The Real Business Cycle Explanation of Unemployment - Assignment Example

Critically assess the real business cycle explanation of unemployment. How strong is the evidence in favor of this approach Introduction The analysis of the performance of economies can offer significant information on their potentials to face unexpected market turbulences. However, because of their structure, economies are quite difficult to be effectively analyzed and evaluated. Usually, different criteria are used for explaining the trends of the market in each particular industrial and economic sector. Current paper focuses on the value of the real business cycle theory (RBC) for explaining unemployment; there is no limitation in regard to the regional or time limits of ‘unemployment’, meaning that reference is made to unemployment as an element of the economy in general, both in the long and the short term. The review of the literature published in the specific field has led to the following assumption: RBC theory can be used for understanding critical aspects of economies but the performance of theory in different market conditions is not standardized. It has been also proved that the evidence against the theory is significant, implying that many of its points should be reviewed as of their validity and accuracy. In any case, it seems that the weaknesses of the specific theory are many, as analyzed through the paper, so that its benefits cannot efficiently support its value as a theoretical tool for explaining one or more elements of modern economies. 2. Real business cycle explanation of unemployment – description and evaluation Unemployment is a critical part of the economy, at the level that it helps to evaluate the performance of the economy, either in the short or the long term. Economies with low unemployment rates are usually characterized as successful, even if the relevant trends are just temporary, an issue analyzed below. Also, it can help to estimate the potential value of measures taken for supporting the performance of an economy: if unemployment trends remain high despite the introduction of measures for increasing GDP in a specific country, then the introduction of different approaches for supporting the local economy is made clear. In order to understand the effectiveness of the Real business cycle in explaining unemployment it would be necessary to present primarily the general framework of the concept, i.e. its core characteristics and parts. Then the use of the theory for explaining unemployment can be evaluated by referring to the existing evidence with reference especially to the approaches against RBC. 2.1 Real business cycle explanation of unemployment as a theoretical concept The real business cycle (RBC) theory, known also as the real business cycle models, was first introduced in 1980s for replacing the New Classical models (Gottschalk 2005). Like their predecessor, the RBC theory aimed to explain the ‘business cycle fluctuations’ (Gottschalk 2005, p.100), as resulted not from monetary events (a view used by the New Classical models for explaining business cycle fluctuations), but rather from real events. In this context, the RBC theory has been based on the rule that business cycle fluctuations are best explained by referring to ‘real shocks’ (Gottschalk 2005, p.100), such as ‘changes in technology or government spending’ (Gottschalk 2005, p.100). In accordance with Snower and Dehesa (1997) the RBC theory is based on the following rule: ‘macroeconomic fluctuations tend to be related to technological shocks’ (Snower and Dehesa 1997, p.19), meaning that each such shock is likely to be followed by microeconomic fluctuations, either in the short or the long term. From this point of view, those people that are best prepared to face such shocks are most capable of surviving in the job market, being able to respond immediately to the relevant market demands. Because of the continuous changes in market conditions due to the intervention of ‘real events’, or else of ‘real shocks’, the RBC theory has been considered as quite valuable for explaining the status and the prospects of modern economies. However, when being used in practice, the RBC theory has been proved problematic, referring especially to the efforts for explaining the various parts of an economy, such as unemployment. This phenomenon is analytically described below using the findings of literature published in the particular field. 2.2 Evaluation of evidence in favor of real business cycle explanation of unemployment Despite the value of RBC theory in interpreting unemployment trends, still the potentials of this theory to provide valid explanations of unemployment have been strongly criticized. Different approaches have been developed in the literature in order to justify the above fact. Through these approaches it is made clear that RBC theory does not offer valid explanations regarding the level of unemployment within a particular period of time. In accordance with Harcourt (1997) the evidence against the RBC theory seems to be significant; certain ‘regularities of US business cycles’ (Harcourt 1997, p.11) are used as examples to justify the weakness of RBC theory to provide a valid view of the market trends, as related to the performance of the economy either in the short and the long term: a) the term ‘unemployment’ as used in economies worldwide reflects the non-voluntary exclusion of people from the job market; it is noted that if people tend to choose not to work unless the