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6.1 Introduction: The Demise of New Classical Macroeconomics Mark I

The dramatic statement by Lawrence Summers concerning real business

cycle theory is no exaggeration. The reason has to do with the striking

implications of developments in business cycle theory associated with the

real business cycle school that initially took place in the early 1980s. We

have already seen in the previous two chapters how the influence of both

monetarism and new classical economics called into question the desirability

and effectiveness of activist discretionary stabilization policies. Such

policies were founded on the belief that aggregate demand shocks were the

main source of aggregate instability. But rather than advocate the persistent

use of expansionary aggregate demand policies in an attempt to achieve

some target rate of (full) employment, both Friedman and Lucas advocated

the use of supply-side policies in order to achieve employment goals (Friedman,

1968a; Lucas, 1978a, 1990a). During the 1960s and 1970s, both

Friedman and Lucas, in their explanation of business cycles, emphasized

monetary shocks as the primary impulse mechanism driving the cycle. The

real business cycle theorists have gone much further in their analysis of the

supply side. In the model developed during the early 1980s by Kydland and

Prescott (1982) a purely supply-side explanation of the business cycle is

provided. This paper marked the launch of a ‘mark II’ version of new

classical macroeconomics. Indeed, the research of Kydland and Prescott

represented a serious challenge to all previous mainstream accounts of the

business cycle that focused on aggregate demand shocks, in particular those

that emphasized monetary shocks.

Particularly shocking to conventional wisdom is the bold conjecture advanced

by real business cycle theorists that each stage of the business cycle

(peak, recession, trough and recovery) is an equilibrium! As Hartley et al.

(1998) point out, ‘to common sense, economic booms are good and slumps

are bad’. This ‘common sense’ vision was captured in the neoclassical synThe

thesis period with the assumption that ‘full employment’ represented equilibrium

and that recessions were periods of welfare-reducing disequilibrium

implying market failure and the need for stabilization policy. Real business

cycle theorists reject this market failure view. While recessions are not desired

by economic agents, they represent the aggregate outcome of responses

to unavoidable shifts in the constraints that agents face. Given these constraints,

agents react optimally and market outcomes displaying aggregate

fluctuations are efficient. There is no need for economists to resort to disequilibrium

analysis, coordination failure, price stickiness, monetary and financial

shocks, and notions such as fundamental uncertainty to explain aggregate

instability. Rather, theorists can make use of the basic neoclassical growth

model to understand the business cycle once allowance is made for randomness

in the rate of technological progress (the neoclassical growth model is

discussed in Chapter 11). In this setting, the business cycle emerges as the

aggregate outcome of maximizing decisions made by all the agents populating

an economy.