Chapter 16
Real Business Cycle
Theory
The
is the newest of the four theories we examine. It focuses on
aggregate supply, in particular upon the long-run aggregate
supply. According to real business cycle theory, changes in
productivity growth account for business-cycle fluctuations in
real GDP. For instance, a decrease in productivity decreases
long-run aggregate supply. In this case, real GDP decreases,
unemployment increases, and the economy goes into recession.
The figure to the right shows a real business-cycle recession.
In the real business cycle framework, there is no short-run
aggregate supply curve; the economy is always on its
long-run aggregate supply curve. Hence the decrease in
productivity shifts the long-run aggregate supply curve leftward
from LAS0 to LAS1.
The decrease in productivity also decreases investment demand, so
that the aggregate demand curve shifts leftward from AD0
to AD1. 
Thus real GDP decreases from $7.0 trillion to $6.5
trillion: The economy goes into recession.
Productivity growth will eventually recover and return to its initial level. When productivity growth automatically increases, long-run aggregate supply and aggregate demand both increase and the recession ends. The figure illustrates this process. Long-run aggregate supply shifts leftward to LAS2, and eventually it shifts back to LAS0. Similarly, aggregate demand shifts leftward to AD2, and ultimately shifts back to AD0. Once productivity returns to its initial level, real GDP returns to $7.0 trillion. To review other business cycle theories, click on the appropriate figure below.
To read the summary, click on the summary figure.
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