Jon’s Blog

The article Real Business Cycles: A New Keynesian Approach, authored by Gregory Mankiw, outlines a new idea regarding economic fluctuations, the real business cycle model. The real business cycle model is one of two stances currently held regarding these fluctuations. The Keynesian centers around general equilibrium and the possibility of market failure. The Classical approach stresses the optimization of private actors, the forces of supply and demand, and efficiency of markets. The real business cycle model is a new break off from the classical school, and credits technological change and an individuals rational response to the change as the source of large fluctuations. Mankiw assesses the theory in the paper, but admits from the intro the he is not an advocate of the idea.

In the article’s first section, Mankiw provides a brief background and set up for the rest of the paper. In Intro Economics courses, students are first exposed to partial equilibrium which eventually builds up to the Walrasian equilibrium and the “invisible hand” theory. The course also explains the classical dichotomy, where real values (employment, output) are determined by the Walrasian system and nominal values (price level, nominal wage) are determined by equilibrium in the money market. Since the nominal values don’t affect the real, the classical view asserts that the money market can be ignored. Both Keynesian and New Classical work attempt to break this dichotamy but in different ways. The theory of real business cycles, however, embraces the dichotomy and the irrelevance of monetary policy.

The disagreement between the two schools can be summed up in the example used in the article. The examples is a temporary increase in government spending. The real business cycle model says that an increase in government spending will increase the demand for goods and thus increase the real interest rate to keep the market in equilibrium. The rise in the interest rate decreases consumption and investment. The key to the real business approach is people will now reallocate their leisure because of the state of the economy. Working today now looks better than in the future, so the labor supply rises , increasing employment and output. In contrast, the Keynesian theory says the rise in the real interest rate does not affect the labor supply but is due to the amount of underutilized labor. The result of the two are the same, but the means to get there are different.

To cement their argument, the real business cycle advocates must explain why it is rational to increase labor during a recession. Their answer is that the price of labor relative to the price of goods falls during a recession, thus wages are PROCYCLICAL. To explain the procyclical nature, there must be substantial fluctuations in the rate of technological change. The reason the economy is in a recession is an inability to produce technological change. This cannot, however, be altered by government response so the “invisible hand” is inefficient. Recessions and other fluctuations, therefore, are natural and efficient.

There have been many arguments formulated against the real business cycle model. First, opponents attack the imperfect information argument of real business cycles. Big fluctuations in technology are very, very broad, well known, and exposed to everyone. There is no way there could be imperfect information in regards to a phenomena so big. The second argument stems from the results of Paul Volcker and his slowing of the economy using monetary policy. Real business cycle advocates argue that government intervention will not affect the outcome of fluctuations, but this was proved wrong in the 80’s. In regards to the procyclical nature of business cycle models, there is an argument for the procyclicalness of money, but not for prices! The last discrepancy comes from the fact that real business cyclists have no addressed and cannot explain the short run Phillips curve.

Mankiw predicts that the advocates of real business cycle models will not be able to provide enough evidence and theory to support their assumptions, while New Keynesians looking into economic fluctuations are on the right track. The article was fairly simple and easy to understand and was an interesting read.

Real Business Cycles: A New Keynesian Perspective (in Symposia: Real Business Cycles)
N. Gregory Mankiw
The Journal of Economic Perspectives, Vol. 3, No. 3. (Summer, 1989), pp. 79-90.
 http://links.jstor.org/sici?sici=0895-33…