In previous chapters we studied the long run evolution of output and consumption, real interest rates and real wages, and the long run evolution of the price level and inflation. In order to focus on long-term trends we made the assumption that all markets are competitive and in continuous equilibrium, through the full adjustment of prices, wages and interest rates.

However, as we noted in Chapter 1, economies are characterized by fluctuations in relation to their long-term trends. In some periods output, consumption and employment grow at high rates, while at other times they grow at low or even negative rates. In some periods unemployment is low and in others quite high. Inflation displays significant fluctuations as well.

Understanding the determinants of aggregate fluctuations is the second main objective of macroeconomics. In this, and the chapters that follow, we present the main theories regarding the nature of aggregate fluctuations.

In this chapter we start by introducing classical models of aggregate fluctuations. “New” classical models are essentially dynamic stochastic general equilibrium models (DSGE), based on optimizing households and firms, and fully competitive markets. Fluctuations in these models are caused by real shocks to productivity, household preferences and government expenditure, and the effects of these shocks are propagated through endogenous dynamic processes, such as consumption and investment.

We start with the so called stochastic growth model, which is an extended stochastic version of the Ramsey model. The utility function of a representative household depends on both consumption of goods and services, and leisure, while random disturbances to real factors, such as productivity, preferences and government expenditure cause aggregate fluctuations.

To be able to analyze the model, we make simplifying assumptions regarding the production and utility functions. Without them the model becomes extremely complicated. The dynamic analysis is conducted in discrete rather than continuous time.

The main impulses that generate aggregate fluctuations are real, i.e shocks to productivity, preferences and government expenditure. This is why this class of models is often referred to as the real business cycle (RBC) model.

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