1. The Real Business Cycle School Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University

2. RBC Macroeconomics Evolved out of New Classical economics of 1970s Evolved out of New Classical economics of 1970s Major proponents Major proponents Edward Prescott (Minnesota) Edward Prescott (Minnesota) Finn Kydland (Carnegie-Mellon) Finn Kydland (Carnegie-Mellon) Charles Plosser (Rochester) Charles Plosser (Rochester) Robert Barro (Harvard) Robert Barro (Harvard)

3. From New Classical to RBC The late 1970s and early 1980s was a time of New Classical Dominance The late 1970s and early 1980s was a time of New Classical Dominance By the early 1980s, however, significant doubts had arisen By the early 1980s, however, significant doubts had arisen “signal-extraction” problem not robust enough to explain business cycles “signal-extraction” problem not robust enough to explain business cycles Evidence supportive of monetary neutrality of announced policy weak Evidence supportive of monetary neutrality of announced policy weak Tobin suggests a “way out” that he does not himself take seriously – random real shocks Tobin suggests a “way out” that he does not himself take seriously – random real shocks

4. From New Classical to RBC Kydland and Prescott take seriously this alternative and develop the foundations of Real Business Cycle Theory – a theory that accounts for cycles wholly by changes in real supply variables. Kydland and Prescott take seriously this alternative and develop the foundations of Real Business Cycle Theory – a theory that accounts for cycles wholly by changes in real supply variables. Kydland and Prescott, “Time to Build and Aggregate Fluctuations,” Econometrica (November 1982) Originally viewed as augmenting the New Classical approach Originally viewed as augmenting the New Classical approach

5. Central Proposition Large random fluctuations in technology produce supply-side shocks to the production function, generating fluctuations in aggregate output and employment as rational individuals respond to the altered structure of relative prices by changing labor (resource) supply and consumption (investment) decisions.

6. RBC Macroeconomics Assault on all previous 20 th century macroeconomics Assault on all previous 20 th century macroeconomics Booms are not “good” and recessions are not “bad” Booms are not “good” and recessions are not “bad” Recessions are not desired by agents in the economy but they are nonetheless unavoidable consequences of changes in constraints agents face Recessions are not desired by agents in the economy but they are nonetheless unavoidable consequences of changes in constraints agents face

7. RBC Macroeconomics Assault on all previous 20 th century macroeconomics Assault on all previous 20 th century macroeconomics Agents react optimally to changes in constraints and the resulting aggregate fluctuations are efficient Agents react optimally to changes in constraints and the resulting aggregate fluctuations are efficient Supply, not demand shocks, are key to understanding economic fluctuations Supply, not demand shocks, are key to understanding economic fluctuations

8. RBC v. New Classical RBC replaces the impulse mechanism of New Classical economics “Technology shocks” instead of “monetary surprise” RBC retains the propagation mechanisms of New Classical economics Rational expectations and relative prices New Classical Economics “Mark II”

9. Reactions of Leading New Classicalists Lucas Lucas Exclusion of money in RBC a mistake Exclusion of money in RBC a mistake Viewed as addition to NC models Viewed as addition to NC models Later says “monetary shocks just aren’t that important” Later says “monetary shocks just aren’t that important” Approves of methodology Approves of methodology micro-based models and use of fully-articulated artificial economies to compare real with experimental economics micro-based models and use of fully-articulated artificial economies to compare real with experimental economics Business cycles are “minor problem” – shifts focus to Growth economics Business cycles are “minor problem” – shifts focus to Growth economics

10. Reactions of Leading New Classicalists Barro Barro RBC promising RBC promising Monetary neutrality of New Classical models a “mistake” Monetary neutrality of New Classical models a “mistake” Shifted focus to Growth economics Shifted focus to Growth economics Defends New Classical Achievements Defends New Classical Achievements Equilibrium modeling Equilibrium modeling Rational expectations Rational expectations Dynamic policy-making and evaluation Dynamic policy-making and evaluation

11. Growth and Cycles Development of RBC and shift of research to Growth represent revival of interest in “supply-side” macroeconomics Development of RBC and shift of research to Growth represent revival of interest in “supply-side” macroeconomics Continuation of pre-Keynesian lines of business cycle research Continuation of pre-Keynesian lines of business cycle research New technology influences both long- run growth as well as producing short- run displacements (disequilibrium?) New technology influences both long- run growth as well as producing short- run displacements (disequilibrium?)

