Why real business cycle theory is important

Most nineteenth century theories of the business cycle were real (non-monetary) in nature, often involving agricultural causes. The harvest is bad and next thing you know, the economy stands in ruins. A pretty good theory when agriculture accounts for more than half of gdp. The Swede Knut Wicksell stood at the peak of this tradition, although he used changes in the natural rate of interest as a more general way of thinking about the initial real shock. In the basic Wicksellian story, a decline in the real rate of return causes entrepreneurs to contract their economic activity. Money and credit contract as well, leading to a downward “cumulative process.”

Real business cycle theory to some extent went underground during the “years of high theory.” Both Hayek and Keynes, while they drew from Wicksell, diverted our attentions away from traditional real business cycle theory mechanisms. Hayek blamed monetary expansion, while Keynes focused more on issues of animal spirits and liquidity premia, and sometimes sticky prices. Kalecki and others worked on the real approach, but it lost its professional centrality.

The rational expectations revolution of the 1970s led us back to real approaches. If people anticipate the future with a fair degree of accuracy and rationality, money will likely be neutral or close to neutral. Furthermore if all markets clear, there should be no room for sticky prices and wages. So what else is left other than real theories of the business cycle?

Any business cycle theory, real or not, must account for at least two generalized phenomena of business cycles: persistence (the cycle is not over right away but rather drags on) and comovement (many sectors of the economy move together). Kydland and Prescott were among the first people to see this problem (kudos to Long, King, and Plosser as well), and among the first to address it.

Kydland and Prescott wrote a seminal article (Econometrica 1982) about “Time to Build and Aggregate Fluctuations.” They resurrected the old Austrian concept of a “period of production.” But rather than engaging in the metaphysics of capital theory, they ran some simulations. They showed that if production takes time, an initial negative shock can cause lower inputs and outputs over a longer period of time. Furthermore they showed that reasonable assumptions about parameter values can lead this mechanism to fit the real world. This article made an immediate splash, and rightly so.

Now today the purely real approach to business cycles no longer stands. Wage and price stickiness now play some role in virtually all business cycle theories, if only because labor market data otherwise appear inexplicable. But you might also say that today “we are all real business cycle theorists.” Most economists subscribe to a hybrid theory involving monetary shocks, real shocks, and imperfect adjustment mechanisms. All of these theories, to some extent or another, rely on the real transmission mechanisms outlined by Kydland, Prescott, and others.