Understanding Real Business Cycles

he 1 960s were a time of great optimism for macroeconomists. Many economists viewed the business cycle as dead. The Keynesian model was the reigning paradigm and it provided all the necessary instructions for manipulating the levers of monetary and fiscal policy to control aggregate demand. Inflation occurred if aggregate demand was stimulated "excessively" and unemployment arose if demand was "insufficient." The only dilemma faced by policymakers was determining the most desirable location along this inflation-unemployment tradeoff or Phillips curve. The remaining intellectual challenge was to establish coherent microeconomic founda- tions for the aggregate behavioral relations posited by the Keynesian framework, but this was broadly regarded as a detail that should not deter policymakers in their efforts to "stabilize" the economy. The return of the business cycle in the 1970s after almost a decade of economic expansion, and the accompanying high rates of inflation, came as a rude awakening for many economists. It became increasingly apparent that the basic Keynesian framework was not the appropriate vehicle for understanding what happens during a business cycle nor did it seem capable of providing the empirically correct answers to questions involving changes in the economic environment or changes in monetary or fiscal policy. The view that Keynesian economics was an empirical success even if it lacked sound theoretical foundations could no longer be taken seriously. The essential flaw in the Keynesian interpretation of macroeconomic phe- nomenon was the absence of a consistent foundation based on the choice theoretic framework of microeconomics. Two important papers, one by Milton Friedman (1968) and the other by Robert Lucas (1976), forcefully demonstrated examples of