12. RBC Antecedents Dennis Robertson Dennis Robertson emphasized real forces emphasized real forces Joseph Schumpeter Joseph Schumpeter “Theory of Capitalist Development” “Theory of Capitalist Development” Knut Wicksell Knut Wicksell Changes in marginal productivity of capital (impulse mechanism) cause divergence of “natural rate of interest” from “bank loan rate” leading to endogenous monetary creation (propagation mechanism), distorting time structure of production and leading to self- reversing boom Changes in marginal productivity of capital (impulse mechanism) cause divergence of “natural rate of interest” from “bank loan rate” leading to endogenous monetary creation (propagation mechanism), distorting time structure of production and leading to self- reversing boom

13. Growth and Cycles For Real Business Cycle Macroeconomics, growth and cycles are inseparably interrelated

14. History and RBC Supply shocks of 1970s Supply shocks of 1970s Two OPEC oil increases Two OPEC oil increases Apparent failure of Demand-side Keynesian model Apparent failure of Demand-side Keynesian model Political emphasis of “new supply-side economics” of Reagan Administration Political emphasis of “new supply-side economics” of Reagan Administration Tax cuts and deregulation Tax cuts and deregulation Renewed interest in statistical properties of economic time-series Renewed interest in statistical properties of economic time-series Seminal work of Nelson and Plosser Seminal work of Nelson and Plosser

15. Cycles and Random Walks Conventional Approach Conventional Approach Imagines economy evolving along a growth path reflecting underlying trend Imagines economy evolving along a growth path reflecting underlying trend Fluctuations about trend due to demand shocks Fluctuations about trend due to demand shocks Shocks “die out” over time, so economic time-series are “trend-reverting” Shocks “die out” over time, so economic time-series are “trend-reverting” Y t = g t (Y 0 ) + b (Y – Y T ) t-1 + z t Y t = g t (Y 0 ) + b (Y – Y T ) t-1 + z t

16. Cycles and Random Walks Y t = g t (Y 0 ) + b (Y – Y T ) t-1 + z t Y t = g t (Y 0 ) + b (Y – Y T ) t-1 + z t At time t1, a shock of size z occurs, but it dies out over time and the growth path reverts to the trend At time t1, a shock of size z occurs, but it dies out over time and the growth path reverts to the trend Conventional approach consistent with the natural rate hypothesis (unanticipated changes in monetary growth produce temporary deviations from Y N ) Conventional approach consistent with the natural rate hypothesis (unanticipated changes in monetary growth produce temporary deviations from Y N ) time Y

17. Cycles and Random Walks Nelson and Plosser, “Trends and Random Walks in Macroeconomic Time Series: Some Evidence and Implications,” Journal of Monetary Economics (September 1982) Most changes in GDP are permanent, with no tendency for Y to revert to former trend Most changes in GDP are permanent, with no tendency for Y to revert to former trend GDP follows a random walk process with drift GDP follows a random walk process with drift

18. Cycles and Random Walks Nelson-Plosser Approach Nelson-Plosser Approach Value in one period still dependent on previous value of the variable, but shocks (z) change output permanently Value in one period still dependent on previous value of the variable, but shocks (z) change output permanently Rather than g being underlying growth rate, g is “rate of drift;” b has value of 1 – “unit root” hypothesis Rather than g being underlying growth rate, g is “rate of drift;” b has value of 1 – “unit root” hypothesis Y t = g t (Y 0 ) + (Y – Y T ) t-1 + z t Y t = g t (Y 0 ) + (Y – Y T ) t-1 + z t

19. Cycles and Random Walks Y t = g t (Y 0 ) + (Y – Y T ) t-1 + z t Y t = g t (Y 0 ) + (Y – Y T ) t-1 + z t At time t1, a shock of size z occurs and it permanently changes the growth path of the economy At time t1, a shock of size z occurs and it permanently changes the growth path of the economy time Y

