Real Business Cycle Theory

Guido Ascari

University of Pavia () Real Business Cycle Theory 1 / 37

Outline

Introduction: Lucas�methodological proposal

The application to the analysis of business cycle �uctuations: TheReal Business Cycle Theory

1 Data: measuring the business cycle (Table 1)2 The model economy: a rigorous description3 The solution of DSGE models: the Blanchard-Khan method4 Table 2: matching moments5 Evaluation of the RBC approach

University of Pavia () Real Business Cycle Theory 2 / 37

The Lucas Methodological Proposal

Lucas (�76,�77,�80,�87). Two important references:1 Lucas, R.E., 1976, Econometric Policy Evaluation: A Critique,Carnegie-Rochester Conference Series on Public Policy, Vol. 1, pp.19-46.

2 Lucas, R.E., 1987, Models of Business Cycles, 1985 Yrjö JahnssonLectures, Basil Blackwell, Oxford.

1. The Lucas�critique: Macroeconomists should build so-calledstructural models, i.e. models where the agents�behavior is invariantwith respect to policy

Microeconomic foundationsGeneral EquilibriumNo distinction between micro and macro: Economic theory

University of Pavia () Real Business Cycle Theory 3 / 37

2. Explicitly dynamic models from the outset:

Dynamic optimizationNeed for a theory of expectations formation => The RationalExpectations Revolution of the 1970s is the logical outcome of Lucas�research program

3. The Methodological Proposal

New analytical and computational instruments (Lucas/Stokey andPrescott, Kydland and Prescott)A new equilibrium concept: recursive equilibrium and "from a point to apath"Importance of expectations in the design of policy experimentsWelfare analysis

University of Pavia () Real Business Cycle Theory 4 / 37

CONCLUSIONS

Modern macroeconomics should employ dynamic general equilibriummodels (DSGE), that is, a macroeconomic model should be theresults of the solution of dynamic optimization problems underuncertainty by optimizing agents populating the model economy.

Build a "laboratory economy": much more di¢ cult task than oldKeynesian theorizing

Kydland & Prescott (1982) accepted the challenge posed by Lucas:they built the �rst Real Business Cycle (RBC) model.

University of Pavia () Real Business Cycle Theory 5 / 37

The basic RBC model in a nutshell

Outline of the RBC methodology:

a discrete-time stochastic model of the economy populated by maximizinghouseholds and �rms

MAIN SOURCE OF FLUCTUATIONS:

The erratic nature of technological progress

University of Pavia () Real Business Cycle Theory 6 / 37

THE BASIC MODEL: AS SIMPLE AS POSSIBLE

The Ramsey model of growth => integrating growth and cycle

All prices are �exible

All markets are walrasian

Rational expectations

No money

Endogenous labour

Technology shocks (and possibly other shocks) => stochastic steadystate

University of Pavia () Real Business Cycle Theory 7 / 37

MAIN RESULT AND FIRST INTUITION

There is only one �nal good in the economy which is producedaccording to a constant return to scale (CRS) production function

Yt = AtF (Kt�1,Nt )

where ln(At/A) = at is an exogenous process of technologicalprogress (or total factor productivity TFP), which evolves accordingto:

at = ρaat�1 + at , at � N�0, σ2a

�i .i .d .

A positive shock to the TFP shifts �rms�labor demand and the AScurve

Movements in employment and economic activity are seen as thee¢ cient responses of a perfectly competitive economy to aproductivity shock. =) Stochastic path of Walrasian equilibria

University of Pavia () Real Business Cycle Theory 8 / 37

POSITIVE TECHNOLOGY SHOCK

University of Pavia () Real Business Cycle Theory 9 / 37

THE PLANNER PROBLEMRBC models do not consider any distortion or market imperfection,therefore the welfare theorems apply to these models:

1) the competitive equilibrium is pareto-optimal2) a pareto-optimal allocation can be decentralized as a competitiveequilibrium

The social planner equilibrium and the competitive equilibrium areidentical and admit a unique solution

