Game of Theories: Real Business Cycle

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- [Tyler] Real business-cycle theory
is about negative supply shocks.

That word "real" in the name --

don't contrast it
with the word "phony,"

but rather contrast it
with "monetary."

Real business cycles
are not about monetary policy --

mostly they're about
negative supply shocks.

Now, the nice thing
about real business-cycle theory

is that it actually explains
most business cycles

in the history of the human race.

Consider earlier economies

where, say, 80% of GDP
was agriculture.

What then could be
the negative shock?

Well, imagine a whole year
of bad rainfall,

and then a very bad harvest.

That would mean lower output
for almost all of the economy.

It would mean people
have less to eat.

It might even mean
more malnutrition,

and that would be
a very bad macroeconomic event.

That's just the simplest example
of real business-cycle theory.

Real business-cycle theory
needs to be modified

for more modern economies,
which are more diversified.

So, what would be an example?

Consider America in the year 1973.

What was the negative shock then?

A much higher price of oil.

OPEC, the oil-exporting cartel,

raised the price of its oil
to American buyers.

Now, oil is an input
into the production

of many goods and services --

like airplane trips,

or building automobiles,

or bathtub rubber duckies.

So, you have
higher production costs.

That means less will be produced,

probably fewer workers will be hired,

and, overall,
incomes will be lower.

Those initial negative shocks

will work their way
through the American economy,

and that will mean
successive negative shocks

for other parts of the economy
even if they don't use oil,

and that ends up
leading to a recession.

Real business-cycle theory
also can apply to the present day.

Consider the economy of Brazil,

where GDP has declined
by more than 5%

over the last two years.

What have been the negative shocks?

First -- falling commodity prices.

Brazil exports
a lot of commodities,

commodities
like soybeans, and cotton,

and coffee, and minerals.

Those commodities are bringing in
lower prices on world markets,

and that means lower incomes
for a lot of Brazilians.

Second -- bad policy.

The behavior
of the Brazilian government

has been erratic
and unpredictable,

and this has increased
the level of perceived risk

in the Brazilian economy.

So to graph a real business cycle,
what does that look like?

Well, in our basic aggregate demand--
aggregate supply model,

it's pretty simple.

The long-run aggregate supply curve
is shifting to the left,

and you can see that means
a lower level of output.

Over the medium term,
due to propagation,

it also may be that
the aggregate demand curve

shifts back and to the left,

and that, of course,
will make the problem worse.

But again, the fundamental event

is simply the shifting back
and to the left

of the aggregate supply curve.

So what are the solutions
when you have a problem

based in real business-cycle theory?

Well, first thing you can do

is try to avoid the problem
in the first place.

If the risk is having an oil price
which is too high,

try to have invested
in the first place

in some energy alternatives.

Second, ask yourself
what can you do

to make your economy
more flexible so it can adjust

to the negative supply shock
more quickly.

All of those responses
will help limit the costs

of having a negative
real-business cycle.

So, what are the problems
in real business-cycle theory?

There are at least two.

First -- It doesn't explain
all business cycles.

A lot of business cycles
do have to do

with monetary policy,
banking, and credit,

rather than the supply side
of the economy.

A second problem
with real business-cycle theory --

it's not always good on explaining
why unemployment is so high

over the course
of many business cycles.

If you imagine a negative shock
hitting the economy,

well, why don't workers
just take lower wages

and stay at work?

And to explain
those employment effects,

often we need to supplement
real business-cycle theory

with other accounts
of business cycles.

So, to sum up,
real business-cycle theory

is a really good theory
for many cases,

but it leaves many others
fundamentally unexplained.

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