20. Implications of Nelson-Plosser Observed fluctuations are fluctuations in the trend, not deviations from a trend. Observed fluctuations are fluctuations in the trend, not deviations from a trend. In NC world, permanent changes in GNP growth cannot occur from monetary shocks since money is neutral; therefore main forces causing instability must be real shocks. In NC world, permanent changes in GNP growth cannot occur from monetary shocks since money is neutral; therefore main forces causing instability must be real shocks. If shocks to productivity growth are frequent and random, path of Y follows a random walk that resembles the business cycle. If shocks to productivity growth are frequent and random, path of Y follows a random walk that resembles the business cycle. No distinction between trend and cycle, so theory of growth and fluctuations must be integrated. No distinction between trend and cycle, so theory of growth and fluctuations must be integrated.

21. Productivity Shocks Unfavorable changes in the physical environment that adversely affect agricultural output Unfavorable changes in the physical environment that adversely affect agricultural output Significant changes in price of energy Significant changes in price of energy War, political upheaval and labor unrest War, political upheaval and labor unrest Government regulations Government regulations Changes in the quality and quantity of capital and labor; new management techniques; new products; new production techniques =>Technological change Changes in the quality and quantity of capital and labor; new management techniques; new products; new production techniques =>Technological change

22. RBC Models: Common Features (1)Representative agent models; agents maximize s.t. constraints (2)Agents form Ratex; signal-extraction problem re permanent v. temporary productivity shocks (3)Continuous market-clearing (4) Exogenous productivity shocks are impulse mechanism for output and employment fluctuations

23. RBC Models: Common Features (5)Propagation mechanisms vary, include consumption smoothing, “time-to-build,” and intertemporal labor substitution (6)Fluctuations in employment voluntary; labor and leisure highly substitutable over time (7)Money is neutral (8) No distinction between SR and LR

24. Changes from New Classicalism Impulse factor – productivity shocks replace monetary shocks Impulse factor – productivity shocks replace monetary shocks Abandon price level/relative price misperception emphasis Abandon price level/relative price misperception emphasis Abandon long run/short run distinction Abandon long run/short run distinction

25. RBC: Model Structure Production Function Production Function Y t = A t F(K t, L t ) Y t = A t F(K t, L t ) Technology Evolution Parameter Technology Evolution Parameter A t+1 = þA t + є t+1 0 < þ < 1 A t+1 = þA t + є t+1 0 < þ < 1 Representative Agent Utility Function Representative Agent Utility Function U t = f(C t, Le t ) U t = f(C t, Le t ) Resource Constraints Resource Constraints C t + I t ≤ Y t ; L t + Le t ≤ 1 C t + I t ≤ Y t ; L t + Le t ≤ 1 Capital Stock Accumulation Equation Capital Stock Accumulation Equation K t+1 = (1-∂) K t + I t K t+1 = (1-∂) K t + I t

26. Technology Shocks and Employment Technology shocks change A, shifting the production function upward; the demand for labor curve will also shift upward. Technology shocks change A, shifting the production function upward; the demand for labor curve will also shift upward. Increased labor demand will increase the real wage and employment. Increased labor demand will increase the real wage and employment. How much? Depends on supply elasticity! How much? Depends on supply elasticity! If labor supply is inelastic? If labor supply is inelastic? If labor supply is elastic? If labor supply is elastic?

27. Technology Shocks and Employment Stylized facts of Business Cycles indicate small procyclical variations in real wage are associated with large procyclical variations in employment Stylized facts of Business Cycles indicate small procyclical variations in real wage are associated with large procyclical variations in employment Is labor supply highly elastic or inelastic with respect to real wage? Is labor supply highly elastic or inelastic with respect to real wage? What does that indicate about the intertemporal substitution of labor for leisure? What does that indicate about the intertemporal substitution of labor for leisure?

