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Real-Business Cycles

Mainstream macroeconomists view recessions as a case of market failure. There are workers who would like to work but cannot because no one is willing to hire them. Their lack of income creates consumers who would like to spend but who cannot because they do not have the funds to do so. As a result, there are businesses that would like to produce and hire more workers, but cannot because there is not enough demand for final output. The circle is complete, and there is something not working properly.

The traditional explanation for this situation was a failure of wages and prices to adjust quickly enough. A change in spending drives the economy away from equilibrium, but sticky wages and/or prices prevent rapid adjustment to a new equilibrium. Because wages and prices do not adjust, output does.

There is a group in macroeconomics--known by several names, including real-business cycle theorists--that tosses out the above explanation and begins by assuming that markets always clear. If a market does not clear, there is a profit opportunity for someone, and someone will take it. Hence wages and prices should not be sticky, but should adjust quickly.

If markets are always in equilibrium, then how do we explain the fluctuations in business activity that have been obvious for over two centuries? The real-business cycle theorists say that an important cause is fluctuation in the rate of technology change. Suppose, for example, the rate of technology slows down. As a result, people's marginal productivity will drop, and as it does, the real wage will drop. People will react to that change in real wage in a rational manner by shifting their work and leisure decisions over time.

Suppose that in some weeks you get paid $15 per hour, and in other weeks you only get paid $5 per hour. If you can work as many hours per week as you want, what kind of pattern will there be to your work? Although some people undoubtedly would work the same in all weeks, most people would work longer in the higher-pay weeks and less in the lower-pay weeks. They will take their leisure in the lower-pay periods, and move their work to the higher pay periods.

The real-business cycle suggests that this same pattern holds over longer periods. When there is a technological shock raising real wage, people will work more causing output to surge, and when there is a technological shock lowering real wage, people will withdraw from work, causing output to fall. This pattern is what we observe as booms and recessions.

Many economists find the real-business cycle theory totally unbelievable. No one can observe the technological shocks that are at the heart of this explanation, and it strikes many as simply ridiculous to argue that the unemployment during a recession is voluntary. On the other hand, the economists who have formed these arguments are among the brightest of the profession, and they can show that the patterns that their mathematical models generate are remarkably similar to the patterns that the real world generates.

The studies on the real-business cycle do show that alternative explanations to the patterns we observe are possible and are a reminder of how little we know for certain in macroeconomics. It may be that this line of inquiry will result in drastic alternations in the way economists view macroeconomics (rendering much of the material in these pages obsolete), but it is also possible that the whole approach may eventually prove to be one more dead end in the study of economics.

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Copyright Robert Schenk