In economics, nominal value is measured in terms of money, whereas real value is measured against goods or services. A real value is one which has been adjusted for inflation, enabling comparison of quantities as if the prices of goods had not changed on average. Changes in value in real terms therefore exclude the effect of inflation. Real values measure the purchasing power net of any price changes over time. The real GDP determines the purchasing power net of price changes for a given year. Real GDP accounts for inflation and deflation. It transforms the money-value measure, nominal GDP, into an index for quantity of total output.

The Real Business Cycle Theories!

Introduction:

The real business cycle theory has been evolved out of the American new classical school of 1980s. It is the outcome of research mainly by Kydland and Prescott, Barro and King, Long and Plosser, and Prescott. Later, Plosser, Summers, Mankiw and many other economists gave their views of the real business cycles.

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They view aggregate economic variables as the outcomes of the decisions made by many economic agents acting to maximize their utility subject to production possibilities and resource constraints. Their views mainly relate to technology shocks, labour market, interest rate, role of money, fiscal policy, prices and wages in business cycles. They are explained below.

Role of Technological Shocks:

The theory of real business cycles explains short-run economic fluctuations based on the assumptions of the classical theory. According to this theory, business cycles are the natural and efficient response of the economy to economic environment.

They are primarily caused by real or supply side shocks that involve exogenous large random changes in technology. An initial shock in the form of a technological advance shifts the production function upward. This leads to increase in available resources, investment, consumption and real output. With the increase in investment, the capital stock increases which further increases real output, consumption and investment.

This process of expansion of the economy continues erratically due to changes in technology over time. According to Plosser, “It is a purely real model, driven by technology disturbances, and hence, it has been labeled a real business cycle model.”

Assumptions:

The real business cycle theory is based on the following assumptions:

1. There is a single commodity in the economy.

2. Prices and wages are flexible.

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3. Money supply and price level do not influence real variables such as output and employment.

4. Fluctuations in employment are voluntary.

5. Population is given. So there is fixed labour force.

6. There are rational identical economic agents in the economy.

7. These agents make optimising decisions.

8. Everyone has the same preferences which depend only on consumption in each year.

9. More consumption is preferred to less so that the marginal utility from consumption diminishes.

10. The economy is subject to irregular (random) real supply side shocks.

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11. It is a single sector economy.

12. There are substantial changes in the rate of technology that affect the whole economy (which is viewed as a single sector).

13. There is constant return to scale production-technology.

14. The economy is in a steady state.

Technological Shock:

Given these assumptions, the production function of the economy is given by

Y = Zf (K,N)

Where Y is total output, Z is the state of technology, K is predetermined capital stock and N is labour input. The produced output can either be consumed or invested.

Assuming that population is given and there is a fixed labour force, output depends on technology and capital stock. So output is determined by the production function, Y= Zf (K). The capital stock, K depreciates at the rate S, so that the undepreciated capital stock evolves as (1-δ) K. This capital stock is available as input for production in the next period.

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With a capital stock K, output is Y and the total resources available in the economy in the current period are Y + (1-δ) K.

Since Y = Zf (K), the total resources can be expressed as Zf (K) + (1-δ) K. These resources can either be consumed or accumulated as capital to be used as investment for the next period.

A real business cycle is generated in a steady state economy when there is a positive exogenous and permanent technological shock. This leads to increase in productivity. As a result, the aggregate production function shifts upward.

The improvement in technology from the initial level Z to Z₁ and the consequent upward shift of the production function from Zf(K) to Z₁f(K) is shown in Figure 1. Given the initial capital stock OK, output increases from OY to OY₁.

As a result, total resources increase from OR to OR₁ and the total resources curve shifts upward from Zf(K)+(1-δ) K to Z₁f(K)+(l-δ)K. With the increase in total resources, both current consumption and capital accumulation also increase. There is increase in capital stock to OK₁.

With no change in technology, the increase in capital stock to K₁ in the next period leads to a further rise in output to OY₂ and the increase in total resources to OR₁. In this way, the economy continues to expand when consumption, investment and output increase gradually leading to a new steady state.

But the path to a new steady state will not be smooth. With a permanent technological advance, consumption and investment increase in the next period. But the increase in total resources and output is smaller than in the initial period. In Figure 1, R₁R₂ < R R₁ and Y₁Y₂ <YY₁.

In the long run, there is a gradual decline in investment and consumption even when output continues to increase at a decreasing rate till the economy reaches the new steady state. The paths of this real business cycle are illustrated in Figure 2.

In period 1, there is a permanent technology shock which advances technology Z from a to b. This leads to increase in investment I from c to d and output Y from e to f. Given the same level of technology Z, shown as the horizontal curve, the investment curve I gradually falls in subsequent periods but the output curve Y continues to increase at a decreasing rate till the economy reaches the new steady state in period 5.

A recession in the real business theory is just the reverse of the expansion. A shock of decline in-technology reduces Z and shifts the production function downward and decreases the available resources. This starts a process of decline in investment, consumption, output and employment. But the models of real business cycle do not explain a recession.

Labour Market:

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The real business cycle theory emphasises that there is intertemporal substitution of labour in the labour market. When a technology advance leads to a boom, the marginal product of labour increases. There is increase in employment and real wage. In response to a high real wage, workers reduce leisure.

On the contrary, when technology is unfavourable and declines, the marginal product of labour, employment and real wage rate are low. In response to a low real wage, workers increase leisure. Thus an important implication of real business theory is that the real wage is procyclical.

Interest Rate:

The real business cycle theory also takes into account the role of real interest rate in response to a technological shock. The real interest is equal to the marginal product of capital. When a favourable technological change leads to a boom, the marginal product of capital and the real interest rate rise.

On the contrary, an unfavourable technical change leading to a recession reduces the marginal product of capital and the real interest rate. When the economy reaches the new steady state, the real interest rate eventually returns to its initial level.

Introduction:

Role of Technological Shocks:

Assumptions:

Technological Shock:

Labour Market:

Interest Rate:

Flexibility of Wages and Prices:

Money Prices And The Real