28. RBC and Lucas-Rapping ASH Lucas-Rapping: in making labor- supply decisions, workers consider future and current C and Le Lucas-Rapping: in making labor- supply decisions, workers consider future and current C and Le Substitution and income effects of changed real wage Substitution and income effects of changed real wage Temporary v. permanent changes in real wages Temporary v. permanent changes in real wages

29. RBC and Lucas-Rapping ASH RBC RBC temporary technology shocks will lead to temporary changes in real wages; no income effect and large supply response temporary technology shocks will lead to temporary changes in real wages; no income effect and large supply response Permanent technology shocks will lead to permanent changes in real wages; large income effect and small supply response Permanent technology shocks will lead to permanent changes in real wages; large income effect and small supply response

30. Labor Supply and Interest Rates Change in the real interest rate affects labor supply by altering relative price of income earned today v. future Change in the real interest rate affects labor supply by altering relative price of income earned today v. future L s = L s (W/P, r) L s = L s (W/P, r) Intertemporal price-ratio Intertemporal price-ratio (1+r) (W/P t ) (W/P t+1 ) (W/P t+1 ) Increase in r increases labor supply; reduction in r reduces labor supply Increase in r increases labor supply; reduction in r reduces labor supply

31. RBC AD and AS An IS-LM model conforming to Ratex, Continuous Market Clearing, and Full- information M s An IS-LM model conforming to Ratex, Continuous Market Clearing, and Full- information M s Output and employment due to real forces; RAS determined by production function and labor supply Output and employment due to real forces; RAS determined by production function and labor supply Tech improvement shifts RAS to right and LM/P adjusts so full employment exists Tech improvement shifts RAS to right and LM/P adjusts so full employment exists Problem with model: Labor supply not dependent on r Problem with model: Labor supply not dependent on r r Y RAS IS (RAD) LM/P

32. RBC AD and AS If labor supply is dependent on r, an increase in r increases labor supply and increases output If labor supply is dependent on r, an increase in r increases labor supply and increases output The RAS curve is positively sloped The RAS curve is positively sloped r Y RAS RAD YeYe rere

33. Characteristics of Model Model entirely real (M and P have no impact on Y or L) Model entirely real (M and P have no impact on Y or L) No LR-SR distinction No LR-SR distinction RAS traces out labor market equilibria RAS traces out labor market equilibria r equilibrates goods market r equilibrates goods market Shifts in RAS lead to variations in Y and L Shifts in RAS lead to variations in Y and L Temporary variations in RAD can cause Y and L variations Temporary variations in RAD can cause Y and L variations

34. Technology Shock: RAD-RAS Begin in equilibrium. Labor market clears at real wage w 1 for given production function Y. At current r 1, RAS and RAD clear at Y 1. Begin in equilibrium. Labor market clears at real wage w 1 for given production function Y. At current r 1, RAS and RAD clear at Y 1. Favorable productivity shock increases A and production function increases to Y*. Favorable productivity shock increases A and production function increases to Y*. RAS increases, driving down the interest rate. RAS increases, driving down the interest rate. The lower interest rate lowers the supply of labor and favorable productivity shock increases labor demand. The lower interest rate lowers the supply of labor and favorable productivity shock increases labor demand. Labor market equilibrium moves to b, employment increases and output increases at the lower interest rate. Labor market equilibrium moves to b, employment increases and output increases at the lower interest rate. r Y RAS 1 RAD Y1Y1 r1r1 Y Y Y w L RAS 2 Y = Y S L2 (r2) S L1 (r1) D L2 D L1 Y Y* L2L2 L1L1 w2w2 w1w1 r2r2 Y2Y2 a a a a b b b b

35. Expenditure Shock: RAD-RAS Begin in equilibrium. Labor market clears at real wage w 1 for given production function Y. At current r 1, RAS and RAD clear at Y 1. Begin in equilibrium. Labor market clears at real wage w 1 for given production function Y. At current r 1, RAS and RAD clear at Y 1. Increase in government purchases shifts RAD to the right, increasing the real interest rate. Increase in government purchases shifts RAD to the right, increasing the real interest rate. The higher interest rate increases the supply of labor and reduces the real wage rate. The higher interest rate increases the supply of labor and reduces the real wage rate. Labor market equilibrium moves to b, employment increases and output increases at the higher interest rate. Labor market equilibrium moves to b, employment increases and output increases at the higher interest rate. r Y RAS RAD 1 Y1Y1 r1r1 Y Y Y w L Y = Y S L2 (r2) S L1 (r1) D L1 Y L2L2 L1L1 w2w2 w1w1 r2r2 Y2Y2 a a a a b b b b RAD 2

