Real Business Cycles

A Reader

James Hartley, Kevin Hoover, Kevin D. Salyer

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781134694785
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Real Business Cycle theory combines the remains of monetarism with the new classical macroeconomics, and has become one of the dominant approaches within contemporary macroeconomics today. This volume presents:
* the authoritative anthology in RBC. The work contains the major articles introducing and extending the theory as well as critical literature
* an extensive introduction which contains an expository summary and critical evaluation of RBC theory
* comprehensive coverage and balance between seminal papers and extensions; proponents and critics; and theory and empirics.
Macroeconomics is a compulsory element in most economics courses, and this book will be an essential guide to one of its major theories.

Part I
Introduction

Chapter 1
The limits of business cycle research

“That wine is not made in a day has long been recognized by economists.” With that declaration in Kydland and Prescott’s “Time to Build and Aggregate Fluctuations” (1982 [3]: 1345),^* the real business cycle school was born. Like wine, a school of thought is not made in a day. Only after it has matured is it possible to judge whether it is good and to separate the palatable portions from the dregs. The literature on real business cycle models has now sufficiently aged, ready for the connoisseurs to pass judgment.

To facilitate those judgments, we have collected together in this volume thirty-one previously published articles relevant to real business cycle models. While there has been no shortage of commentaries on the real business cycle program, the commentaries have been widely scattered and have often focused on narrow aspects of the models or represented partisan positions. Until now, there has not been an easily accessible means for students of business cycles to assess the real business cycle program on the basis of the original sources from the perspectives of the critics as well as the proponents. To date, the most systematic accounts of the real business cycle program are found in the works of active proponents, particularly in Thomas Cooley’s (ed.) Frontiers of Business Cycle Research (1995b), and in the programmatic manifestoes of Kydland and Prescott (1991 [12], 1996 [13]). Yet the critical literature is burgeoning.

The present volume brings together the important articles which make the case for and against real business cycle models. The articles begin with the classics of the real business cycle school, starting with Kydland and Prescott’s (1982 [3]) seminal model. In addition, we include articles on the methodology of real business cycle models, particular aspects of the program (e.g., calibration, the measurement of technology shocks, methods of detrending), as well as articles that attempt to evaluate the empirical success of the real business cycle model.

The real business cycle program is still a very active one. We therefore hope that this anthology will prove useful to students and professional macroeconomists working on real business cycle models — bringing some perspective to the literature and pointing the way to further research. As an aid to research, the articles are reprinted here as facsimiles rather than reset. The preservation of the original pagination, facilitating authoritative citations, more than compensates, we believe, for the loss of an aesthetically pleasing typographical consistency.

It is difficult for the neophyte in any area of economics to jump into the middle of a literature that was meant to advance the current interests of established economists, rather than a didactic purpose. In the remainder of this introductory chapter, we aim to provide a segue from the common knowledge of the advanced student of macroeconomics (or of the nonspecialist professional) to the essential elements of the real business cycle program. The objective is to provide a clear, accessible background to the literature that avoids unnecessary technical complications. At the same time, in this introductory essay we present our own assessment of the successes and failures of the real business cycle program. It is an assessment with which many economists will strongly disagree. We nevertheless hope that it will be easier for others to articulate their own assessments against the background of our effort. The articles reprinted in the volume provide the necessary raw materials.

The technical demands of real business cycle models are often very high. As a further aid to the neophyte reader of the literature, and to the potential user of the models, the second introductory chapter to the volume is a user’s guide to real business cycle models, which provides a step-by-step account of how to formulate, solve, and simulate a real business cycle model.

So much for preliminaries; let us turn now to the background of the real business cycle program and to the assessment of its successes and failures.

I The Real Business Cycle Conjecture

The philosopher of science Karl Popper (1959, 1972) argued that science progresses through a series of bold conjectures subjected to severe tests. Most conjectures are false and will be refuted. The truth, by definition, will survive the ordeal of testing and emerge unrefuted at the end of inquiry in an infinitely distant future. The boldest conjectures are often the most fruitful, because, making the strongest claims, they are the most readily refuted and their refutation narrows the universe of acceptable conjectures most rapidly. We argue that real business cycle models are bold conjectures in the Popperian mold and that, on the preponderance of the evidence (to use a legal phrase), they are refuted. It is not, however, straightforward to see this, because the real business cycle conjecture is advanced jointly with a claim that models should be assessed using a novel strategy. We must therefore evaluate the conjecture and the assessment strategy simultaneously.

