Real business cycle theory developed out of the new classical tradition and attempts to explain economic activity fluctuations in a world without coordination failures, “price stickiness, waves of optimism or pessimism, monetary policy, or government policy in general.” Therefore, in contrast to the Keynesian approach, RBC theory describes all fluctuations as real fluctuations in supply, and hence every fluctuation is a new equilibrium rather than a point of dis-equilibrium.

An important historical moment for RBC models came with the publications of Ragmar Frisch (1933) and Eugen Slutzky (1937), who distinguished between impulse and propogation mechanisms. Impulse mechanisms are what initially cause a “variable to deviate from its steady state value, whereas propagation mechanisms: “causes deviations from the steady state to persist for some time.” All deviations from the steady state arise from exogenous productivity shocks, in contrast to the Keynesian theory in which demand-side fluctuations account for output fluctuations. This is why RBC theory designates little importance to other impulse mechanisms like tax rates, monetary policy, and preferences, all of which are very important in Keynesian theory.

The growth of output in Robert Solow’s model (1956, 1957) is dependent upon the capital labor ratio and the “solow residual”, which embodies the “technical possibilities” that augment the productivity of labor. This residual is stochastic, exogenously determined, and accounts for almost half of the growth in output. RBC theory is then founded in a neo-classical growth model augmented by stochastic shocks to productivity. Stadler points out that “once one incorporates stochastic fluctuations in the rate of technical progress into the neoclassical growth model, it is capable of displaying business cycle phenomena that match reasonably closely those historically observed in the USA.” (pg 1753).

Stadler then points out a few common features of RBC models. 1) they have their foundations in micro-economic behavior. The behaviors of representative agents are aggregated to determine the overall impact on the economy. Furthermore, all agents have rational expectations and all markets are instantly clearing with no information asymmetries. For this reason, all RBC theories are built within the framework of competitive general equilibrium models. 2) All firms and households are maximizing agents. 3) Cycles are dependent upon the shocks to technology that impact the production function—therefore, rather than deviations, these productions functions have been redefined so that all cyclical behavior is still an equilibrium condition. 4) There are propagation mechanisms that magnify or mitigate the exogenous shocks to labor-augmenting technology.

Kydland and Prescott (1982) present a classic example of an RBC model in which all volatility in output can be accounted for by stochastic changes in productivity. Like most RBC models, it has the problem that it overpredicts the correlation between productivity and output. Because these models are developed and tested around the same data, the standard deviation of output predicted in the model is identical with the data.