Question

In real business cycle theory, why can't the change in the money supply prompted by a series of events catalyzed by an adverse supply shock be considered the cause of the business cycle?

Short answer

In real business cycle theory, the business cycles are driven by changes in technology, not by changes in the money supply. Even though an adverse supply shock may prompt a change in the money supply, this is seen as a reaction rather than a cause of the business cycle. RBC theory sees the original supply shock as the main cause of business cycle fluctuations.

Step-by-step solution

Establishing Understanding of Real Business Cycle Theory

Real Business Cycle (RBC) theory suggests that business cycles are largely driven by technology shocks, which change the productive capacity of the economy. It is important to understand that within this theory, monetary policy and changes in the money supply are not seen as contributing to the business cycle - this is a fundamental assumption of the RBC theory. The primary role of the money supply, in the context of classical economics, is to affect prices, not output.

Understanding the Impact of Supply Shocks

In contrast to monetary policy, supply shocks can significantly impact the underpinnings of the business cycle in RBC theory. Suppose an adverse supply shock like a sharp increase in the price of oil or a drought. This directly reduces the economy’s productive capacity and can set off a series of events, possibly including a change in the money supply.

Exploration of Money Supply Change in Response to Supply Shock

Given this sequence of events, one could assert that the change in money supply may be the cause of the business cycle. But under the RBC theory, the money supply changes reactively, not proactively. In other words, changes in the money supply are not what initiate the cycle but are instead responses to the initial supply shock.

Reiteration of the Underlying Theoretical Position of RBC

Returning to the original tenet of the RBC theory - it posits that business cycle fluctuations are not caused by changes in the money supply. Therefore, even though a change in the money supply may be observed in response to adverse supply shocks, it is not this change in the money supply that should be considered the cause of the business cycle, but instead the underlying supply shock itself.