Course

Real Business Theory

Instructor: Tyler Cowen, George Mason University

This is " Game of Theories: Real Business Cycle " from our Principles of Economics: Macroeconomics course. So far in our business cycles deep dive, we’ve covered

This is "Game of Theories: Real Business Cycle" from our Principles of Economics: Macroeconomics course.

So far in our business cycles deep dive, we’ve covered two of the four main theories: Keynesian and monetarist. Now, we’re going to move away from aggregate demand and monetary policy to check out the supply side of things in real business cycle (RBC) theory.

In RBC, the “real” part refers to real shocks to an economy. Specifically, it refers to supply shocks.

Think about what might happen if the price for oil suddenly increased dramatically. We rely on oil a ton. Not only is oil crucial for travel, but also for the production of many everyday goods. That steep price increase would be a negative supply shock and put a damper on many sectors of the U.S. economy. A recession could follow.

This is exactly what happened in the U.S. in 1973 when the price of oil quadrupled for American buyers.

Okay, so RBC is useful for a complex supply shock. But it can also explain many of the economic downturns throughout human history. For instance, in ancient times when economies relied primarily on agriculture, a drought would be truly awful for the economy. It’s a much simpler example, but it’s still a negative supply shock.

What are the solutions to a downturn in RBC? Basically, try to avoid over-reliance on the supply of any particular good. In the case of an oil shock, be prepared by investing in alternative energy solutions. And try to make your economy flexible so that it can quickly respond to a negative real supply shock and limit the cost.

Like the theories we’ve discussed in previous videos, there are limitations to what RBC can explain. For instance, it’s not as useful in explaining recessions that are caused by monetary policy, banking, and credit in a modern economy. Check out our video for more on where RBC can, and can’t, shed light.

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