# The Keynesians attribute business cycle fluctuations to

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The Keynesians attribute business cycle fluctuations to

The Keynesians attribute business cycle fluctuations to what they regard as the fundamental instability of private spending--especially investment and consumer durable goods expenditure. The New Classical view holds that unanticipated changes in monetary growth are the primary cause of deviations from the “natural rate” of output and employment. Real Business Cycle theorists claim business cycles can be explained as an optimizing response of economic agents to random productivity shocks. This is a tough model to explain to non-economists Households Maximize consumption and leisure subject to constraints. Constraints include the number of hours in a day and the resource prices (such as the wage). Firms Maximize profits subject to constraints Constraints include prices of outputs and inputs, and productivity. Constrained optimization problem for an infinitely-lived “representative” consumer-producer. Charles Plosser. “Understanding Real Business Cycles,” Journal of Economic Perspectives, Summer 1989, pp. 51-73. l [u (Ct ,1 Nt )] t[tF ( Kt , Nt ) Ct Kt 1) (1 ) Kt ] t t 0 t 0 If t increases, that Where: means you can get L is the LaGrangean function more output from Ct is consumption in period t the same stock Nt is work in period t of capital and work effort 1- Nt is leisure in period t Kt is the capital stock in period t is the depreciation rate per period t is a “shift factor” that alters total factor productivity in period t. is the time preference parameter, where 0< < 1; and t is the LaGrangean multiplier in time t. When productivity rises, the opportunity cost of leisure (measured in forgone output) rises, which induces the representative agent to substitute work for leisure. Hence the random productivity shock brings about an expansion of real output. The intertemporal substitution of work for leisure (and vice versa) in reaction to technology shocks is the principal force underlying business cycle expansions and contractions The problem for Plosser, Finn Kydland, and other Real Business Cycle theorists is to provide plausible estimates of t or “total factor productivity.” The methods used to perform these estimates have been widely criticized Annual productivity growth 6 4 2 0 -2 -4 -6 1955 1960 1965 1970 1975 1980 1985 Policy implications of Real Business Cycle theory Some economists take the theory to mean that countercyclical aggregate demand management is doomed to ineffectiveness--since, after all, they claim that 70 percent of the deviation of real output from trend in the postwar era is explained by productivity shifts. Technological change is a factor that policy makers cannot control. Chatterjee explains that the Central Bank (the “FED” in the U.S.) should nevertheless exercise its stabilizing function in financial markets.