Real Business Cycle Models: An Introduction

In this article we present a simple real business cycle (RBC) model, in order to show that these models capture many of the features of business cycles in the real economy. While these models are very abstract, we argue that they are a useful way of thinking about the macro-economy. RBC models have also been influential in refocusing attention on supply issues in macroeconomics, after a long postwar focus on aggregate demand management in Australia and most other western economies. Policies such as structural reform and labour market reform are clearly aimed at influencing the supply side of the economy and productivity, and can be understood within the framework of RBC theory. RBC models have developed rapidly recently, yet there remains a good deal of misunderstanding about the methods and aims of these models. In this article we present a review of the literature and examine a simple model, using graphical techniques, to clarify some issues. We also argue that these models, while having limitations, have caused a fruitful re-examination of supply issues in economics, after the almost exclusive focus on aggregate demand in macroeconomics until the late 1970s.