Since the publication of Kydland and Prescott’s “Time to Build and Aggregate Fluctuations” (1982 [3]), the paradigm real business cycle model, a large and active group of new classical macroeconomists have elaborated and developed the real business cycle model. As important as these developments are to the real business cycle program, none of them fundamentally affects the critical points that we will make.¹ Our assessment will, therefore, focus on the original Kydland and Prescott model and its successor models in a direct line. We will also refer frequently to the programmatic statements and methodological reflections of Kydland, Prescott and Lucas, the most articulate defenders of the aims and methods of equilibrium business cycle models.

(i) Equilibrium business cycles

To common sense, economic booms are good and slumps are bad. Economists have attempted to capture common sense in disequilibrium models: full employment is modeled as an equilibrium: that is, as a situation in which each worker’s and each producer’s preferences (given his or her constraints) are satisfied, while anything less than full employment represents a failure of workers or employers or both to satisfy their preferences. The real business cycle model is an extraordinarily bold conjecture in that it describes each stage of the business cycle — the trough as well as the peak — as an equilibrium (see, for example, Prescott, 1986a [4]: 21). This is not to say that workers and producers prefer slumps to booms. We all prefer good luck to bad.² Rather it is to deny that business cycles represent failures of markets to work in the most desirable ways. Slumps represent an undesired, undesirable, and unavoidable shift in the constraints that people face; but, given those constraints, markets react efficiently and people succeed in achieving the best outcomes that circumstances permit.

Some other models have come close to the real business cycle conjecture. Models of coordination failure treat booms and slumps as two equilibria and posit mechanisms that push the economy to one equilibrium or the other (e.g., Cooper and John, 1988; Bryant, 1983). Since the boom equilibrium is the more desirable, policies might seek to affect the mechanism in a way that improves the chances of ending in the boom state. The Phillips-curve models of Milton Friedman (1968) and Robert Lucas (1972, 1973) envisage people achieving their preferences conditional on an incorrect understanding of the true situation. Booms occur when workers believe that real wages are higher than they really are, inducing them to supply more labor than they would if they knew the truth; slumps occur when workers believe that real wages are lower than they really are. Were people fully informed, there would be no booms or slumps.³

The real business cycle model is starker. As with Lucas’s monetary model, every stage of the business cycle is a Pareto-efficient equilibrium, but the source of the fluctuations is not misperceptions about prices or the money supply, but objective changes in aggregate productivity (so-called technology shocks). Thus, in the midst of a slump (i.e., a bad draw), given the objective situation and full information, every individual, and the economy as a whole, would choose to be in a slump.

Contrary to the claims of some proponents of the real business cycle (e.g., Hodrick and Prescott, 1997 [31]: 1), there is no pre-Keynesian historical precedent for viewing business cycles as equilibria. Kydland and Prescott (1991 [12]) see such a precedent in the business cycle models of Ragnar Frisch (1933), while Lucas (1977: 215; 1987: 47 inter alia) sees such a precedent in the work of Hayek (1933, 1935) and other members of the Austrian School. Hoover (1988, ch. 10; 1995 [15]) demonstrates that these precedents are, at best, superficial. Frisch’s business cycle models are aggregative and do not involve individual optimization, even of a representative agent. Some Austrians reject the notion of equilibrium altogether. Hayek, who is not among these, accepts dynamic equilibrium as an ideal case, but sees business cycles as the result of mismatches of capital type and quantity to the needs of production transmitted to unemployment through a failure of wages and prices to adjust to clear markets in the short run — clearly a disequilibrium explanation.⁴ The real business cycle model advances a novel conjecture as well as a bold one.

(ii) The novelty of the real business cycle model

Novel in their bold conjecture, real business cycle models nonetheless have precursors. The primary antecedent is Robert Solow’s (1956, 1970) neoclassical growth model. In this model, aggregate output (Y) is produced according to a constant-returns-to-scale production function Ф(•) using aggregate capital (K), aggregate labor...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Acknowledgements
• Part I Introduction
• Part II The foundations of real business cycle modeling
• Part III Some extensions
• Part IV The methodology of equilibrium business cycle models
• Part V The critique of calibration methods
• Part VI Testing the real business cycle model
• Part VII The Solow residual
• Part VIII Filtering and detrending
• Index