— Ch. 1 · Foundations And Origins —
Real business-cycle theory.
~5 min read · Ch. 1 of 5
In 1982, Finn E. Kydland and Edward C. Prescott published a paper titled Time to Build And Aggregate Fluctuations that changed how economists viewed economic ups and downs. Their work emerged from the new classical macroeconomics tradition, which sought to explain business cycles without relying on nominal shocks like changes in money supply. Before their intervention, monetary economists Milton Friedman and Robert Lucas had proposed in the early 1970s that misperceptions about wages drove booms and recessions. They argued workers made decisions based on whether they thought wages were higher or lower than reality. Perfect information would eliminate these fluctuations entirely according to their framework. Kydland and Prescott shifted focus to real factors instead of nominal ones. They envisioned random technological shifts as the primary driver of economic activity. These shocks could be innovations, bad weather events, oil price spikes, or stricter environmental regulations. The general idea was that something directly altered how effective capital and labor became within an economy.
Mechanics Of Shocks
A positive but temporary shock to productivity momentarily increases the effectiveness of workers and capital. This allows a given level of resources to produce more output than before. Individuals then face two distinct tradeoffs when deciding how to respond. One is the consumption-investment decision where people must choose between spending today or saving for tomorrow. If productivity is high, individuals might consume all extra output immediately. However, those valuing future consumption may invest part of it into capital to enhance production later. This explains why investment spending fluctuates more than consumption does. The life-cycle hypothesis suggests households base decisions on expected lifetime income rather than current earnings alone. Households prefer smooth consumption over time so they save during high-income periods and defer spending until low-income times follow. The other major decision involves the labor-leisure tradeoff. Higher productivity encourages substituting current work for future work since hourly wages rise temporarily. More labor input combined with less leisure results in greater output, consumption, and investment today. An opposing effect exists because higher earnings might reduce desire to work now or in the future. Yet given the procyclical nature of labor observed in data, the substitution effect appears to dominate this income effect. A string of such productivity shocks likely creates booms while recessions follow strings of bad shocks.