Real Business Cycle TheoryFrom New Classicals to RBCEmpirical Evidence?Major ContributionsStylized Facts about Business CyclesReal Business Cycle (RBC) ModelsFeatures of RBC ModelsPositive Technology ShockWhy shocks have persistent effectsA Simple RBC ModelSolution (1)Solution (2)Money, Credit, RBC King and Plosser, 1984The Productivity PuzzleFive Major CriticismsGeneral Arguments against RBCAn Econometric ProblemReal Business Cycle TheoryReal Business Cycle TheoryGraduate Macroeconomics IECON 309 – Cunningham2From New Classicals to RBCFrom New Classicals to RBCThe New Classical Economics (NCE)New Classical Economics (NCE) challenged Keynesian theory, and stimulated the development of New Keynesian (NK) and Real Business Cycle (RBC) TheoryNK theoryNK theory accepts the REH, but emphasizes the importance of imperfect competition, costly or impeded price adjustments, and externalities. It argues that nominal shocks are the predominant cause of business cycles.RBC theoryRBC theory accepts the REH, but views cycles arising in frictionless, perfectly competitive economies with complete markets. It argues that cycles arise through the reactions of optimizing agents to real disturbances, such as random changes in technology or productivity.3Empirical Evidence?Empirical Evidence?Stadler, 1994 (JEL) writes:“...such models are capable of mimicking the most important empirical regularities displayed by business cycles.”4Major ContributionsMajor ContributionsRBC theory makes the contribution of demonstrating that fluctuations in economic activity are consonant with competitive general equilibrium environments in which all agents are rational optimizers.RBC Theory makes (exogenous) stochastic fluctuations in factor productivity the predominant cause of fluctuations in business activity.Coordination failures, price stickiness, waves of optimism or pessimism, or monetary or fiscal policy are not needed to explain business cycles.5Stylized Facts about Business CyclesStylized Facts about Business Cycles1. Cycles vary a lot in amplitude and duration.2. Output movements in many sectors display a high degree of coherence.3. Investment and durable goods production is much more volatile than output.4. Nondurable goods consumption is less volatile than output.5. Velocity of money is countercyclical in most countries.6. The relationship of monetary aggregates and output is highly variable.7. Long-term interest rates are less volatile than short-term interest rates.8. Short-term interest rates are almost always positively correlated with output.9. Long-term interest rates are have a negative or zero correlation with output.10. Prices levels are procyclical.11. Employment is as variable as output, and positively correlated.12. Productivity is less volatile than output.6Real Business Cycle (RBC) ModelsReal Business Cycle (RBC) ModelsLike New Classical Economics, the RBC theorists agree that:–Agents optimize–Markets clearTherefore, the business cycle is an equilibrium phenomenon, and is optimal!7Features of RBC ModelsFeatures of RBC Models1. Adopt a representative agent model, focusing on a rep. household and firm, agents homogeneous, so that there are no aggregation problems.2. Firms and households optimize explicit objective functions, subject to resource and technology constraints.3. The cycle is driven by an exogenous shock to productivity.4. The impact of productivity is amplified by intertemporal substitution of leisure. The increase in productivity raises the opportunity cost of leisure, causing employment to increase.5. All agents have rational expectations.6. All markets continually clear.7. There are complete markets.8. There are no informational asymmetries.8Positive Technology ShockPositive Technology ShockLRAS1PNYY=F(N,K)LRAS2P1P29Why shocks have persistent effectsWhy shocks have persistent effectsAgents seek to smooth consumption over time. This implies that the increase in output will result in an increase in investment, and therefore the capital stock. (weak)Agents also intertemporal substitute labor supply toward periods when real wages are higher, and away from periods when real wages have fallen. (stronger)Lags in investment (time-to-build) can result in current shocks affecting future investment and therefore future output. (stronger)Firms answer increased demand first by drawing on inventories. Once inventories are depleted, then the firms respond with production changes. If the firms face rising marginal costs, they will replenish inventories slowly, causing output changes to persist. (weak)10A Simple RBC ModelA Simple RBC Model1)5()4()1()3(CRSis),,0(~),,()2(10,)(EMax)1(120ttttttttztttttjjtjtjttlnicyikkfiidznkfzylcuU11Solution (1)Solution (1) tttttttttttttttttttttknkfzkcnkfznkfzlculcu)1(),()8(0)1(),(E)7(0),(),()6(0),()5(111221First Order ConditionsAssume  = 1, log-linear utility, and Cobb-Douglas production. Solve for zt , ct , and kt+1.12Solution (2)Solution (2)The utility function forces income and substitu-tion effects of a wage change cancel each other. (1) So employment is constant. -1111)(where)1()3()1(1)2(tttttttttttknzfzknkknzcNote that shocks affect consumption, but also the capital stock, so have long-term effects.13Money, Credit, RBCMoney, Credit, RBCKing and Plosser, 1984King and Plosser, 1984Banking firms supply financial (transactions) services.A positive shock to productivity will also stimulate demand for transactions, and therefore transactions services.So the volume of such services will vary with output.Inside money is created.Money is endogenously created in response to real sector activity.Y causes M.14The Productivity PuzzleThe Productivity PuzzleIf all the important shocks are productivity shocks, then worker hours and productivity should move together.Thus productivity should be highly positively correlated with output and hours. In the real world, the correlation is negative (if at all).15Five Major CriticismsFive Major Criticisms1. There is no evidence of the large, economy-wide disturbances that drive these models.2. These models have not been subjected to rigorous econometric testing. In fact, there appears to be no way objective way to test how well these