University of Pavia () Real Business Cycle Theory 10 / 37

Data: Measuring the Business Cycle

TRADITIONAL BUSINESS CYCLE THEORY: output trend Ytevolves smoothly over time, Yt = a+ bt. Cycles are viewed asdeviation from trends, i.e. Yt � Yt

RBC THEORY: cycles can be explained also assuming that Ytevolves according to a random walk, i.e., Yt = b+ Yt�1 + ut . In thiscase much of the movements in Yt are due to movements in Ytrather then to trend deviations Yt � Yt => Integrating growth andbusiness cycle theory

University of Pavia () Real Business Cycle Theory 11 / 37

Data: Measuring the Business CycleH-P Filter

Minfy gt g

∞t=0

∞

∑t=1

n(yt � ygt )

2+ λ

��ygt+1 � y

gt���ygt � ygt�1

��2o

H-P �lter suppresses the really low frequency �uctuations � 8 yearsquarterly data λ = 1600linear trend λ� > ∞original series λ = 0

This makes the trend component a weighted average of past, present andfuture values => and the cyclical component is de�ned as

y ct = yt � ygt = yt �J

∑j=�J

ajyt�j

University of Pavia () Real Business Cycle Theory 12 / 37

University of Pavia () Real Business Cycle Theory 13 / 37

University of Pavia () Real Business Cycle Theory 14 / 37

Business cycles are all alike

University of Pavia () Real Business Cycle Theory 15 / 37

University of Pavia () Real Business Cycle Theory 16 / 37

University of Pavia () Real Business Cycle Theory 17 / 37

University of Pavia () Real Business Cycle Theory 18 / 37

Some stylized facts about growth

University of Pavia () Real Business Cycle Theory 19 / 37

University of Pavia () Real Business Cycle Theory 20 / 37

The Basic Structure of the RBC model

1 Endowment, initial condition and ownership2 Preferences3 Technology4 Law of motions of endogenous/exogenous state variables5 Individual resource constraints6 Aggregate resource constraints7 Markets equilibrium condition8 De�nition of equilibrium

University of Pavia () Real Business Cycle Theory 21 / 37

HOW TO SOLVE THE MODEL - SEVEN STEPS

1 Find all the �rst order necessary conditions2 Calculate the economy steady state3 Log-linearize the model around the steady state4 Solve for the recursive law of motion5 Calculate the IRFs in response to di¤erent shocks6 Calculate the moments: correlations, and standard deviations for thedi¤erent variables both for the arti�cial economy and for the actualeconomy.

7 Compare how well the model economy matches the actual economy�scharacteristics

University of Pavia () Real Business Cycle Theory 22 / 37

Go to �les:

notesRBC.pdf

detailmodel_matlab.pdf

University of Pavia () Real Business Cycle Theory 23 / 37

THE BASIC MODEL: AS SIMPLE AS POSSIBLE

Prescott did not think such a simple model could be of any use =>surprising result!

Main policy conclusion: �uctuations of all variable (output,consumption, employment, investment...) are the optimal responsesto technology shocks exogenous changes in the economicenvironment.

Shocks are not always desirable. But once they occur, this is the bestpossible outcome: business cycle �uctuations are the optimal responseto technology shocks => no need for government interventions: itcan be only deleterious

University of Pavia () Real Business Cycle Theory 24 / 37

Furious response from the "people from the Oceans" => Rogo¤:"brilliant theories �rst look ridiculous then they become obvious".

From mid�80s to mid�90s: ten years lost in useless ideological debatesbetween the Oceans and the Lakes

From mid�90s: convergence on methodology: "the RBC approach asthe new orthodoxy in macroeconomics"

University of Pavia () Real Business Cycle Theory 25 / 37

Criticism

Empirical philosophy: calibration vs. estimation

Too many parameters?Too much �exibility in choosing parameters? "The book of Ed"No possible statistical testing against alternativesis matching moments a desirable feature? econometrician aresuspicious of correlations

University of Pavia () Real Business Cycle Theory 26 / 37

Criticism

Solow residual and technology shocksNeed for highly persistent technological shocks: why? and above all:what are they?

