Real Business Cycle Model: Study with Video Lessons, Practice Problems & Examples

The Real Business Cycle Model emphasizes changes in aggregate supply as the primary driver of economic fluctuations, contrasting with the Keynesian focus on aggregate demand. It posits that inflation and recession stem from technological changes or resource availability, often illustrated by a supply shock like rising oil prices. This leads to a leftward shift in the long-run aggregate supply curve, resulting in lower real GDP while maintaining the same price level. Understanding this model is crucial for grasping the dynamics of economic cycles.

Real Business Cycle Model

Throughout this course, we're focused mainly on the Keynesian Model of Economics. Let's check out another one called the Real Business Cycle Model. Okay. So the Real Business Cycle Model of Economics, the main difference is that it focuses on changes in aggregate supply rather than changes in aggregate demand. Okay? So the Real Business Cycle Model believes that inflation and recession are caused mainly by changes in technology. So that's going to be an increase to aggregate supply or changes in the availability of resources. So generally, this could be like a supply shock. Generally, we'll think about this as a decrease in our aggregate supply. Maybe, prices have gone up for our resources or we've lost access to key resources and that is going to cause a recession like that. Okay? So that's the main reason that we have fluctuations in our economy based on the real business cycle model is these changes in aggregate supply. The other models that we've discussed, the Keynesian model, well, they believe that we have to fight recessions by increasing aggregate demand and the monetarist model believes increases in the money supply will lead to increased spending. Okay. So the other models focus on changes in spending, while this one focuses on aggregate supply. Okay? We focus on aggregate supply in this model rather than aggregate demand. So as an example, let's think of a supply shock here. So there's a supply shock where an increase in oil prices causes the input prices of many firms to increase. Okay? So oil prices have surged and now the availability of oil is much less, right? There's much higher prices which leads to lower production and employment. So we have here, we're going to have our long-run aggregate supply curve and we've got our aggregate demand curve, okay? This is our original situation and now we have this supply shock leading to a lower availability of resources and causing Long Run Aggregate Supply to fall here. Okay? So this was our first long-run aggregate supply. This is our new long-run aggregate supply. So we had this original equilibrium around here where we had this price level. So this is the price level in the economy and this is the real GDP in the economy. And we'll have this first equilibrium, price level PL1. And then the long-run aggregate supply shifts to the left, right? So this lowers, our production in the economy, which leads to lower employment and lower demand as well. So this model believes that there's this reduction in production, reduction in production. That's a cool rhyme right there. Is also going to lead to a reduction in aggregate demand. So now, aggregate demand is also going to shift to the left. Based on this lower production, there's just less demand, less employment, less money being made. And we'll have this shift left in aggregate demand as well which leads us to a new equilibrium. And but notice what happens at this new equilibrium is we have the same price level. So real GDP changed from GDP1 to this lower GDP, GDP2, based on the lower availability of resources, but the price level remains constant. That's the idea of the real business cycle is that we go through these fluctuations in aggregate supply rather than the fluctuations in aggregate demand. Aggregate supply is in this model the one that drives all of the changes in the economy. Okay? So that's the main thing to remember about the Real Business Cycle Model is that it's focused on changes in aggregate supply rather than changes in aggregate demand, that lead to the fluctuations in the economy. Cool? Alright. That's about it for the Real Business Cycle Model. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the main difference between the Real Business Cycle Model and the Keynesian Model?

The main difference between the Real Business Cycle (RBC) Model and the Keynesian Model lies in their focus on economic fluctuations. The RBC Model emphasizes changes in aggregate supply as the primary driver of economic cycles, attributing inflation and recession to technological changes or resource availability. In contrast, the Keynesian Model focuses on aggregate demand, suggesting that economic fluctuations are driven by changes in consumer and government spending. While the RBC Model sees supply shocks, such as rising oil prices, as pivotal, the Keynesian Model advocates for increasing aggregate demand to combat recessions.

How does a supply shock affect the economy according to the Real Business Cycle Model?

In the Real Business Cycle (RBC) Model, a supply shock, such as a sudden increase in oil prices, leads to a leftward shift in the long-run aggregate supply (LRAS) curve. This shift results in lower production and employment, causing a decrease in real GDP. The model posits that this reduction in production also leads to a decrease in aggregate demand, as lower employment and production reduce overall spending. Despite these changes, the price level remains constant, highlighting the RBC Model's focus on supply-side factors as the main drivers of economic fluctuations.

What role do technological changes play in the Real Business Cycle Model?

In the Real Business Cycle (RBC) Model, technological changes are a key factor influencing economic fluctuations. Positive technological advancements can increase aggregate supply by making production more efficient, leading to higher real GDP and employment. Conversely, negative technological changes or setbacks can reduce aggregate supply, causing lower production and employment, and potentially leading to a recession. The RBC Model views these technological changes as primary drivers of economic cycles, emphasizing their impact on the supply side of the economy.

Why does the Real Business Cycle Model focus on aggregate supply rather than aggregate demand?

The Real Business Cycle (RBC) Model focuses on aggregate supply rather than aggregate demand because it attributes economic fluctuations primarily to changes in production capabilities and resource availability. The model posits that factors such as technological advancements or supply shocks (e.g., changes in oil prices) directly impact the economy's productive capacity. This focus contrasts with models like the Keynesian Model, which emphasize aggregate demand and spending as the main drivers of economic cycles. By concentrating on supply-side factors, the RBC Model aims to explain how variations in production and resource availability lead to changes in real GDP and employment.

How does the Real Business Cycle Model explain recessions?

The Real Business Cycle (RBC) Model explains recessions as a result of negative supply shocks or adverse technological changes. For instance, a sudden increase in the price of key resources like oil can reduce the economy's productive capacity, leading to a leftward shift in the long-run aggregate supply (LRAS) curve. This shift results in lower real GDP and employment. The model suggests that these supply-side disruptions cause a reduction in aggregate demand as well, due to decreased production and income. Thus, recessions in the RBC Model are driven by factors that affect the economy's ability to produce goods and services.