Real Business Cycles, investment demand shock and Schumpeterian Combined Productivity

Real Business Cycles:

The mid-twentieth century economist Joseph Schumpeter was the most influential exponent of the belief that changes in technology were the principal force driving business cycles. Schumpeter saw technological development as inherently lumpy. There were five-year periods throughout which a great deal of new technology diffused rapidly throughout the economy. These were booms. There were five-year periods throughout which the pace of technological innovation and diffusion was much slower. These were stage of relative stagnation. Schumpeter saw the main feature of the business cycle as the co-movements of investment, output, employment, and interest rates- all were high together in a boom all were low together (relative to trend) in a recession.

It is simple to see how uneven invention and innovation patterns could generate such real business cycles—business cycles driven by the basic technological dynamic of the economy. Presume that the most common shift in technology involves (1) a sudden step up in the efficiency of labor, accompanied by (2) a sudden increase in investment demand as it becomes more profitable for a business to enlarge its capital stock. Such a shock has a supply component--an increase ΔY* in this year's potential output--and an investment demand component--an increase ΔI0 in this year's investment demand.

How does the economy's full-employment equilibrium shift in response to such a combined shock? We simply add mutually the effects of a supply shock and outlined immediately above and the effects of an investment boom driven by investors' increasing optimism, outlined in the previous section. The modification in the equilibrium domestic real interest rate from a supply shock is:

217_supply shock.jpg

The modification from an investment demand shock is:

908_investment demand shock.jpg

Adding them mutually, the modification in the equilibrium interest rate from this Schumpeterian technology shift is:

2214_Schumpeterian technology shift.jpg

The improved profitability of investment expands investment demand shifting the red investment demand curve to the right. However the positive technology shock does more than just make investment more profitable: it boosts the current competence of labor as well. Higher productivity signifies higher incomes, which denotes more savings, which shifts the total savings line to the right as well. The raise in investment demand tends to raise the interest rate. The raise in savings caused by higher incomes tends to lower it. Which dominates? Assume that the investment demand term dominates. Afterward the domestic real interest rate will rise.

A Schumpeterian Combined Productivity and Investment Shock as Seen in the Flow-of-Funds:

250_Schumpeterian Combined Productivity.jpg

Legend: Higher productivity today with optimism about future technological developments affects both the supply and demand curves in the market for loan able funds. It is reasonable to conclude that the economy will boom, with real GDP as well as investment rising, domestic real interest rates rising, the exchange rate falling and capital flowing in to finance domestic investment. This pattern is the standard pattern observed in a business-cycle boom.

It is then straightforward to compute the changes in the components of aggregate demand:

1538_components of aggregate demand.jpg

And the modification in the equilibrium level of the exchange rate is:

2083_modification of exchange rate.jpg

Provided that the shock shifts the investment demand curve in figure to the right by more than it shifts the total savings line, the worth of the exchange rate will fall.

Therefore this combination positive technology shock to the efficiency of labor as well as the profitability of investment has produced:

•    An increase in output.
•    A sharp increase in investment.
•    A refuse in the exchange rate: a reduction in the value of foreign currency, and a rise in the value of domestic currency.
•    A decrease in net exports: a rise in the flow of foreign capital into the country to finance domestic investment.

These shifts in the economy are those that are usually found in a business cycle boom. Possibly these Schumpeterian forces are the principal cause of the booms and recessions that we see in our economy.

Most economists though would be skeptical of the claim that most of our business cycles are such real business cycles. There is one quality feature of the ‘boom’ phase of the business cycle as defined by Schumpeter that the model can’t produce- a fall in unemployment. It can’t do so- this chapter's model, finally is one in which the economy is always at full employment, thus how could the model produce an increase in employment correlated with its technology-driven boom?

A few economists speculate that the pattern of unemployment found in the business cycle is due to movements in the level of real wages. When real wages are elevated than expected or than average more people will be willing to work for wages. When real wages are provisionally lower than their average trend, some workers will choose to forego working for a month or a season or a year. According to this schema unemployment is high whenever a significant fraction of the labor force have looked at their employment opportunities, found that they were being proffered unusually low wages, as well as decided to do something other than work for a while.

There is, but a serious problem with this approach. Only some of the cyclically unemployed in a business cycle slump choose to describe themselves as "voluntarily unemployed." They make out themselves not as people making a balanced economic decision to spend a lot more time being unhurried, however as people who want to work--who would be eager to work if only someone would hire them at the wages others are being paid--but who can't find work for the reason that there is excess supply in the labor market.

A subsequent problem is that real business cycle theory explains booms--rapid rises in output--as the result of the rapid diffusion of technology and a sharp increase in the efficiency of labor. However how is it to describe a recession or a depression--a time when production doesn’t grow at all, but declines? Does the efficiency of labor decline for the reason that of technological regress? Are we supposed to consider that production was lower in 1991 than in 1990 because businesses had forgotten how to use their most productive modes of operation? It seems improbable.

Therefore the Schumpeterian approach may well provide a correct theory of booms or of some booms. It is harder to observe how it could provide an accurate account of recessions and depressions or of the high levels of cyclical joblessness found in times of recession and depression.

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