Keynesian and Real Business Cycle Theories Essay

Keynesian and Real Business Cycle Theories - Essay Example The effects of the declining trends in economy expand to all the areas such as production, income, consumption and employment level. Therefore it has been an important issue for the economists of all eras to study the main concerns such as the causes of the business cycle and the responsive behaviour needs to be adopted by the policy makers. Despite many explanations provided by the economists the questions remain still controversial. The main groups of economists involved in the controversy are the Keynesian economists and the classical economists. According to the classical point of view the business cycles are the result of disturbances in the production and spending. The classical economists do not find the need of government action in order to counter the recessions in the economy. On the other hand according to the Keynesian economists the wages and the prices do not respond very quickly to the disturbances in the production level and the employment level. Therefore the Governmental action is needed in order to deal with the situation. In the next section the essay will further elaborate the debate between the two school of thoughts. The Real Business cycle theory is the extended version of the classical theory, which sees business cycle as the result of the productivity shocks. According to the Real business cycle theory the reduction in the productivity at temporary basis creates a declining effect on the real wages, employment level and output and increase the interest rate and the prices. The RBC theory finds a positive relation ship between the business cycle and the level of real wage, prices and the overall productivity level of Labour. On the other hand the theory asserts a negative relation ship between the price level and the business cycle. The anti-cyclical trend of price level is taken as failure by many of the critics of the theory. Except the productivity shocks the increase in the Government purchase also increase the employment level, the interest rate and the price level. Hence the classical model undertake the study of both fiscal factors and the productivity shocks. Although the fiscal policy can play its part in order to improve employment level and output but the classical economists do not support the role of Government action and states that the invisible hand can adjust the market to the most efficient level. The role of money in the RBC is neutral. RBC theorists suggest that increasing or decreasing the nominal money supply can effect the price level but cannot effect the output level, employment and interest rate. The statement of money being neutral by the classical economists has been a failure. It has been proven several times that the role of money supply is not neutral and the money supply has been used in many countries as the policy measure for stabilising the economy. In the case of the extended classical theory i.e. misperceptions theory the sudden change in the in the money supply can affect the output. If the consumers can make rational forecasts regarding the macroeconomic variables the such as money supply the Government regulating bodies cannot surprise the consumers since the will make the judgement regarding the actions of the regulating body. Hence according to