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6.15 The Policy Implications of Real Business Cycle Theory

Before 1980, although there was considerable intellectual warfare between

macroeconomic theorists, there was an underlying consensus relating to three

important issues. First, economists viewed fluctuations in aggregate output as

temporary deviations from some underlying trend rate of growth. An important

determinant of this trend was seen to be an exogenously determined

smooth rate of technological progress. Second, aggregate instability in the

form of business cycles was assumed to be socially undesirable since they

reduced economic welfare. Instability could and therefore should be reduced

by appropriate policies. Third, monetary forces are an important factor when

it comes to explaining the business cycle. Orthodox Keynesian, monetarist

and new classical economists accepted all three of these pillars of conventional

wisdom. Of course these same economists did not agree about how

aggregate instability should be reduced. Neither was there agreement about

the transmission mechanism which linked money to real output. In Keynesian

and monetarist models, non-neutralities were explained by adaptive expectations

and the slow adjustment of wages and prices to nominal demand shocks.

In the new classical market-clearing models of the 1970s, non-neutralities

were explained as a consequence of agents having imperfect information.

When it came to policy discussions about how to stabilize the economy,

monetarists and new classical economists favoured a fixed (k per cent) monetary

growth rate rule, whereas Keynesian economists argued in favour of

discretion (see Modigliani, 1986; Tobin, 1996). The main impact of the first

wave of new classical theory on policy analysis was to provide a more robust

theoretical case against activism (see Kydland and Prescott, 1977). The political

business cycle literature also questioned whether politicians could be

trusted to use stabilization policy in order to reduce fluctuations, rather than

as a means for maximizing their own interests (see Nordhaus, 1975 and

Chapter 10).

During the 1980s everything changed. The work of Nelson and Plosser

(1982) and Kydland and Prescott (1982) caused economists to start asking

the question, ‘Is there a business cycle?’ Real business cycle theorists find the

use of the term ‘business cycle’ unfortunate (Prescott, 1986) because it suggests

there is a phenomenon to explain that is independent of the forces

determining economic growth. Real business cycle theorists, by providing an

integrated approach to growth and fluctuations, have shown that large fluctuations

in output and employment over relatively short time periods are ‘what

standard neoclassical theory predicts’. Indeed, it ‘would be a puzzle if the

economy did not display large fluctuations in output and employment’

(Prescott, 1986). Since instability is the outcome of rational economic agents

responding optimally to changes in the economic environment, observed

fluctuations should not be viewed as welfare-reducing deviations from some

ideal trend path of output. In a competitive theory of fluctuations the equilibria

are Pareto-optimal (see Long and Plosser, 1983; Plosser, 1989). The idea that

the government should in any way attempt to reduce these fluctuations is

therefore anathema to real business cycle theorists. Such policies are almost

certain to reduce welfare. As Prescott (1986) has argued, ‘the policy implication

of this research is that costly efforts at stabilisation are likely to be

counter-productive. Economic fluctuations are optimal responses to uncertainty

in the rate of technological progress.’ Business cycles trace out a path

of GDP that reflects random fluctuations in technology. This turns conventional

thinking about economic fluctuations completely on its head. If

fluctuations are Pareto-efficient responses to shocks to the production function

largely resulting from technological change, then monetary factors are

no longer relevant in order to explain such instability; nor can monetary

policy have any real effects. Money is neutral. Since workers can decide how

much they want to work, observed unemployment is always voluntary. Indeed,

the observed fluctuating path of GNP is nothing more than a continuously

moving equilibrium. In real business cycle theory there can be no meaning to

a stated government objective such as ‘full employment’ because the economy

is already there! Of course the real business cycle view is that the government

can do a great deal of harm if it creates various distortions through its taxing

and spending policies. However, as we have already noted, in real business

cycle models a temporary increase in government purchases will increase

output and employment because the labour supply increases in response to

the higher real interest rate brought about by higher (real) aggregate demand.

If technological change is the key factor in determining both growth and

fluctuations, we certainly need to develop a better understanding of the factors

which determine the rate of technological progress, including institutional

structures and arrangements (see Chapter 11). To real business cycle theorists

the emphasis given by Keynesian and monetarist economists to the issue of

stabilization has been a costly mistake. In a dynamic world instability is as

desirable as it is inevitable.

Finally, Chatterjee (1999) has pointed out that the emergence of REBCT is

a legacy of successful countercyclical policies in the post-Second World War

period. These policies, by successfully reducing the volatility of GDP due to

aggregate demand disturbances compared to earlier periods, has allowed the

impact of technological disturbances to emerge as a dominant source of

modern business cycles.