CHAPTER
ONE
INTRODUCTION
1.1 Background
Not
until the events of late 1920s in the United States of America (USA) and indeed
the industrial world, characterized by the Great Depression, macroeconomics, as
a branch of economics was non-existent by that title. Before then, it was the
world of microeconomics and the classical economists and business cycle was
seen as a normal fact of life. Expected
to re-occur periodically (say in every seven or eight years) no attempt was
made to curtail business cycles by way of stabilization policies. The events of the 1930s provoked a wave of
new thinking.
By
the mid-1940s, Keynes and Keynesian school of thought had fully emerged,
providing alternative explanations to economic phenomena. Consequently,
economists no longer viewed business cycles as a normal fact of life. To the Classical economists fluctuations are
real essence of a market economy. Thus,
if there is disequilibrium between demand and supply, self-correcting forces
will naturally evolve to stabilize the market.
Government, in this case, need not intervene.
The
Keynesians, on the other hand, were of the view that fluctuations caused by
supply-demand disequilibrium could be and should be controlled. They pointed out that business cycle
characterized by expansions and contractions “are symptoms of underlying
problems of the economy which should be dealt with”. By similar positions,
macroeconomics found its feet in the annals of economists. Today it has become the theoretical and
practical response to the problem of inflation, unemployment, growth and business
cycle. Consequently, business cycle became
an issue, both in theoretical and empirical terms.
To
date literature on business cycle is abundant.
But modern business cycle research is due to the path breaking paper of
Kydland and Prescott (1982). According
to Rebelo (2005: 2), three revolutionary ideas were associated with that paper.
They are that:
“…business cycle
can be studied using dynamic general equilibrium models. These models feature atomistic agents who
operate in competitive markets and form rational expectations about the
future. The second idea is that it is
possible to unify business cycle and growth theory by insisting that business
cycle models must be consistent with the empirical regularities of long-run
growth. The third idea is that we can go
way beyond the qualitative comparison of model properties with stylized facts
that dominated theoretical works in macro economics before 1982”.
Beyond
these revolutionary ideas, another major contribution of Kydland and Prescott
(KP) paper is that supply-side shock due to technological advances are the
driving force behind business cycles rather than variations in demand. It
is apposite to point out that KP (1982) model is recognized and classified as a
real business cycle (RBC) model. And in
the class of business cycle research, RBC has received much attention. The RBCs are models of business cycles that
explain cycles as fluctuations in potential output. The development of such a model is in
response to the disillusion with the Keynesian consumption function or even the
IS-LM framework described as being too simplistic as to take care of the dynamics
underlying macroeconomics particularly intertemporal substitutions and
uncertainties.