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Real Business Cycle Theory and Demand Shocks Cycle

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Real business cycle models are characterized by a neglect of demand shocks and highlight technological productivity shocks that are the primary source of economic fluctuations. The strong assumptions of supply-driven dynamics and demand determined influences are considered in accordance with real business cycle theory. According to Entorf (1992), ‘ the backward propagation mechanism of demand shocks dominates the forward propagation of supply disturbances’ .In certain cases, business cycles are hit by productivity shocks that in turn affect consumer expectations and this has all the features of an aggregate demand shock that increases output, employment, and inflation.

Productivity shock tends to have a temporary negative effect on inflation and employment (Lorenzoni, 2006). A demand shock is captured by a shift in consumer expectations and a disruption in market equilibrium or market adjustment that leads to a demand detriment and shifts in the demand curve. A demand shock can represent demand increase or demand decrease and an increase in demand is seen as a shift of the demand curve resulting in either increase or decrease of equilibrium quantity and price. According to Lorenzoni (2006), demand shocks can be related to changes in public sector expectations and productivity shocks can be associated with aggregate supply shocks.

In the certain traditional Keynesian description and business cycle theories and models, the demand shocks or sudden growth in demand of products and services actually drive growth and business cycle and bring about changes in the market ad economy. For the real business cycle model which is seen as different and quite opposed to the demand shock cycle, the focus is on supply rather than demand and real business cycle highlights the fact that shocks or economic variations are driven by technological changes and technological or supply shocks in which there are rapid fluctuations of supply-driven by changes in technology.

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