The Real Business Cycle (RBC) Model receives a lot of criticism from online bloggers and from other economists. A lot of the criticism is justified. The model assumes away all frictions and market failures. It assumes that the consumers and workers can be analyzed as though they were all essentially the same or perhaps as though we could pay attention to only an average individual’s preferences. The most contentious aspect of the RBC model however has always been the assumed source of business cycle fluctuations. In the RBC model, variations in productivity, perhaps brought on by the inevitable unevenness in the pace of innovation, drive all of the variations in hours worked, investment, production and so forth.
I mentioned in a previous post that this stark version of the RBC model is not really taken very seriously by researchers anymore — at least with regard to the role of productivity shocks. Better measurement has deprived the canonical RBC model of the innovations necessary to generate cyclical variations in economic activity. While early RBC models used Solow residuals as proxies for actual changes in productivity, subsequent research demonstrated that these measures were virtually entirely due to variations in unobserved utilization (capital utilization, labor effort, etc.). Thus, in the data, variations in TFP occur at seasonal frequencies (which is pretty difficult to believe in the economy we live in today) and even in response to tax stimulus (an investment tax credit will stimulate investment and also “cause” measured TFP to rise). Even worse, the measured increases in the seasonal variations or in response to tax changes are essentially of the same magnitude as the variations observed over the business cycle. Papers that do attempt to adjust for unobserved input variations (say by including measured energy use) typically find that they eliminate a huge amount of variation in productivity. The well-known study by Basu, Fernald and Kimball (2006) produces “cleansed” Solow residuals which are at best unrelated to cyclical variations in GDP (Basu et al. actually claim that true productivity variations are negatively correlated with detrended GDP). Of course there are actual productivity shocks (e.g., Hurricane Katrina, the terrible 2011 Japanese Tsunami, the 2 day blackout in the northeast US in 2003, …) but none of these seem to be responsible for substantial changes in employment or production.
This begs the question: If the RBC model does not survive as a model of actual business cycle fluctuations, why do we still teach it in graduate macroeconomics?
I can think of three answers to this question. The first answer is due to its prominent historical place in the development of the field. Macroeconomics changed forever after the first-generation RBC models were developed. These models ushered in new methods and techniques many of which are still in use today. Similarly, the fact that we know that real shocks do not cause business cycle fluctuations (at least the way they were conceived by the original RBC theorists) is an important component of our understanding. Even when you are on a long voyage, it often is important to look back every now and then.
Second, the RBC model is an excellent pedagogical device. The RBC model is almost always the first DSGE model students confront and it is also functioning as the standard backdrop in more advanced DSGE frameworks. Many of the intuitions carry over and present themselves in more modern instances of the model. For instance, researchers have extended the basic framework to analyze tax policy, international business cycles, government spending shocks, and of course monetary policy. Often the correct intuition required for the more elaborate models can be seen in the original RBC framework.
Last, there may yet be situations in which the RBC model might be applicable. While modern advanced economies do not have business cycles that are driven by real shocks, other economies might. For example, suppose you wanted to analyze the economy of ancient Egypt. The Egyptian economy would be closely tied to the flooding of the Nile river and other types of weather shocks. If the waters don’t rise enough, food production will fall. If there is a particularly good year for growing, the Egyptians will accumulate a large stock of foods which might well be traded or stored. I would suspect that the effects of these real shocks might well have tremendous impacts on production, consumption, work, storage and so on and the RBC model might provide an interesting guide as to what patterns one might expect in the data. (If there is an enterprising student out there who has an idea of where we could find some actual data on production, etc. for ancient Egypt, send me an e-mail, I would love to write this paper with you … )
OK OK, we know that you like DSGE models, Chris. But this really does seem a bit circular. If, as many of us think, DSGE models really are highly misleading to the point of being nearly useless, then studying an only occasionally actually relevant version of it, the RBC model, because it was the original version of it and continues to provide crucial keys to how it works, just does not impress all that much.
Not even the most hardcore Keynesian (OK, there are some stupid Post Keynesians who pretend that there is always a demand shortage in an economy) would deny that there are recessions which are caused by supply-side shocks, the obvious one from the last century being the oil crisis. Given that we will experience something similar (yet nor transitory but permanent) again somewhen in this century I think that supply side analysis à la RBC can be very useful.
But right now we are in a recession which is caused by a demand-side shock and the freshwater folks are treating it as anything but (Mulligan’s “food stamps caused the Great Depression”, Lucas’ and Cochrane’s adopting treasury view and so on) and ordering the wrong medicine.
So RBC is not problematic, what’s problematic is that its most out-spoken and influential proponents are in demand denial the middle of the Great Recession, 80 years in after the Great Depression.
