Explain in brief the salient features of real business cycle theory. In what respects is it different from other theories of business cycle?

 Real business cycle theory also known as RBC theory explains macroeconomic instability. The theory states that instability in an economy is a result of real factors affecting aggregate supply instead of monetary or spending factors affecting aggregate demand. In other words, this theory argues that business cycles arise owing to real factors disturbing aggregate supply not factors disturbing aggregate demand.

According to the theory, changes in technology and resources available are responsible for business cycles or instability. Such changes in technology and resources affect productivity and productivity affects aggregate supply.  Suppose, prices of oil increases significantly due to any reason like creation of cartel such as OPEC, then operating certain types of machinery becomes very expensive, raw materials become much expensive due to hike in transport costs, etc.

Due to increase in the expenses output per worker, i.e. productivity in an economy declines and it causes long-run aggregate supply to fall. This fall in aggregate supply has been shown in the figure as leftward shift from AS1, to AS2, As real output falls from Y1, to Y2, then people do not demand as much money to buy the reduced goods and services. So the demand for money falls. In addition to it, decrease in output/slow down in business activity will force producers/firms to decrease business borrowings and it causes deposits to fall.

As a result money supply also falls. Reduction in money supply pushes aggregate demand curve to leftward from AD1, to AD2, with no change in the price level. On contrary to it, suppose there is an innovation of technology/discovery of new resources resulting increase in productivity, therefore, increase in aggregate supply.

Increase in aggregate supply or output will cause the demand for money to buy increased goods and services.  Apart, business firms would borrow money from banks and therefore increase in deposits from public and it will cause money supply to increase and therefore increase in aggregate demand.

The new classical business cycle theory has the following tenets/postulations.

. Economy is affected by aggregate demand and aggregate supply shocks.

The advocates of the new classical business cycle theory argue that fluctuations in an economy are result of demand and supply shocks. Generally, unanticipated changes in monetary and fiscal policies lead aggregate demand shocks. While unanticipated changes in raw material prices, natural crisis, significant changes in technology, etc. cause aggregate supply shocks.

Such shocks may be positive as well as negative. Positive aggregate demand shocks affects demand favourably or vice-versa.  Similar the case of aggregate supply shocks is. Firms or producers produce more and pay more their workers when they face positive shocks and opposite happens in case of negative shocks.

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