Economics 314 Coursebook, 2008 Jeffrey Parker 7 STOCHASTIC GROWTH MODELS AND REAL BUSINESS CYCLES Chapter 7 Contents A. Topics and Tools .................................................................................1 B. Walrasian vs. Keynesian Explanations of Business Cycles .................3 Why do we have multiple theories of business cycles? ...........................................3 Classification of business-cycle models .................................................................4 C. Understanding Romer’s Chapter 4..........................................................7 Romer’s baseline model......................................................................................7 Introducing random shocks ................................................................................9 Analysis of household behavior .........................................................................11 Solving the model?..........................................................................................13 Romer’s “special case”......................................................................................14 Method of undetermined coefficients.................................................................17 Trend stationarity, difference stationarity, and unit roots..................................18 D. Calibration vs. Estimation in Empirical Economics .........................19 E. Suggestions for Further Reading.......................................................21 Seminal RBC papers.......................................................................................21 Surveys and descriptions of RBC models ...........................................................21 F. Studies Referenced in Text ................................................................22 A. Topics and Tools Economists recognized the existence of cyclical fluctuations in economic ac-tivity long before modern macroeconomic measurements such as GDP and the unemployment rate were collected and published. Indeed, one macroeconomics text cites a reference to something analogous to a business cycle in biblical7 — 2 sources! During the latter half of the 19th century, economists began to note re-current booms and depressions of the industrial economy in which each “trade cycle” resembled the others in many respects. Business-cycle analysis began in earnest in the 1890s. An early comprehensive compilation of business-cycle sta-tistics was Wesley Clair Mitchell=s Business Cycles, published in 1913.1 Dennis Robertson and A.C. Pigou were among the leading economists who developed theories to try to explain Mitchell’s empirical observations on business cycles in the pre-depression period. John Maynard Keynes revolutionized the analysis of business cycles in 1935 with his General Theory of Employment, Interest and Money. Keynes focused the attention of economists on the role of deficient demand in generating and pro-longing cyclical downturns. As we shall study later, Keynes believed that invest-ment, operating through its effect on aggregate demand, was the primary engine driving the business cycle. The influence of Keynes’s ideas began to wane in the 1970s when the combi-nation of inflation and oil-shock-induced stagnation in production–stagflation–presented macroeconomists with situations that did not fit the tradi-tional Keynesian theory. They tried to understand these new events by building models of the business cycle based on rigorously specified sets of microeconomic assumptions such as utility maximization. The families of theories that grew out of this first generation of “microfoundations" models are the subject matter of an upcoming section of this course. Robert Lucas developed a model with imperfect information and market clearing that seemed to explain some of the more prominent business-cycle features. “New Keynesian” macroeconomists re-sponded with a alternative set of theoretical explanations based on sticky wages or prices. Later new Keynesians emphasized the presence of coordination fail-ures that lead to inefficiencies in aggregate equilibrium. In this chapter, the focus is on “real business cycle” (RBC) models. These models attempt to explain the business cycle entirely within the framework of efficient, competitive market equilibrium. They are a direct extension of the Ramsey growth model. However, unlike the Ramsey model, the rate of techno-logical progress is assumed to vary in response to shocks, which leads to cyclical fluctuations in growth. 1The third part of this work was published separately in 1941 as Business Cycles and their Causes, which was reprinted in a paperback edition by Porcupine Press in 1989.7 — 3 The RBC models give a very different policy recommendation for business cycles than Keynesian models. While Keynesian models emphasize the ineffi-ciencies of fluctuations and especially the waste resulting from unemployed re-sources during recessions, RBC models claim that cyclical fluctuations are effi-cient responses of the economy to unavoidable variations in the rate of techno-logical progress. Thus, RBC advocates argue that government action to stabilize the economy is inappropriate. As with any other theory, the major issue for the real-business-cycle model is whether it is capable of explaining the pattern of movements that characterize the modern business cycle. Opinions on the empirical performance of RBC models vary; these will be examined in detail in a later chapter. B. Walrasian vs. Keynesian Explanations of Business Cycles Why do we have multiple theories of business cycles? Since the currently popular basic theories have been around for at least thirty years, it might seem as though by now the empirical evidence on business cycles ought to have pointed to one of the models as the most relevant. There are sev-eral reasons why we have not achieved such an empirical consensus. The princi-pal reason is that the various models that we shall study during the remainder of the semester are, in many respects, observationally equivalent. This means that similar outcomes are consistent with several theories, so observing these out-comes cannot be used to reject one theory in favor of others. It does not mean, however, that the two theories are necessarily equivalent. Even theories that have very different implications for the optimal design of economic policy may share many of the same predictions