I don’t interpret the productivity innovations in the RBC model to be a stand-in for all supply side shocks. I definitely agree that supply side events influence the economy (tax changes, oil price changes, etc.). I know that there are some RBC theorists who are willing to be more liberal with their interpretation of the productivity residuals but I’m not one of them (Prescott I think has suggested that they could be interpreted as changes in union bargaining power).
Chris, which supply-side shocks do you not consider being stand-ins for productivity innovations? And also: Do you see the great recession as largely an outcome of supply-side shocks?
I don’t think the great recession was caused by shocks that would be thought of as traditionally supply-side. Though, from a modern perspective, the distinction between supply-side variables and demand-side variables is not clear cut. If I were to analyze the effects of an oil price shock, I would include imported prices in the model. Given productive inputs, there would be no measured increase productivity in the value-added production function. (Similarly for tax changes.)
“Though, from a modern perspective, the distinction between supply-side variables and demand-side variables is not clear cut.”
I both agree and disagree with that. I think the shocks can have very similar effects on the real economy (although they tend to have very different effects on prices). But I also think that a distinction can be made, and that that distinction is incredibly important for policy. Demand side shocks are fixable while supply side — if at least treated exogenously (as the RBC literature does) — are not. I find it hard to imagine that the great recession was “efficient”, and I find it a little bit sad that a large share of our profession seems to believe so.
I just wanna add to the discussion that I agree with both Chris’ and pontus’ points. Technically speaking it is often difficult or impossible to distinguish a supply- from a demand side shock (especially in macro models that focus on finance issues) but from a, to use Mankiw’s terminology, “macroeconomist not as scientist but engineer” perspective it is necessary in order to determine whether the CB or the fiscal authority can do something.
In natural sciences the world is easier, if your physical model says that the bridge you build does not collapse your recommendation to the guys who wanna build it is “do it”. But social sciences are harder and macroeconomists gotta be able to switch from being able to do deep theory and giving policy advocacy which isn’t totally in snyc with their deep theory.
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An argument “begs the question” when one of its premises assumes the truth of the conclusion that the argument is supposed to be proving.
You’re right of course. I’m using this expression according to its “modern” usage (in other words, its incorrect usage).
I agree that the RBC model is a useful tool. But mainly because it formalizes everything we knew in 1928. The issue we must address as a profession is how to model the ideas that were introduced to economics in the General Theory. I do not think that conventional DSGE models have come close, largely because they went down a path that Joan Robinson referred to as Bastard Keynesianism. Its time to stop focusing on sticky prices and time to start focusing on high unemployment as an equilibrium.
Chris, I think you should also note that in LOTS of labor search, international finance, and asset pricing models, TFP shocks (non-purified) are still used as the main exogenous shock.
Fair enough. At the same time, in partial equilibrium contexts, introducing a shock like a TFP shock can be successfully used as a labor demand shifter — an increase in the price of the good the firm sells (or in demand if the firm charges a markup) will shift labor demand exactly like a TFP shock would. So, if the labor search model views the shock as being broader than a TFP shock it can still work.
In asset pricing models there are often cases in which the source of the shocks is never specified (the theory is independent of the nature of the shocks).
True! I much prefer the asset pricing models where the type of shock isn’t specified.
Also note that a lot of times when people introduce new techniques – like the technique for dealing with heterogeneity introduced in Krusell-Smith – they use TFP shocks as the shock, because they’re easier to handle than more realistic types of shocks.
Stacy Schiff. Cleopatra: A Life, 2010. This is a well-researched biography. If memory serves, Schiff does comment on the flooding, storage and redistribution to the needy from the imperial grain storage houses due to the changes in the climate and the Nile.
If I remember right when studying “real business cycle theory” in macro there were a few problems with it. By trying it numerically by plugging numbers in and getting numbers out I was never able to get a cycle. No graph moving in time.
When I looked for references there were none in the book. No bibliography. Thats when I quit sitting in class for trying to research for some thing that could give a cycle.
Here is what I think the problem with “real business cycle theory” as presented by a university’s custom copy of Blanchard’s “Macroeconomics.” (The customised copy might have had bibliographic references removed.) Outside of numerical solving, symbolically the equations never had time, t, as an independent variable and no derivatives in time terms. The equations were not equations that allowed for a dynamic solution. The answer would not have any time terms.
If you feed in shocks that roughly match non-purified TFP residuals, the RBC model will do quite well mimicking realistic business cycle patterns.
The real business cycle theory equations I saw if I remember correctly were in fact equilibrium equations. Not dynamic.
The emperor has no cloths.
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Great!. Countless hours wasted, enormous resources consumed to master and fill the journals with a model best- if not exclusively -suited to analyzing……..Ancient Egyptian Macroeconomics! Tut, Tut. (-:
So egyptian slaves work less if a negative productivity shock hits the economy? RBC models are not suited even for that. But maybe Tom Hanks could have had a higher standard of living on his island if he had been familiar with rbc models…
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