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Macroeconomic Schools of Thought

Real Business Cycle Model


Real Business Cycle Model

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throughout this course, we're focused mainly on the Keynesian model of economics. Let's check out another one called the real business cycle model. Okay, so the real business cycle model of economics, the main difference is that it focuses on changes in aggregate supply rather than changes in aggregate demand. Okay, so the real business cycle model believes that inflation and recession are caused mainly by changes in technology. So that's gonna be an increase to aggregate supply or changes in the availability of resources. So generally this could be like a supply shock. Generally we'll think about this as a decrease in our aggregate supply. Maybe prices have gone up for our resources or we've lost access to key resources and that is going to cause a recession like that. Okay, so that's the main reason that we have um fluctuations in our economy based on the real business cycle model, is these changes in aggregate supply. The other models that we've discussed, the Keynesian model, well, they believe that we have to fight recessions by increasing aggregate demand and the Monetarist model believes increases in the money supply will lead to increased spending. Okay, so the other models focus on changes in spending while this one focuses on aggregate supply. Okay, we focus on aggregate supply in this model rather than aggregate demand. So as an example, let's think of let's think of a supply shock here. So there's a supply shock where an increase in oil prices causes the input prices of many firms to increase. Okay, so oil prices have surged and now the availability of oil is much less, right? There's much higher prices which leads to lower production and employment. So we have here, we're gonna have our long run aggregate supply curve and we've got our aggregate demand curve. Okay, so this is our original situation and now we have this supply shock leading to a lower availability of resources and causing long run aggregate supply to fall here. Okay, so this was our first long run aggregate supply. This is our new long run aggregate supply. So we had this original equilibrium around here where we had this price level. So this is the price level in the economy. And this is the real GDP in the economy. And we'll have this first equilibrium uh price level, P. L. One. And then the long run aggregate supply shifts to the left right. So this lowers our this lowers our our production in the economy, which leads to lower employment and lower demand as well. So this model believes that there's this reduction in production reduction in production. That's a cool rhyme, right? There is also going to lead to a reduction in aggregate demand. So now aggregate demand is also going to shift to the left um based on this lower production, there's just less demand, less employment, less money being made. And we'll have this shift left in aggregate demand as well, which leads us to a new equilibrium. And but notice what happens at this new equilibrium is we have the same price level. So real GDP changed from G. D. P. One to this lower GDP GDP to uh based on the lower availability of resources, but the price level remains constant. That's the idea of the real business cycle, is that we go through these fluctuations in aggregate supply rather than the fluctuations and aggregate demand. Aggregate supply is in this model, the one that drives all of the changes in the economy. Okay, so that's the main thing to remember about the real business cycle model, is that it's focused on changes in aggregate supply rather than changes in aggregate demand uh That lead to the fluctuations in the economy. Cool, Alright, that's that's about it. For the real business cycle model, let's go ahead and move on to the next video.