36. Temporary v. Permanent Shocks In the previous model, wealth effects were ignored. In the previous model, wealth effects were ignored. If shocks are permanent, wealth effects can’t be ignored. When permanent shocks occur, induced changes in the real wage also will led to additional changes in RAD. If shocks are permanent, wealth effects can’t be ignored. When permanent shocks occur, induced changes in the real wage also will led to additional changes in RAD. A change in technology will cause RAS and RAD to move in the same direction. A change in technology will cause RAS and RAD to move in the same direction. A positive technology shock that raises RAS raises the real wage, increases real income and increases RAD. A positive technology shock that raises RAS raises the real wage, increases real income and increases RAD. A change in expenditures will moderate the change in RAD. A change in expenditures will moderate the change in RAD. An increase in government purchases that reduces the real wage reduces real income and decreases RAD. An increase in government purchases that reduces the real wage reduces real income and decreases RAD.

37. Temporary v. Permanent Shocks A positive technology shock increases RAS to RAS2. A positive technology shock increases RAS to RAS2. If the shock is temporary, the wealth effect is small and RAD increases by a small amount. If the shock is temporary, the wealth effect is small and RAD increases by a small amount. The real interest rate falls as higher output is achieved. The real interest rate falls as higher output is achieved. This does not change the prediction of the model which ignores wealth effects. This does not change the prediction of the model which ignores wealth effects. r Y RAS RAD YeYe rere RAS 2 RAD 2 Y2Y2 r2r2

38. Temporary v. Permanent Shocks A positive technology shock increases RAS to RAS2. A positive technology shock increases RAS to RAS2. If the shock is permanent, the wealth effect on expenditures will be large and increase RAD by roughly the same amount as the increase in Y. If the shock is permanent, the wealth effect on expenditures will be large and increase RAD by roughly the same amount as the increase in Y. Out put increases but the interest rate remains approximately the same. Out put increases but the interest rate remains approximately the same. This prediction of the model is different than that which ignores wealth effects. This prediction of the model is different than that which ignores wealth effects. r Y RAS RAD YeYe rere RAS 2 RAD 2 Y2Y2

39. “Testing” RBC Models Kydland and Prescott were first to show that RBC models could generate time-series data that possessed statistical properties similar to actual US business fluctuations. RBC theorists generally have not attempted to provide models capable of econometric testing. Instead, RBC theorists have developed the method of calibration to test their models.

40. Calibration Method (1) Construct RBC equilibrium model (2) Provide specific functional forms (3) Calibrate the model - simulate random shocks with computer generated random numbers (4) Trace out key macroeconomic variables from exercise and compare with actual time-series

41. Calibration Method Such exercises are able to mimic the actual economy with respect to important time-series data and replicate the stylized facts of business fluctuations Problem: How to choose between competing models? No criteria equivalent to significance testing in econometrics to answer such a question.

42. RBC and Money Accepted stylized fact: Positive correlation between money and output. Generally accepted (Friedman and Schwartz) by Keynesians, Monetarists and New Classicalists that changes in monetary growth cause changes in real output growth. In RBC models, money is “super” neutral. How do RBC models account for the accepted stylized fact?

43. RBC and Money Caveat: Positive correlation between money and output may indicate that money responds to output. But then why does it look like monetary growth comes before output growth? Expectations of future output growth may lead to increases in money demand that increase the quantity of money supplied. Bank money (demand deposits) is endogenous; bank money can be produced faster than real output. Money supply changes before output but output changes cause money supply changes.

