Lecture VI Real Business Cycle and Ed Prescott

What are RBC models? • Macroeconomic models in which business fluctuations to a large extent can be accounted for by real rather than nominal shocks • RBC models assume the economy remains at general equilibrium rather than disequilibrium, as is the case for Keynesian and monetarist models

Kydland Prescott • The theory was introduced in Kydland Prescott’s Time to Build And Aggregate Fluctuations • They envisioned the main source of business cycle fluctuations are supply shocks, which could then have long-lasting residual effects • These supply shocks are changes to productivity that may derive from technology shifts like innovations, but may also derive from regulatory changes, changes in input prices, weather variability, etc.

Isolating trend from cycle • The first step in the RBC process is to try to decompose a macroeconomic series into its two main components the secular trend a cyclical component • Because a series may change its trend due to technology or other supply shock, we cannot assume the series’ trend will remain stable • The methodology employed is a filter; the most common one, designed by Prescott and Hodrick is the Hodrick-Prescott or HP filter

LN Real US GDP 1947 -2010 Q 3

US GDP data Difference of Logs

Correlation in US GDP first differenced data • T h e c o r r e l

Filtering the GDP data • When you look at the US first differenced data you will note the periods that are mode correlated; these are the long runs that are above or below the long-term trend • A filter will adjust the “level” by shifting upward of downward from the 0 line to try to even out the observations that are above and below the line • In other words, the 0 line is adjusting to fit the differenced data • The part that is left is the “white noise” which is uncorrelated with its lagged values and the trend

That’s about all I know • In order to actually perform RBC model building, you need to have a H-P filter routine, which can be found on the internet • The you need a model of the economy, which also requires lots of data – good data • You then need a set of estimate coefficients – some of these apparently are considered more reliable than others; you can tell the program how much confience you have in the parameters

Run and Shock the Model • Then you need software that can run the model, add “shocks” to the various sectors • You use Monte Carlo random generators to generate these shocks • You then observe how the model behaves under this “stress test” environment • You see if you observe the magnitude and direction we observe in the real world as well as the comovements of the various sectors

What are they looking for? • They look at the following sectors: output, consumption, investment, labor hours and productivity and capital stock • Expected correlations and standard deviations are as follows:

What can they not do? • The shocks that are generated are of the magnitude they suppose actually affect the economy • They are not intended to mimic actual shocks because these are not observable • They merely show that a general equilibrium model subject to rand shocks can generate an economy that looks like our economy; in other words it is “well-behaved” and doesn’t (usually) run of somewhere • But when it does, you got a problem!

Some very unfortunate news • Occasions such as the recent financial crisis, not to mention the other “big one” 80 years ago do challenge the notion that most business cycles and most of the volatility in one are due to real and not nominal shocks • Same for the early 1980’s recession; both RET and RBC models don’t really like to face such realities • As I have said before and will maintain for as long as I live and breath, business cycles are not of any one type • Understanding this fact is essential to understanding how the economy works, or doesn’t work, and each cycle should be explained based on our intellect and not a fixed idea about them

Critiques • Summers, Hoover, Sheffrin, Mankiw, Mc. Callum, Phelps, Eichenbaum, Stadler, and Hartley, et. all had various criticisms of New Classical theory

Critique 1 • The relative size of the substitution effect versus the income effect implied by RBC models is much greater than those found from microeconomic studies of households, who tend to maintain a rather steady amount of effort

Critique 2 • Too much reliance on unobservable supply shocks especially in recessions • Critics regard the amount of shocks necessary to obtain the kind of volatility observed is “quite implausible” (Muellbauer, 1997)

Critique 3 • Recessions as periods of “technological regress” • RBC folks argue that, by technology shocks, they include regulations that can reduce productivity • Muellbauer points to UK early 1990 s which clearly suffered from non-RBC factors: massive interest rate increases, overvalued currency while entering ERM, and a collapse in property values, all non-RBC variables

Critique 4 • The idea that all unemployment is voluntary seem totally implausible, especially during the Great Depression • Also quit rates are pro-cyclical rather than counter-cyclical, if increases in unemployment, which is counter-cyclical, were truly voluntary • And there are others