Real Business Cycles

The Classical Model builds on the principles developed in microeconomics to explain how equilibrium production and employment might be determined from profit maximizing behavior and utility maximizing behavior. 

The Real Business Cycles Model further refines this to a simple model that explains how Robinson Crusoe could have business cycles on an island with no other agents, no wage rate, no price level, and, in particular, no monetary authority.  This demonstration removes monetary policy and wage/price stickiness from the discussion.

The first step is to draw a production function and indifference curves on a diagram of output vs. labor.  The equilibrium is at a tangency between the production function and one of the indifference curves.

The application then analyzes the effects of technology shocks, which cause business cycles in this model.  You can choose among three types of additive and multiplicative shocks.

Because shocks to technology can cause recessions in the Real Business Cycles model, but nominal wage rates and nominal prices do not even appear in the model, there is no role for monetary policy to play in alleviating these shocks.

The decade of the 1970's established the importance of this line of thinking.  The energy shortages can be interpreted as shocks to the production function, and the model calls into question the use of monetary policy to fight business cycles during that era.

Model Link:  The Real Business Cycles Model
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Printable PDF Exercises

Related Models

The Real Business Cycle Model presented here combines the production function from the Demand for Labor with a transposed view of the indifference curves from the Supply of Labor.  It arrives at an equilibrium without introducing a wage rate.


Robert J. Barro, Macroeconomics.

Daniel Defoe, The Life and Strange Adventures of Robinson Crusoe, 1719.