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Jul 26, 2012

Business Cycles Explained: Real Business Cycle Theory

Does the ‘Real Business Cycle Theory’ have a corner on reality? Cowen gives us a crash course.

Real Business Cycle Theory holds shocks to technology are the real causes economic downturns. According to these “realists,” technology shocks emanate from events that prevent an economy from producing the goods and services that it produced in the past. In the simplest form of the model, we trace the ripples from one major negative event.

Cowen highlights the 2011 Tsunami and earthquake in Japan as an example of a negative shock to technology. At the epicenter of the disaster we find loss of life, property, and wealth. In economic aftershocks or ripples, we find price adjustments, and interrupted work and investment decisions. Further out we find effects reaching sectors that weren’t immediately affected by the disaster. As the shock spreads, massive economic downturn takes place.

One of the strengths of Real Business Cycle Theory is that it applies to almost every downturn in history. However, as the economies grow in size and complexity, the task of determining the size and relevance of a technological shock correspondingly grows more complex. Take the recent financial crisis as an example—what initial negative shock reverberates through our current recession?

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