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6.3 Real Business Cycle Theory in Historical Perspective

Real business cycle theory, as developed by its modern proponents, is built on

the assumption that there are large random fluctuations in the rate of technological

progress. These supply-side shocks to the production function generate

fluctuations in aggregate output and employment as rational individuals respond

to the altered structure of relative prices by changing their labour

supply and consumption decisions. While this development is in large part a

response to the demise of the earlier monetary misperception models and

Lucas’s call to construct ‘artificial economies’, it also represents a general

revival of interest in the supply side of the macro equation.

The idea that business cycles might be driven by real rather than monetary

forces is certainly not an entirely new idea. The real business cycle models

inspired by Kydland and Prescott’s (1982) seminal paper belong to a long

line of analysis which was prominent in the literature before Keynes’s (1936)

General Theory (see Haberler, 1963, for a superb survey of the interwar

business cycle literature). Whereas some economists such as Ralph Hawtrey

held to the extreme monetary interpretation of the business cycle, the work of

others, in particular Dennis Robertson, Joseph Schumpeter and Knut Wicksell,

emphasized real forces as the engine behind business fluctuations (see

Deutscher, 1990; Goodhart and Presley, 1991; T. Caporale, 1993). While the

work of Robertson was not as dismissive of monetary forces as modern real

business cycle theory, according to Goodhart and Presley there is a great deal

of similarity between the emphasis given by Robertson to technological

change and the recent work of the equilibrium theorists. Technological change

also played a pivotal role in Joseph Schumpeter’s analysis of the short-run

instability and long-run dynamics of capitalist development. Since the introduction

of new technology influences the long-run growth of productivity as

well as causing short-run disequilibrating effects, Schumpeter, like modern

real business cycle theorists, viewed cycles and growth as inseparably interrelated

(see Schumpeter, 1939). Caporale (1993) argues that Knut Wicksell

was also an early expositor of real business cycle theory. Caporale shows that

Wicksell attributed ‘trade cycles to real causes independent of movements in

commodity prices’. To Wicksell the main cause of the trade cycle is a supplyside

shock that raises the natural rate of interest above the loan rate of

interest. This is equivalent to a reduction in the loan rate of interest since the

banking system will typically fail to adjust the loan rate immediately to

reflect the new natural rate. Loan market disequilibrium acting as a propagation

mechanism leads to endogenous money creation by the banking system

in response to entrepreneurs’ demand for loans to finance investment. The

investment boom, by distorting the time structure of production, thereby

creates inflationary pressures. Eventually the money rate of interest catches

up with the natural rate and the boom comes to an end. While this story had a

major influence on later Swedish and Austrian monetary theories of the trade

cycle, Caporale highlights how the Wicksell trade cycle story begins with a

real shock to the marginal product of capital. Wicksell’s real shocks plus

endogenous money account of the trade cycle is therefore remarkably similar

to the modern versions of REBCT provided by, for example, King and

Plosser (1984); see below, section 6.12.

Following the publication of Keynes’s (1936) General Theory, models of

the business cycle were constructed which emphasized the interaction of the

multiplier–accelerator mechanism (Samuelson, 1939; Hicks, 1950; Trigg,

2002). These models were also ‘real’ in that they viewed fluctuations as being

driven by real aggregate demand, mainly unstable investment expenditures,

with monetary factors downgraded and supply-side phenomena providing the

constraints which give rise to business cycle turning points (see Laidler,

1992a). Whatever their merits, multiplier–accelerator models ceased to be a

focus of active research by the early 1960s. To a large extent this reflected the

impact of the Keynesian revolution, which shifted the focus of macroeconomic

analysis away from business cycle phenomena to the development of

methods and policies which could improve macroeconomic performance.

Such was the confidence of some economists that the business cycle was no

longer a major problem that by 1969 some were even considering the question:

‘Is the Business Cycle Obsolete?’ (Bronfenbrenner, 1969). Similar

conjectures about ‘The End of the Business Cycle’ appeared during the late

1990s, often framed in terms of discussions of the ‘new economy’; see, for

example, Weber (1997). We have already seen that during the 1970s and

1980s the business cycle returned with a vengeance (relative to the norm for

instability post 1945) and how dissatisfaction with Keynesian models led to

monetarist and new classical counter-revolutions.

The most recent developments in business cycle research inspired by equilibrium

theorists during the 1980s have proved to be a challenge to all the

earlier models relying on aggregate demand fluctuations as the main source

of instability. Hence real business cycle theory is not only a competitor to the

‘old’ Keynesian macroeconomics of the neoclassical synthesis period but also

represents a serious challenge to all monetarist and early MEBCT new classical


In addition to the above influences, the transition from monetary to real

theories of the business cycle was further stimulated by two other important

developments. First, the supply shocks associated with the two OPEC oil price

increases during the 1970s made macroeconomists more aware of the importance

of supply-side factors in explaining macroeconomic instability (Blinder,

1979). These events, together with the apparent failure of the demand-oriented

Keynesian model to account adequately for rising unemployment accompanied

by accelerating inflation, forced all macroeconomists to devote increasing research

effort to the construction of macroeconomic theories where the supply

side has coherent microfoundations (see Chapter 7). Second, the seminal work

of Nelson and Plosser (1982) suggested that real shocks may be far more

important than monetary shocks in explaining the path of aggregate output over

time. Nelson and Plosser argue that the evidence is consistent with the proposition

that output follows a path, which could best be described as a ‘random


Before examining the contribution of Nelson and Plosser in more detail it

is important to note that the desire of both Keynesian and new classical

economists to build better microfoundations for the supply side of their

models should not be confused with the emergence during the late 1970s and

1980s of a distinctive ‘supply-side school’ of economists, particularly in the

USA during the presidency of Ronald Reagan. Writing in the mid-1980s,

Feldstein distinguished between ‘traditional supply-siders’ and the ‘new supply-

side economics’ (Feldstein, 1986). Traditional supply-siders base their

analysis on mainstream neoclassical economic analysis and emphasize the

efficiency of markets, the importance of incentives for economic growth, and

the possibility of government failure. A large consensus of economists would

subscribe to this form of supply-side economics, including Keynesians, monetarists

and new classicists (see Friedman, 1968a; Tobin, 1987; Lucas, 1990a).

In contrast, the new supply-siders, such as Arthur Laffer, Jude Wanniski and

President Reagan himself, made ‘extravagant claims’ relating to the impact of

tax cuts and deregulation on the rate of economic growth. While supplysiders

claimed that the incentive effects of the Reagan tax cuts were responsible

for the US recovery after 1982, Tobin (1987) argued that Reagan’s policies

amounted to ‘Keynesian medicine, demand tonics masquerading as supplyside

nostrums, serendipitously administered by anti-Keynesian doctors’. For

discussions of ‘Reaganomics’ and the influence of ‘new supply-siders’ during

the 1980s see Samuelson (1984); Blanchard (1986); Feldstein (1986); Levacic

(1988); Modigliani (1988b); Roberts (1989); and Minford (1991).