A Macroeconomics Reader

By Brian Snowdon; Howard R. Vane | Go to book overview

18

Real business cycles

A new Keynesian perspective

N. Gregory Mankiw

Journal of Economic Perspectives (1989) 3, Summer, pp. 79-90

The debate over the source and propagation of economic fluctuations rages as fiercely in the late 1980s as it did in the late 1930s in the aftermath of Keynes’s The General Theory and in the midst of the Great Depression. Today, as then, there are two schools of thought. The classical school emphasizes the optimization of private economic actors, the adjustment of relative prices to equate supply and demand, and the efficiency of unfettered markets. The Keynesian school believes that understanding economic fluctuations requires not just studying the intricacies of general equilibrium, but also appreciating the possibility of market failure on a grand scale.

Real business cycle theory is the latest incarnation of the classical view of economic fluctuations. It assumes that there are large random fluctuations in the rate of technological change. In response to these fluctuations, individuals rationally alter their levels of labor supply and consumption. The business cycle is, according to this theory, the natural and efficient response of the economy to changes in the available production technology.

My goal in this chapter is to appraise this newly revived approach to the business cycle. I should admit in advance that I am not an advocate. In my view, real business cycle theory does not provide an empirically plausible explanation of economic fluctuations. Both its reliance on large technological disturbances as the primary source of economic fluctuations and its reliance on the intertemporal substitution of leisure to explain changes in employment are fundamental weaknesses. Moreover, to the extent that it trivializes the social cost of observed fluctuations, real business cycle theory is potentially dangerous. The danger is that those who advise policy-makers might attempt to use it to evaluate the effects of alternative macroeconomic policies or to conclude that macroeconomic policies are unnecessary.


WALRASIAN EQUILIBRIUM AND THE CLASSICAL DICHOTOMY

The typical undergraduate course in microeconomics begins with partial equilibrium analysis of individual markets. A market for a good is characterized by a downward sloping demand curve and an upward sloping

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