wages is at a satisfactory level, a fact highlighted in RBC theory, then the term ‘not in the labor force’ would be used instead of the term ‘unemployed’. In other words, the term ‘unemployment’ itself shows the non-voluntary exit from workplace, a fact that needs to be taken into consideration when having to evaluate the non-participation of an individual in a country’s labor force; b) the ‘behavior of real wages’ (Hartcourt 1997, p.11) also indicates the non-existence of relationship between unemployment and wages. Indeed, it seems that labor supply is not sensitive to real wages (Hartcourt 1997), meaning that the decision of workers to exit the workplace is not depended on the level of wages, at least as such view is reflected to the empirical evidence developed in regard to this issue (Hartcourt 1997); c) in the context of the RBC theory, there is no equilibrium between the quits and unemployment during recessions; however, such view is not justified in the empirical research; on the contrary, it has been proved that during strong recessions, unemployment is high and quits are rather limited, compared to periods of strong economic growth (Hartcourt 1997); d) one of the most important criterion for evaluating the performance of a particular economy is the level at which this economy is volatile to monetary events; these events can affect all aspects of the economy, including unemployment. From this point of view, unemployment is depended on the monetary events related to the local economy. The RBC theory suggests that ‘real outcomes are likely to be independent from monetary events’ (Hartcourt 1997), an approach, which cannot be accepted taken into consideration the following fact: monetary events are likely to be sudden, i.e. they are not prepared in advance (Hartcourt 1997). The evaluation of RBC theory, as developed above, is based on findings related to the USA economy; these views could be also used for explaining the potential of RBC theory to explain unemployment in countries with similar economic and social characteristics. In other countries also these assumptions could be valuable for understanding the role of RBC in describing critical elements of the economy, such as unemployment, an assumption that is based on the literature retrieved in regard to this issue, as analyzed below. An important weakness of RBC theory is revealed through the study of Hartley, Hoover and Salyer (1998); the above theorists focus on the interpretation of leisure and consumption as included in RBC theory. It seems that consumption is decreased during recessions, while leisure is increased (Hartley, Hoover and Salyer 1998). This trend is explained as follows: ‘real wages is procyclical’ (Hartley, Hoover and Salyer 1998, p.555), a fact that leads to implications regarding the potential use of RBC theory for explaining unemployment. Indeed, in accordance with the above view, the increase in unemployment could be justified using the following argument: during recessions, the demand for goods is decreased while the demand for leisure is increased, being depended on the performance of the economy. However, the above phenomenon is not standardized. Leisure and consumption do not necessarily move towards different directions. It is possible for these two elements (metrics) of the economy to move together, being increased or decreased simultaneously. For instance, in the case of ‘a temporary increase of the government purchase’ (Hartley, Hoover and Salyer 1998, p.555); in the above case, both leisure and consumption are normally expected to fall (Hartley, Hoover and Salyer 1998, p.555). At this point also, the RBC theory is proved problematic, as of the validity of its rules under different market conditions. From a similar point of view, Mitchell and Muysken (2008) note that the use of RBC theory for explaining unemployment can be partially effective, in the terms that this theory seems to be related to the political and economic framework of USA. It is explained that in 1980s a trend has been developed in USA for promoting the concept of voluntary unemployment. In fact, this was an effort to reduce the value of involuntary unemployment as an indicator of ‘coordination failures and wage rigidities’ (Mitchell and Muysken 2008, p.65). The above view has been also supported by Keynesians, who negatively criticized the validity of RBC theory in regard to the explanation of unemployment. In the study of Snower and Dehesa (1997) the failure of the RBC theory to explain unemployment is described as follows: the RBC theory is not considered as not appropriate for explaining unemployment; however, it is made clear that this theory can explain unemployment in regions with specific economic characteristics, especially ‘USA and the other OECD countries’ (Snower and Dehesa 1997, p.19). It is further explained that in Europe, an increasing trend of unemployment can be observed the last 25 years. This phenomenon has been developed, as Snower and Dehesa (1997) suggests, because ‘people hours’ of work are unresponsive to real wage’ (Snower and Dehesa 1997, p.19). In fact, it seems that in Europe people have been waiting for real wages to be increased over the years, an expectation that has not been fulfilled. On the contrary, in the last two decades, it seems that in Europe, like all over the world, real wage has been decreased, a fact that has caused severe pressures to economies worldwide. The response of each economy to this phenomenon has been different. In the case of