“Why did nobody notice it?” asked Queen Elizabeth II. during a visit at London School of Economics (Pierce 2008). She referred to the Global Financial Crisis 2007/08 (GFC). Why did economists fail to advise politicians inasmuch as crises do not arise?
The Real Business Cycle theory (RBCT) was a common framework of analysing economics. Important representatives of RBCT are Edward C. Prescott and Finn E. Kydland. Both won the Nobel prize in economic sciences in 2004 inter alia for their contributions to understand driving forces behind business cycles (BCs) (The Nobel Prize 2018). This essay will analyse how useful RBCT and its policy prescriptions are in understanding and dealing with the GFC.
The thesis statement of this essay is that RBCT and its policy implications are not suitable to understand or deal with the GFC.
First of all, I will give an overview of RBCT. Subsequently, its strengths and weaknesses will be analysed. Then, the GFC will be explained. Afterwards, this essay will contain a comparison between RBCT and Marx’s crisis theory as well as Minsky’s financial instability hypothesis (FIH). Finally, the appropriateness of RBCT and its policy prescriptions to deal with the GFC will be discussed.
Table of Contents
1. Introduction
2. Overview of RBCT
3. Analysis of strengths and weaknesses of RBCT
4. Explanation of the GFC
5. Comparison of RBCT with Marx’s crisis theory and Minsky’s FIH
6. Appropriateness of RBCT to deal with the GFC 2007/08
7. Conclusion
Research Objective and Scope
This essay critically examines the theoretical and methodological foundations of Real Business Cycle Theory (RBCT) and evaluates its efficacy in explaining and addressing the Global Financial Crisis (GFC) of 2007/08, while contrasting its approach with alternative crisis theories.
- Theoretical evaluation of Real Business Cycle Theory.
- Methodological critique of supply-side business cycle explanations.
- Comparative analysis with Marxian crisis theory and Minsky’s Financial Instability Hypothesis.
- Assessment of policy prescriptions in the context of the 2007/08 economic collapse.
- Analysis of market failure versus rational equilibrium models.
Excerpt from the Book
2. Overview of RBCT
The RBCT is generally based on the growth theory of Solow (Arnal 2016, 87). RBCT agrees with Solow insofar that internal mechanisms of market economies are stable. Technology shocks are the reason for cyclical fluctuations according to RBCT (Francisa and Ramey 2005, 1).
Kydland and Prescott (1982) provided a purely supply-side explanation of BCs. They presented a specific theory of BCs and a methodology for testing competing BC-theories (Kydland and Prescott 1982). The RBC methodology breaks down to two principles: The economy should always be modeled using dynamic general equilibrium models and a model’s aptness for describing reality should be assessed using calibration.
RBCT include the following assumptions: forward-looking rational expectations, stable preferences, perfectly competitive environment, complete information, optimising rational agents, no frictions and no adjustment or transaction costs. Furthermore, a representative agent framework is used where agents purpose to maximise their utility under resource constraints. Price flexibility guarantees continuous market clearing so that equilibrium always prevails. Exogenous shocks to technology are random, act as the impulse mechanism and have an impact on the supply side of the economy (Gill 1997, 79; Snowdon and Vane 2005, 307-308).
Summary of Chapters
1. Introduction: Presents the research question regarding the usefulness of RBCT in understanding the GFC and states the thesis that RBCT is inadequate for this purpose.
2. Overview of RBCT: Details the foundational assumptions of Real Business Cycle Theory, including the focus on technology shocks and dynamic general equilibrium models.
3. Analysis of strengths and weaknesses of RBCT: Examines academic critiques of RBCT, focusing on the lack of empirical link between the model and observed economic phenomena.
4. Explanation of the GFC: Describes the progression of the 2007/08 financial crisis, focusing on the subprime mortgage market and the role of financial institutions.
5. Comparison of RBCT with Marx’s crisis theory and Minsky’s FIH: Contrasts the supply-side focus of RBCT with the inherent crisis tendencies in Marxian theory and the debt-driven instability described by Minsky.
6. Appropriateness of RBCT to deal with the GFC 2007/08: Argues that the GFC demonstrates market failures that contradict the core assumptions of equilibrium and rational behavior in RBCT.
7. Conclusion: Summarizes findings, concluding that RBCT failed to anticipate the crisis and that alternative theories are more appropriate for understanding financial instability.
Keywords
Real Business Cycle Theory, RBCT, Global Financial Crisis, GFC, Business Cycles, Macroeconomics, Rational Expectations, Financial Instability Hypothesis, Minsky, Marxian Theory, Monetary Policy, Subprime Mortgages, Market Equilibrium, Supply-side Economics, Economic Modeling.
Frequently Asked Questions
What is the primary objective of this research paper?
The paper aims to evaluate whether Real Business Cycle Theory (RBCT) provides a useful framework for understanding the causes and dynamics of the 2007/08 Global Financial Crisis.
What are the core pillars of RBCT mentioned in the study?
The core pillars include the use of dynamic general equilibrium models, the assumption of rational expectations, price flexibility, and the attribution of economic fluctuations primarily to exogenous technology shocks.
How does the author characterize the methodology of RBCT?
The methodology is described as being built upon supply-side principles, focusing on representative agents and the calibration of models rather than empirical fit to real-world market deviations.
What is the thesis of the paper regarding the GFC?
The author argues that RBCT and its associated policy prescriptions are not suitable for understanding or addressing the complexities of the Global Financial Crisis.
How is the GFC compared to other economic theories in the text?
The text compares RBCT with Marx’s crisis theory and Hyman Minsky’s Financial Instability Hypothesis, noting that the latter provides better insights into the debt-driven collapse of the financial system.
Which key terminology is used to characterize the crisis?
The study highlights terms such as "subprime mortgages," "collateralized debt obligations (CDOs)," "Minsky moment," and "market failure."
Why does the author claim the assumption of "rational agents" is doubtful?
The author points to the blind trust financial institutions placed in credit rating agencies and the massive scale of foreclosures as evidence that agents did not act in a way that suggests a perfect, rational equilibrium.
Does the author believe that monetary policy was relevant to the crisis?
Yes, the author notes that the Federal Reserve's interest rate adjustments played a central role in the formation of the housing bubble and the subsequent economic downturn, contradicting the RBCT view that monetary policy is irrelevant.
What is the significance of the "Minsky moment" mentioned in the work?
It refers to the moment when overindebted agents default and are forced to sell assets, leading to a revaluation of debt that triggers broader systemic instability, which the author uses to explain the GFC better than RBCT.
What is the final conclusion regarding the utility of RBCT?
The author concludes that economists failed to foresee the crisis partly because they relied on models like RBCT, which ignore the inherent instabilities of the financial system, and suggests that future research should focus on theories better equipped to predict crises.
- Arbeit zitieren
- David Höhl (Autor:in), 2018, A Critical Analysis of the Main Theoretical and Methodological Tenets of Real Business Cycle Theory. Is It Suitable to Understand the Global Financial Crisis of 2007/08?, München, GRIN Verlag, https://www.grin.com/document/465437
