/
househol
d/f
ir
m ai
mst
omaxi
mizet
hei
rut
il
it
yorpr
ofi
ts,
subj
ectt
opr
evai
l
ingr
esour
ceconst
rai
nts.
2.Agent
sfor
m expect
ati
ons r
ati
onal
l
y and do not suf
fer i
nfor
mat
ional
asy
mmet
ri
es.
3.Pr
icef
lex
ibi
l
ityensur
escont
inuousmar
ketcl
ear
ingsot
hatequi
l
ibr
ium al
way
s
pr
evai
l
s.Ther
ear
enof
ri
cti
onsort
ransact
ioncost
s.
4.Fl
uct
uat
ionsi
naggr
egat
eout
putandempl
oymentar
edr
ivenbyl
arger
andom
changes i
nthe av
ail
abl
e pr
oduct
ion t
echnol
ogy
.Exogenous shocks t
o
t
echnol
ogyactast
hei
mpul
semechani
sm i
nthesemodel
s.
5.Av
ari
etyofpr
opagat
ionmechani
smscar
ryf
orwar
dthei
mpactoft
hei
nit
ial
i
mpul
se.
6.Fl
uct
uat
ionsi
nempl
oymentr
efl
ectv
olunt
arychangesi
nthenumberofhour
s
peopl
e choose t
o wor
k.Wor
k and l
eisur
e ar
e assumed t
o be hi
ghl
y
subst
it
utabl
eov
ert
ime.
7.Monet
arypol
i
cyi
sir
rel
evant
,hav
ingnoi
nfl
uenceonr
ealv
ari
abl
es,t
hati
s,
moneyi
sneut
ral
.
8.Thedi
sti
nct
ionbet
weent
heshor
trunandt
hel
ongr
uni
ntheanal
ysi
sof
economi
cfl
uct
uat
ionsandt
rendsi
sabandoned.
RBC t
heor
yis bui
l
ton t
he assumpt
ion t
hatt
her
e ar
elar
ge r
andom
f
luct
uat
ionsi
nther
ateoft
echnol
ogi
calpr
ogr
ess.Thesesuppl
ysi
deshockst
o
t
he pr
oduct
ion f
unct
ion gener
ate f
luct
uat
ions i
n aggr
egat
e out
put and
empl
oyment
. Rat
ionali
ndi
vi
dual
srespondt
otheal
ter
edst
ruct
ureofr
elat
ive
pr
icesbychangi
ngt
hei
rlaboursuppl
yandconsumpt
ionf
unct
ion.
2|
