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Did 2008’s Great Recession Undermine the Real Business Cycle Theory?

Posted on Aug. 8, 2019

Keynesian economics advocates the use of countercyclical policies to lessen the impact of the business cycle. Countercyclical monetary policy calls for increasing the money supply in a waning economy to put downward pressure on interest rates and stimulate growth, and doing the opposite when inflation is accelerating. Countercyclical fiscal policy involves reducing government spending and raising taxes during booms while increasing spending and cutting taxes during a recession.

On the other hand, the real business cycle (RBC) theory questions whether countercyclical policies actually exacerbate swings in business cycles. As an economist and researcher with the Federal Reserve Bank of Philadelphia explained in a paper published in 1999, the RBC theory claims that changes in productivity — and not monetary and fiscal disturbances — cause cyclical booms and busts in economic activity. Because RBCs are, according to adherents, caused by productivity fluctuations, countercyclical monetary and fiscal policies are not necessary. They will not decrease the severity of changes in the business cycle, and the costs of lowering output are greater than the benefits.

RBC theory assumes that the U.S. economy at least comes close to approximating a perfect market, one that is highly competitive and functions smoothly without the need for government regulations. However, the postwar U.S. economy may mimic a perfect-markets economy, precisely because postwar countercyclical policies prevented instability from dominating business fluctuations. RBC theory questions whether postwar countercyclical policies helped or hindered the U.S. economy’s progress toward a near-optimal business cycle. Do countercyclical policies guide the economy toward optimal behavior, or do they do just the opposite and cause a gap between actual and optimal behavior?

Prewar-era business cycles were marked by greater financial instability and sharper output fluctuations than their postwar-era counterparts, suggesting that the countercyclical policies used in the postwar years performed well.

During the years between 1933 and the 1999 paper describing the RBC (and nearly another decade after the paper’s release), the United States did not suffer a single prewar-style financial crisis. But then 2008 and the Great Recession came along.

In 2014 the Federal Reserve Bank of Minneapolis considered the challenges that the 2008 recession presented to the RBC theory, which predicts that labor productivity drops when output drops. Government data from the recession showed that per-worker productivity actually increased during the Great Recession even though total output fell dramatically. RBC proponents countered that the government data did not account for intangible capital, arguing that doing so would have shown higher output.

In 2018 a group of researchers from the Minneapolis Fed weighed in again, concluding that modern RBC models could account for the economic fluctuations observed in the Great Recession. Specifically, they argued that when augmented to consider money and flexible prices, RBC models have the same implications for shock relevance — and for optimal monetary and fiscal policy — as New Keynesian models.

Most literature credits the Great Depression as the origin of countercyclical policies. But perhaps it isn't looking back far enough. According to Genesis 41, an adviser to the Egyptian pharaoh forecast seven years of boom followed by seven years of bust. Joseph advised the pharaoh to reserve one-fifth of the land’s produce during the years of plenty. When the seven-year famine began, Egypt had bread. Did Joseph favor Keynes over RBC? Researchers with the Minneapolis Fed seem to answer with a shrug.

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