Solow residual is highly correlated with output

University of Pavia () Real Business Cycle Theory 27 / 37

RBC View:

RBC theory argue that the strong correlation between output growthand Solow residuals is the evidence that productivity shocks are animportant source of economic �uctuations.

Critics:

Are economic �uctuations really caused by productivity shocks?

Expansions arise because of increases in productivity!. . . What does that mean about recessions? (Summers 1986)

It means that recessions are periods of technical regress! Burnside etal. estimates the probability of technological regress implied by SR tobe 37%!

Less implausible if supply shock considered more broadly (OPEC,strikes etc.)

University of Pavia () Real Business Cycle Theory 28 / 37

Real Achille�s heel: "measure of our ignorance"

Hall (1988): SR is useful to forecast military spending or othervariables that should not be a¤ected by technological shocks

Hall (1990): SR is mis-measured if there is imperfect competition,IRTS, or labour hoarding, or variable capacity utilization

Evans (1992):

money, interest rates and public spending Granger-cause SRa substantial component of σSR seems to be cause by aggregatedemand shocks

Bottom line: SR as measured out from a simple C-D production functionis very spurious

University of Pavia () Real Business Cycle Theory 29 / 37

Early criticism

The Labour Market

Need for an highly elastic labour supply => labour market problemsThe increase in productivity translates to an increase in hours workedand to an increase in real wages. The e¤ect on the real wage isrelatively stronger the lower is the elasticity of labor supply 1

φ . In theextreme case of �xed labor supply all the increase in labor demandwould translate into an increase in the real wage.

CRITICS:

- labor supply does not depend that much on the intertemporal real wage;- high unemployment is mainly involuntary

University of Pavia () Real Business Cycle Theory 30 / 37

Hansen and Wright (FRBMQR, 1992)

Two problems:

σh > σw in the data, but not in the model

Fixer: Need for an highly elastic labour supply (Hansen, JME, 85)

corr(H,w) ' 0 in the data, close to 1 in the modelFixer: single shock problem (Christiano and Eichenbaum, AER, 92)

University of Pavia () Real Business Cycle Theory 31 / 37

University of Pavia () Real Business Cycle Theory 32 / 37

Fixing the �rst problemModelling the extensive margin

Most of movements in unemployment hours comes from movements fromin and out of unemploymentAssume workers either work 0 hours or work h0Given total labour demand Ht , the numbers of workers needed are Et = Ht

h0Rogerson�s lotteries => Given the labour force Nt , the probability ofgetting a job is EtNt =

Ht/h0Nt

Expected utility from leisure

E (U) =Ht/h0Nt

U(c , 1� h0) +Nt �Ht/h0

NtU(c , 1) =

=Ht/h0Nt

[U(c , 1� h0)� U(c , 1)] + U(c , 1)

LINEAR IN Ht !! => in�nite elasticity

University of Pavia () Real Business Cycle Theory 33 / 37

Fixing the second problemGovernment spending shock

University of Pavia () Real Business Cycle Theory 34 / 37

University of Pavia () Real Business Cycle Theory 35 / 37

Are wages and prices �exible?

RBC theory assumes that wages and prices are completely �exible, somarkets always clear.

RBC proponents argue that the degree of price stickiness occurring inthe real world is not important for understanding economic�uctuations.

They also assume �exible prices to be consistent with microeconomictheory.

Critics:

Wage and price stickiness explains involuntary unemployment and thenon-neutrality of money.

University of Pavia () Real Business Cycle Theory 36 / 37

SUMMING UP

Empirical signi�cance of intertemporal labor substitution mechanismis doubtful.

RBC theory implies that recessions are periods of technical regress!

Money is neutral so does not explain positive correlation betweenprices and output; and that this can be recti�ed by endogenizing themoney supply (Cooley and Hansen, AER, 1989)

Wage and price rigidity can help to explain involuntary unemploymentand non-neutrality of money

University of Pavia () Real Business Cycle Theory 37 / 37