First Look at RBC

In studying for my macro exam Monday, I've decided to summarize some macroeconomic theories for this next week of blog postings (as well as be active on Wikipedia).

Most of the theories we've encountered pertain to the business cycle. Ideally, a business cycle model exhibits three key ideas: it's persistent over time, sectors of the economy move together and there are changes in the labor supply. Because real business cycle theory does best with these, it is most popular.

Of course that doesn't mean it's very accurate. RBC, developed by Robert Lucas, Finn Kydland and Edward Prescott, is deeply rooted in rational expectations and independent of money supply. Indeed, people do not make mistakes in this economic model; downturns happen with productivity shocks. As people adjust to productivity shocks, the economy recovers. Thus all changes are exogenous.

I think that last point is one of the weakest points of RBC. All changes are exogenous? If all shocks are exogenous, then where does technology come from? Does that mean that people who are working on new technology are not included? Or just those technology-pursuing activities? But shouldn't they be included because it's rational to pursue technology? Technology shocks are both endogenous and exogenous in RBC; it can't be both.

There are other problems, mostly labor related. It also has zero predictive power; what counts as a "productivity shock?" How do you weight shocks against each other? How long does a shock last?

Yet it's still the mainstream theory. Go figure.