MACROECONOMICS: REAL BUSINESS CYCLE THEORY

RBC Problems with pre-RBC business cycle

explanations: They lack INTERNAL CONSISTENCY:

They were constructed in an ad-hoc fashion; implications of some Keynesian models suggesting the abandonment of rational economic agents.

They fall foul of the Lucas Critique. However, they are EXTERNALLY CONSISTENT:

They do explain the data. However, a problem with data is that it doesn’t show

causality; a range of theories may explain the data, but it is unclear which one (if any) is correct.

Thus, RBC theory attempts to make both an Internal and External consistent model which scales up the micro – problem.

RBC – THE MICRO PROBLEM Create a model of a complete, closed economy

which is defined parametrically – it won’t provide any diagrams, but will give a ‘replica’ of the actual economy.

Consider the following (mega nasty) equation:

This needs a bit of explanation: The consumer wants to MAXIMISE UTILITY; we can

model utility as the expected value of the DISCOUNTED (beta – discount factor) function of CONSUMPTION (C) and LEISURE (1 – Labour hours worked) – we also assume RATIONAL EXPECTATIONS; they have the full data set at time t+j (sigma).

Of course, the consumer also faces constraints, so all the equations are presented on the next slide.

0

1,j

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RBC

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1,j

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Change in the Capital Stock = Investment – depreciation of current capital stock

Output = Consumption + Investment

Output = Production Function

1=proportion of time spent working + proportion of time spent on leisure

RBC The upshot of solving that

system (which you DO NOT need to do), is that you end up with the following endogenous variables as a FUNCTION OF MICRO-PARAMETERS.

The first advantage of this is that the Lucas Critique no longer, apparently, holds – each variable is independent of Government policy.

RBC models vary from standard econometric models in that they uses a process of CALIBRATION as opposed to ESTIMATION. Calibration – respecifying the

model itself Estimation – guessing the

parameters

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AdhL

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RBC The RBC theorists rely on the parameter ‘At’ for the source

of the SHOCKS – omitting it will give a very smooth fitted line without the shocks that are evident in the real world.

‘At’ is TOTAL FACTOR PRODUCTIVITY the ability to transform inputs into outputs.

It can be defined, therefore, as TECHNOLOGY. RBC theory also relies on At as a source of shocks because

of it’s implication of Procylical Real Wages: RBC theory is based on a Walrasian Equilibrium; there is NO

INVOLUNTARY UNEMPLOYMENT. Thus, a recession can be viewed as simply a reallocation of labour

from those working to those indulging in Leisure – it is a pareto optimal point, still.

Dubious implication aside, the only way to explain this is a procylical real wage – as a recession looms, the real wage falls, encouraging workers to substitute leisure for work.

If we assume an unchanging production function, the most likely result would be a counter-cyclical real wage (due to MPL rising in a recession – less labour – and falling in a boom – more labour, diminishing returns).

Therefore, must rely on TECHNOLOGICAL SHOCKS.

RBC RBC, at first glance, appears to be

fucking amazing. Empirically, it supports data to a high degree

– it explains 87% of output; although this figure falls to 57% when considering Labour. This suggests that it is EXTERNALLY CONSISTENT

It addresses the problems initially set out; it appears to be internally consistent as it has been derived from the micro problem and is defined by micro parameters.

However, there are numerous criticisms that can be levelled at it; indeed, Robert Solow said that RBC was rubbish.

RBC Problems with RBC: Real Wage is NEITHER PROCYLICAL OR COUNTER-CYCLICAL.

This is also a problem for Keynesian business cycle models, but is fairly devastating for RBC theory as a pro-cyclical real wage is such a crucial implication.

It uses the SOLOW RESIDUAL (see Economic Growth slides) as a proxy for technological change. This is dubious on numerous fronts; firstly the Solow Residual was meant to be a

‘measure of ignorance’ – i.e., how much we did NOT know not an accurate measure of technological change.

Solow Residual captures numerous ‘off the production function’ factors influencing output (in addition to technological change); for example, firms may ‘hoard’ labour during a recession this will lead to lower productivity, but the Solow residual will not be able to distinguish what’s causing the lower productivity.

Thus, the Solow Residual is not a good measure for year to year technological change.

Large technological shocks do not happen as frequently as the model prescribes. Large technological shocks will get a lot of media coverage and political involvement

– the oil shocks in the 70’s, for example. However, there does not appear to be such regular, substantial shocks.

Reliance on Labour being highly responsive to interest rate changes. In order to explain Large changes in Employment, but only Small changes in the

determinants of employment (Real Wage, Interest Rate), we have to model Labour supply as highly elastic with regards to the interest rate.

However, labour isn’t people do not consider the interest rate (and therefore the relative benefits of intertemporal substitution of labour to leisure) when taking a job.

ESTIMATION (assume model is wrong) VS CALIBRATION (assume model is right)

RBC

Therefore, RBC theory is an interesting attempt to create a coherent model of business cycles, but simply lacks any degree of empirical consistency beyond the apparent fit between RBC models and empirical data.