Real Business Cycles: Neo Classical Model

Introduction

• Outcome of C.F

• Neoclassical / 2nd century of new classical models

• classical framework

  REAL

  • these business cycles are because of real factors, supply side factors
  • the fluctuations can arise due to the ‘shocks’¹
  • +ve shock: generally lead to a boom² $y\uparrow$
  • if it is going to augment economic growth
  • -ve shock: generally lead to a recession³ $y\downarrow$
  • if it is going to be detrimental to economic growth

Real Business Cycles

Real business cycles, which is an outgrowth of neoclassical theory, built on original classical system, which essentially believes that the business cycles are due to the supply side factors or the real shocks which could be positive or negative.

Some of the examples of positive shocks are

• good weather
• increase in population
• reforms
• technology
• innovation, and so on.

Some of the negative shocks are

• drought
• natural disasters
• mass death
• collapse of civilizations⁴

Real Business Cycles Model

The two important features are

1. The agents would optimize⁵
2. Markets clear

Agent: an individual
Max: Utility
Sources:
	- consumption
	- leisure

$$U_t=U(c_t,L{e}_t)$$

Individuals produce first ,which which he forgoes his leisure. The aggregate production function is given by:

$$Y_t=Z_t\cdot F(k_t,N_t)$$

Two differences between the classical and the neoclassical model

• $Z_t$ is a positive shock (technical progress)
• $K_t$ is not held fixed, its as per the choice of the agent

The choice that the individual makes is the reason for the fluctuation

• The first difference is $Z_t$, which is the shocks to production processes⁶.
• The second difference is that $K$ doesn’t have a bar i.e., the capital stock is chosen and not given.

Everything he produces, he consumes partly and he sells the remaining. Thereby making money.

Apart from the labor-leisure trade-off, there is also trade-off between consumption today and savings from the future consumption.

$$Y_t=C_t+S_t$$

Savings for today increases the capital stock for the next period, which you invest.

$$K_{t+1}=S_t+(1-\delta )K_t$$

Thus output, employment consumption and savings are the choices made by the individual.

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Effects of the positive technology shock would lead to shift in the production function and thereby giving an opportunity for the agent to take advantage of this, which means before the positive shock, the agent was supplying labor (working for) $N_0$ and corresponding output at $Y_0$.

After the positive shock, which is only for one period, we could see that the agent would prefer to work for the same $N_0$ but increases output to $Y_0’$ or work up to $N_1$ and further increase output to $Y_1$.

Thus, we see the choices made by the agent are the output, the employment, the consumption and the savings.

Footnotes

1. A sudden change (perhaps, in the policy) ↩

2. rise in your output, e.g. (a +ve shock can come due to Reforms, New natural resources, Innovation (R&D), IT revolution, Population, Industrial Revolution)

   • Population, depends on the state of the economy. The same country might at one point in time demand for more population and in the next moment might want to curtail population
   ↩

3. reduction in your output (a -ve shock can arise due to Wars, Famine, Natural Disasters, COVID-19 (Mass death), Japan Tsunami) ↩

4. It’s a bit extreme tho. ↩

5. Get the best out of the given scenario ↩

6. It can be in the form of new technology, new raw materials, new government regulations (subsidies etc) ↩