Type: Economics
Pages: 5 | Words: 1332
Reading Time: 6 Minutes

The real business cycle theory (RBC theory) is one of the modern schools of macroeconomics. It argues that business cycles are primarily caused by the fluctuation of different economic indicators. Other theories see the cause of economic fluctuations against fluctuations in demand (Keynesian) or as a result of government intervention (such as discretionary fiscal policy or monetary policy) in the economic cycle (Battaglini & Coate, 2008). The essence of the macroeconomics study is to understand and predict the possible outcomes that can be the results of the economic changes.

In any economic system, cyclical fluctuations can be distinguished: the ups and downs in the economy caused by shocks in aggregate demand and aggregate supply and called business cycles. Phases of the business cycle are the rise (peak) or the recession (decline), and the bottom; then, there is a crisis. The most severe recession is called depression. Often, these fluctuations in business activity are unpredictable and irregular. They also differ by the period, frequency, and size of the business cycle. The causes of these cycles can be very different: from the wars, revolutions, the process and the behavior of investors to, for example, the number of magnetic storms a year and macroeconomic rationality of agents. In general, behavior of the economy is unstable due to a permanent imbalance between aggregate supply and demand, total expenditure and production levels.

As a rule, the policy of the state (fiscal policy) depends on the state of the economy of the country; that is, from being on what phase of the cycle the country is — the rise or recession. If the country is in recession, authorities are conducting enabling economic policies to lead it out of the bottom. If the nation is experiencing an upswing, the government is moderating economic policies in order to prevent high inflation in the country.

Monetary policy can be implemented by changing the monetary base. Central banks use open market operations to change the monetary base. The central bank buys or sells reserve assets (usually financial instruments such as bonds) in exchange for the deposit money at the central bank. These deposits can be converted into cash. Together, these cash and deposits formed the monetary base, which is the central bank’s liabilities denominated in its own currency. Usually, other banks can use the monetary base as a partial allowance and increase the overall money supply in circulation. Monetary authorities exercise regulatory control over commercial banks. Monetary policy can be implemented by changes in the volume of assets that banks must hold in reserves of the central bank. Banks hold only a small portion of their assets as the cash available for immediate withdrawal. The residue is inverted in illiquid assets such as mortgages and loans. Altering the rate of liquidity, the central bank changes the amount of available credit funds. The central bank, as a rule, often does not change the reserve requirements as it creates volatile changes in the money supply as a result of the credit multiplier.

Formation of the state budget on the basis of a stable and centralized tax collection transforms itself into the state’s largest economic entity, able to deal effectively with the challenges it faces economic, defense, social, nature protection and other considerations. Specific tax rates should take into account the needs of the state in tax revenue, as well as business interest in the development of production. Obviously, they should be determined on the basis of a compromise since their significant growth can undermine incentives for investment to expand production and to business in general. High tax rates on business can result in the growth of the shadow economy sector, or manipulation of taxes. All this reduces the revenues to the state budget and eventually destroys the whole economic system and social model.

Determining the size of the specific rates still has no scientific basis and is solved by political means. The increase in taxes reduces the tax base, which means the amount of economic (business) activities subject to taxation: entrepreneurs, in this case, either go out of business altogether or transfer it to the shadow economy sector. Conversely, lower taxes create incentives for investment and business development. The growth of the same tax base, in this way, is completely compensated for the loss of tax revenues from lower tax rates.

The economic cycle

Existence of the economy as a set of resources for the steadily growing consumption is oscillatory. Fluctuations in the economy expressed in the economic cycle. Fine point of the economic cycle is the recession that under certain scale can go into crisis. Concentration (monopolization) of capital leads to the wrong decisions on the scale of the economy of the country or even the world. Any investor is seeking to obtain income from one’s capital, waiting for the investor’s income increase derived from the lifting phase of the peak when the maximum income can be achieved. In the downturn, investor believes it is beneficial for oneself to invest in projects with returns below yesterday. Without such investments, the industrial activity is reduced as a consequence of paying workers in this field who are consumers of goods and services to other areas. Thus, the crisis of one or more branches affects the whole economy.

Another problem of the concentration of capital is the withdrawal of money from the sphere of consumption and production of consumer goods, as well as the sphere of production of means of production of these goods. Money received in the form of dividends (or profits) is accumulated in the accounts of investors. There is a lack of money to maintain the high level of production and as a result of the decline in production. While rising unemployment, the population saves on consumption; there is a drop in demand.

The services industries and industries that produce durable goods are less affected by the devastating effects of the economic downturn. Recession even helps to activate certain activities in particular increasing demand for the services of pawnshops and lawyers who specialize in bankruptcy. The most sensitive to cyclical are the companies that produce capital goods and consumer durables: car manufacturers and building companies are the best example. These firms are not only harder to tolerate other business downturn, but most benefit from a recovery in the economy. There are two reasons: the possibility of postponing purchases and monopolization of the market. Purchase of capital equipment can often be postponed for the future: in the difficult economic times, manufacturers tend to refrain from purchasing new machinery and equipment and construction of new buildings. During the long recession, firms often prefer to repair or upgrade old equipment instead of spending a lot of money for the purchase of new one. As a result, investment in capital goods during the economic downturn dramatically reduces. The same applies to consumer durables. Unlike food and clothes, buy a luxury car or an expensive home appliances can be postponed until better times. In economic downturns, people are more inclined to repair rather than change durables. Although the volumes of sales of food and clothing, as a rule, are also reduced, this decrease is usually less than the drop in demand for durable goods.

Monopoly power in most industries that produce capital goods and some durable consumer goods occur due to the fact that the markets of these products are usually dominated by a few large firms. The monopoly position allows them to keep prices at the same level during economic downturns, reducing production in response to falling demand. Consequently, the fall in demand has much greater impact on production and employment, rather than price. The example of such industries can be the general communal areas, like water provision, canalization services, etc. A different situation is typical for industries producing goods of short-term consumption. The fall in demand in these industries usually causes general decline in prices since none of the firms has significant market power.


  • Battaglini, M., & Coate, S. (2008).Fiscal policy over the real business cycle a positive theory. Cambridge, MA: National Bureau of Economic Research.
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