Real Business Cycles and DSGE Models

How some economists explained booms and busts through technology shocks, and how today's central banks use large DSGE models.

Why do economies go through booms and recessions? Keynesian economists emphasise changes in demand and sticky prices. A different school, real business cycle theory, offered another explanation.

Real business cycle theory

In 1982, economists Finn Kydland and Edward Prescott argued that business cycles can be explained by real shocks, especially changes in technology and productivity, rather than by demand or money. They won the Nobel prize in 2004.

In this view:

A positive technology shock raises productivity, so firms hire and invest more, producing a boom.
A negative shock, such as an oil price spike, lowers productivity and output.
People adjust how much they work in response to changes in wages and productivity.
Recessions are the economy’s efficient response to shocks, not failures of markets.

Criticism

Many economists found the theory unconvincing for explaining events such as the Great Depression or 2008, which looked like failures of demand and finance rather than sudden falls in technology. Critics also questioned whether people really choose to work much less during recessions.

DSGE models

Real business cycle theory introduced a method that became standard: dynamic stochastic general equilibrium, or DSGE, models.

Dynamic: they model how the economy evolves over time.
Stochastic: they include random shocks.
General equilibrium: they model how all markets interact.

Modern New Keynesian DSGE models combine this method with sticky prices, making room for demand and monetary policy. Central banks, including the Federal Reserve, the European Central Bank and the RBI, use such models for forecasting and analysing policy.

After 2008

The 2008 crisis exposed weaknesses: many DSGE models had little role for banks and financial markets. Economists have since added financial frictions, household differences and other features to make models more realistic.

An oil shock

Oil prices jump sharply, raising costs for transport and manufacturing. A real business cycle model treats this as a negative productivity shock: output falls, firms hire less and wages drop. A New Keynesian model would add that sticky prices and the central bank's response also shape the outcome.

Thinking economic models are meant to be perfect replicas of the economy

Models simplify to highlight key mechanisms. Their usefulness depends on whether they capture the forces that matter for the question being asked.

Key takeaways

Real business cycle theory explains booms and busts through technology and productivity shocks.
Kydland and Prescott won the 2004 Nobel prize for this work.
DSGE models, now combined with sticky prices, are used by central banks.
After 2008, economists added banks and finance to make models more realistic.