Review on Understanding Real Business Cycle

Review on “Understanding Real Business Cycle” by Charles I. Plosser In the journal of Economic Perspectives – Volume 3, Number 3 – Summer 1989 – Pages 51 – 77, Charles I. Plosser introduced the Neoclassical Model of Capital Accumulation for the use of studying real business cycle. The paper discussed the model focusing on the impact of technological shock. The model is based on the capital stock is accumulated. The technology shock could provide a rational choice of the agents in the economy which can affecting the economy overtime.

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The capital accumulation model is a simple model which has only a few main variables. The main variables included output, current consumption, investment, work hours and leisure. The model has assumed that many individual are identical and exited permanently. The mathematical representation of the agents’ utility is [pic] where consumption and leisure are the variables of the utility function. The agents are maximizing their utility and live forever. Work hours and capital are the variables of calculating the production function.

The equation of the production function is [pic]. Since the capital K can be depreciated, the capital stock is describe by [pic], where [pic] is the percentage of depreciated assets. The neoclassical model is under two budget constraint. Firstly, the sum of consumption and investment is equal to the output. Secondly, there is a particular length of time that can be spent as either work hours or leisure. The model also assumed that the agents in the economy can change the level of consumption and level or the length of work hours and leisure freely.

The real business cycle model is initialed by technological shock or change in productivity. While other shock such as money, government spending and tax could have an impact on the model, the author focus mainly on technological shock in the paper. The paper stated that, a growth in technology first increase the productivity per capita. Assuming the shock only affects the short-run. The model suggested that the agents will tend to work more currently and consume more than invest. As a resulted, the wealth of the agents increased resulting in increasing consumption in the future.

Therefore, the effect of the productivity change can be sustained to the economic fluctuation in the future. The paper strengthened their suggestion of the neoclassical model by providing statistic analysis of US economy in 1954-1985. The summary statistic showing that the growth of economy can be predicted well by the neoclassical model. Since the model is initialed by the technological or productivity change, the statistics have proven that technology growth is a main factor of determining economic fluctuation. There are some limitations stated in the paper.

For example, the summary statistics of the US economy have shown that the model has a poor prediction of the working hours change. This is because the model has assume the agents can choose their working hours freely, but it is not possible in the real world. The other limitation of the model is the model only focus on the change of technology, ignore other factors such as government spending and tax. Government spending is likely to increase output and tax can influence consumption and investment level which in order to affect the output level.

Ignoring these factors meaning that the model is not able to predict the economic fluctuation by the government action. Moreover, the neoclassical model can not reflect the effects of different sectors’ actions. For example, a technology shock increased the productivity which increased the output level. The model is then predicting the agents in the economy will tend to work more and increase the output level in the future, but the Reserve Bank may adjust the interest rate due to the increased output level.

The Reserve Bank action can decrease the output level, which is contrasted to the prediction of the model. In conclude, the main difference between the neoclassical model and the Keynesian model is the accumulation of capital stock. It is the strength of the neoclassical model to estimate the economic fluctuation over time. However, the model is limited to response the productivity change only. In order to have a more precise estimation of the real business cycle, the model should take other factors (such as fiscal policy) into account. So the model can be used to response vary situations in the future.

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