What is the core idea of the real business cycle theory about macro fluctuations?

• A. Fluctuations are largely due to real shocks such as changes in technology; prices and wages are flexible; policy interventions have limited stabilizing effects.
• B. Fluctuations are caused by monetary policy mistakes; policy always stabilizes.
• C. Prices and wages are sticky, making monetary policy effective in smoothing cycles.
• D. Policy interventions can permanently raise potential output.

Answer: (D)

Real business cycle theory holds that macro fluctuations come from real, supply-side shocks—most notably changes in technology or productivity that shift the economy’s production possibilities. When a technology shock improves how much the economy can produce, output and employment tend to rise; a negative shock does the opposite. Prices and wages are assumed to be flexible and adjust quickly, so markets clear and there isn’t persistent slack that a policy stimulus is needed to fix. Because the movement in output is driven by real, fundamental changes in the economy’s capacity, stabilization policies don’t have lasting power to change the long-run path of output.

This is why the idea that policy interventions can permanently raise potential output doesn’t fit RBC. In RBC, potential output is determined by technology, capital accumulation, and preferences—factors that policies can influence only indirectly and not in a way that permanently alters the growth trajectory. The emphasis is on real shocks and flexible prices, with policy playing a limited stabilizing role.