44. RBC and Money RBC theorists divided into two camps Kydland and Prescott, “Business Cycles: Real Facts and the Monetary Myth,” FRB Minneapolis Quarterly Review (Spring 1990) Denial of stylized fact that money leads the cycle Plosser, “Understanding Real Business Cycles,” Journal of Economic Perspectives (Summer 1989) Role of money remains an “open question”

45. Measuring Technology Shocks How does one measure technological progress? “Solow residual” That part of ∆Y that can’t be explained by ∆K or ∆L Y = A F (K, L) Y = A K β L 1- β where 0 < β < 1 ∆Y/Y = ∆A/A + β ∆K/K + (1- β ) ∆L/L ∆A/A = ∆Y/Y – [ β ∆K/K + (1- β ) ∆L/L]

46. Measuring Technology Shocks Prescott (“Theory Ahead of Business Cycle Measurement”) suggested (∆A/A) is a random walk with drift plus serially uncorrelated error Plosser (“Understanding Real Business Cycles”) uses (∆A/A) and (∆Y/Y) to show that aggregate fluctuations in Y are mainly due to fluctuations in technology

47. Measuring Technology Shocks

48. The Stylized Facts RBC literature led to a renewed effort to discover and measure the stylized facts of business fluctuations Forced a re-evaluation of existing theories in light of the new data Central controversies over Real wages Price level

49. Real Wages and Business Cycles Are real wages pro-cyclical or counter-cyclical? Orthodox Keynesianism and Orthodox Monetarism Real wages are counter-cyclical Changes in AD with sticky or lagging wages (due to adaptive expectations) RBC Real wages are strongly pro-cyclical Changes in technology shift production function and change the demand for labor Empirics Real wages are slightly pro-cyclical Problem: procyclical wages require elastic labor supply to produce observed variations in employment and output, but micro data does not support notion of elastic labor supply

50. Price Level and Business Cycles Is the price level pro-cyclical or counter-cyclical? Orthodox Keynesianism, Monetarism, New Classical Price level and inflation are pro-cyclical RBC Evidence from entire 1954-89 period is that price level and inflation are counter-cyclical Empirics and Impulse Mechanisms Impulse determines behavior of price level and inflation Supply-side changes lead to counter-cyclical prices Demand-side changes lead to pro-cyclical prices

51. Policy Implications (1) More robust case against activism “Costly efforts at stabilization are likely to be counter-productive. Economic fluctuations are optimal responses to uncertainty in the rate of technological progress.” - Prescott, “Theory Ahead of Business Cycle Measurement” (2) Fiscal policy is more potent than monetary policy but should still be avoided.

52. RBC and AD Management Aggregate demand management has been successful in reducing the volatility of business fluctuations from demand-side disturbances compared to earlier periods; technological disturbances have emerged as a dominant source of modern business fluctuations as a consequence. - Chatterjee, “Real Business Cycles: A Legacy of Countercyclical Policies”

53. Criticisms of RBC Theory (1) Evidence concerning labor supply elasticity weak (2) Technology shocks are directly unobservable Doubts concerning size and frequency to produce large variations in Y and L Doubts that technological regression occurs to produce recessions (3) Pro-cyclical Solow residual due to other reasons Pro-cyclical utilization rates of labor and capital

54. Criticisms of RBC Theory (4) Is large unemployment really voluntary? pro-cyclical movement of vacancy rates and voluntary quits (5) Is money neutral in the short-run? American and British dis-inflations of the 1980s (6) Persistence (Unit-root hypothesis or lack of trend-reversion) AD changes can produce permanent effects if it induces technological change Hysteresis effects

55. Criticisms of RBC Theory (7) No micro-economic foundation for technological change and innovation Plausible models of demand conditions, R&D expenditures and “learning by doing” effects (8) Representative agent models sidestep rather than address aggregation and coordination problems (9) Lack of robust empirical testing

56. RBC: An Assessment RBC refocused attention on what we actually know or don’t know about business fluctuations Output does not appear to be trend-reverting, but rather follows a random walk with drift Re-integration of growth theory and theory of fluctuations Furthered cause of building macro-models with micro-foundations Renewal of interest concerning role of supply-side in macroeconomics