the USA, this trend of unemployment can be effectively explained using the RBC theory. In European countries, different rules and frameworks would be retrieved for explaining current unemployment trends, as indicating the potentials of European economies to get stabilized. At the next level, the key rule of the RBC theory that ‘real wages is procyclical’, has been strongly criticized. In fact, the empirical evidence gathered in regard to this issue has proved that real wages is more likely to be ‘midly procyclical to acyclical’ (Knoop 2010, p.94); however, the RBC theory is based on the fact that real wages are likely to be influenced by ‘strong procyclical changes’ (Knoop 2010, p.94). In other words, the above theory cannot be used for explaining unemployment unless real wages is considered as being procyclical – not midly but fully. From this point of view, the effectiveness of RBC theory to explain unemployment should be doubted. Only if RBC theory is related to specific economic environment, for instance markets similar to the USA market, it can be used for developing valid explanations regarding the status and the trends of unemployment. Another important disadvantage of RBC theory can be also identified at the following point: RBC theory is based on the dependency of market fluctuations on technological shocks. However, the concept of ‘technological shock’ is quite difficult to be described, at least with accuracy. It is a broad concept, having the ability to incorporate many different issues, for instance the lack of skills in a specific market sector. Moreover, the following problem seems to exist: the term ‘technological shock’ is difficult to be described not only as of its context but also of its extension, i.e. the region within which the shock is likely to be related (Knoop 2010). Which criteria should be used for deciding that a technological change is so critical so that it should be regarded as such shock? Also, on what terms the technological changes developed across a region would be regarded as a technological shock, i.e. which would be the size of the area involved in order for such phenomenon to exist? The above issues reveal the inability of RBC theory to respond to all market needs, being itself inaccurate, as of its characteristics and demands. In accordance with Boehm (2002) the RBC theorists are aware of the above weaknesses of RBC theory. Trying to cover the lack of adequate empirical work in relation to the RBC theory, the above theorists have introduced unique methods for testing their evidence. They tend to avoid ‘models that can be tested by standard econometric methods’ (Boehm 2002, p.32-33); instead, they use models that are tested through methods based on casual empiricism; in this way, the findings are not differentiated, at least not much, from the historical data, as retrieved through standard econometric methods. 3. Conclusion The control of unemployment can be achieved through different approaches. In order to guarantee that unemployment is kept at relatively low levels it is necessary to identify the facts that tend to cause unemployment. Also, the relation of unemployment to other elements of the economy needs to be made clear. The RBC theory can be used for explaining unemployment in modern market conditions. The advantage of the theory seems to be its reference to technological changes, which the RBC theory regards as critical for macroeconomic fluctuations. However, the criteria used for describing the dependency of unemployment on technological changes seems to be problematic, in the context described above. The literature presented above revealed that the RBC theory can be effective for explaining unemployment in markets with specific characteristics, such as the USA market. In markets that are likely to suffer from continuous turbulences and changes, such as the European market, an alternative theory would be used, instead of RBC theory, for explaining unemployment. The fact that RBC theory is applicable only under specific terms cannot lead to the assumption that the theory has failed to reflect the modern economic trends. However, it would be necessary for the particular theory to be reviewed and appropriately customized, possibly using rules and criteria that have been proved successful in theories that were used in the past for responding to similar market needs, such as, for example, the Keynesian theory. References Boehm, S. 2002. Is there progress in economics?: knowledge, truth and the history of economic thought. Cheltenham: Edward Elgar Publishing. Cross, R. 1995. The Natural rate of unemployment: reflections on 25 years of the hypothesis. Cambridge: Cambridge University Press. Gottschalk, J. 2005. Monetary policy and the German unemployment problem in macroeconomic models: theory and evidence. New York: Springer Science & Business. Harcourt, G. 1997. A "second edition" of The general theory, Volume 2. London: Routledge. Hartley, J., Hoover, K., and K. Salyer. 1998. Real business cycles: a reader. London: Routledge. Knoop, T. 2010. Recessions and depressions: understanding business cycles. Omaha: ABC-CLIO. Mitchell, W. and J. Muysken. 2008. Full employment abandoned: shifting sands and policy failures. Cheltenham: Edward Elgar Publishing. Mullineux, A. 1984. The business cycle after Keynes: a contemporary analysis. Lanham: Rowman & Littlefield. Snower, D. and G. Dehesa. 1997. Unemployment policy: government options for the labour market. Cambridge: Cambridge University Press. Read More