The Real The Real Business Cycle Business Cycle

SchoolSchoolIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

RBC MacroeconomicsRBC Macroeconomics Evolved out of New Classical Evolved out of New Classical

economics of 1970seconomics of 1970s Major proponentsMajor proponents

Edward Prescott (Minnesota)Edward Prescott (Minnesota) Finn Kydland (Carnegie-Mellon)Finn Kydland (Carnegie-Mellon) Charles Plosser (Rochester)Charles Plosser (Rochester) Robert Barro (Harvard)Robert Barro (Harvard)

From New Classical to RBCFrom New Classical to RBC The late 1970s and early 1980s was a The late 1970s and early 1980s was a

time of New Classical Dominancetime of New Classical Dominance By the early 1980s, however, significant By the early 1980s, however, significant

doubts had arisendoubts had arisen ““signal-extraction” problem not robust signal-extraction” problem not robust

enough to explain business cyclesenough to explain business cycles Evidence supportive of monetary neutrality Evidence supportive of monetary neutrality

of announced policy weakof announced policy weak Tobin suggests a “way out” that he does not Tobin suggests a “way out” that he does not

himself take seriously – random real shockshimself take seriously – random real shocks

From New Classical to RBCFrom New Classical to RBC Kydland and Prescott take seriously this Kydland and Prescott take seriously this

alternative and develop the foundations alternative and develop the foundations of Real Business Cycle Theory – a of Real Business Cycle Theory – a theory that accounts for cycles wholly theory that accounts for cycles wholly by changes in real supply variables.by changes in real supply variables.Kydland and Prescott, “Time to Build and Kydland and Prescott, “Time to Build and Aggregate Fluctuations,” Aggregate Fluctuations,” EconometricaEconometrica (November 1982)(November 1982)

Originally viewed as augmenting the New Originally viewed as augmenting the New Classical approachClassical approach

Central PropositionCentral Proposition

Large random fluctuations in Large random fluctuations in technology produce supply-side shocks technology produce supply-side shocks to the production function, generating to the production function, generating fluctuations in aggregate output and fluctuations in aggregate output and employment as rational individuals employment as rational individuals respond to the altered structure of respond to the altered structure of relative prices by changing labor relative prices by changing labor

(resource) supply and consumption (resource) supply and consumption (investment) decisions.(investment) decisions.

RBC MacroeconomicsRBC Macroeconomics Assault on all previous 20Assault on all previous 20thth

century macroeconomicscentury macroeconomics Booms are not “good” and Booms are not “good” and

recessions are not “bad”recessions are not “bad” Recessions are not Recessions are not desireddesired by by

agents in the economy but they agents in the economy but they are nonetheless are nonetheless unavoidable unavoidable consequences consequences of changes in of changes in constraints agents faceconstraints agents face

RBC MacroeconomicsRBC Macroeconomics Assault on all previous 20Assault on all previous 20thth

century macroeconomicscentury macroeconomics Agents react optimally to changes Agents react optimally to changes

in constraints and the resulting in constraints and the resulting aggregate fluctuations are aggregate fluctuations are efficientefficient

Supply, not demand shocks, are Supply, not demand shocks, are key to understanding economic key to understanding economic fluctuationsfluctuations

RBC v. New Classical

RBC replaces the impulse mechanism of New Classical economics “Technology shocks” instead of “monetary

surprise” RBC retains the propagation

mechanisms of New Classical economics Rational expectations and relative prices

New Classical Economics “Mark II”

Reactions of Leading Reactions of Leading New ClassicalistsNew Classicalists

LucasLucas Exclusion of money in RBC a mistakeExclusion of money in RBC a mistake Viewed as addition to NC modelsViewed as addition to NC models

Later says “monetary shocks just aren’t that Later says “monetary shocks just aren’t that important”important”

Approves of methodologyApproves of methodology micro-based models and use of fully-articulated micro-based models and use of fully-articulated

artificial economies to compare real with artificial economies to compare real with experimental economicsexperimental economics

Business cycles are “minor problem” – shifts Business cycles are “minor problem” – shifts focus to Growth economicsfocus to Growth economics

Reactions of Leading Reactions of Leading New ClassicalistsNew Classicalists

BarroBarro RBC promising RBC promising Monetary neutrality of New Classical Monetary neutrality of New Classical

models a “mistake”models a “mistake” Shifted focus to Growth economicsShifted focus to Growth economics Defends New Classical AchievementsDefends New Classical Achievements

Equilibrium modelingEquilibrium modeling Rational expectationsRational expectations Dynamic policy-making and evaluationDynamic policy-making and evaluation

Growth and CyclesGrowth and Cycles

Development of RBC and shift of Development of RBC and shift of research to Growth represent revival of research to Growth represent revival of interest in “supply-side” interest in “supply-side” macroeconomicsmacroeconomics

Continuation of pre-Keynesian lines of Continuation of pre-Keynesian lines of business cycle researchbusiness cycle research

New technology influences both long-New technology influences both long-run growth as well as producing short-run growth as well as producing short-run displacements (disequilibrium?)run displacements (disequilibrium?)

RBC AntecedentsRBC Antecedents Dennis RobertsonDennis Robertson

emphasized real forcesemphasized real forces

Joseph SchumpeterJoseph Schumpeter ““Theory of Capitalist Development”Theory of Capitalist Development”

Knut WicksellKnut Wicksell Changes in marginal productivity of capital Changes in marginal productivity of capital

(impulse mechanism) cause divergence of “natural (impulse mechanism) cause divergence of “natural rate of interest” from “bank loan rate” leading to rate of interest” from “bank loan rate” leading to endogenous monetary creation (propagation endogenous monetary creation (propagation mechanism), distorting time structure of mechanism), distorting time structure of production and leading to self-reversing boomproduction and leading to self-reversing boom

Growth and CyclesGrowth and Cycles

For Real Business Cycle For Real Business Cycle Macroeconomics, Macroeconomics,

growth and cycles growth and cycles are are inseparably inseparably interrelatedinterrelated

History and RBC History and RBC Supply shocks of 1970sSupply shocks of 1970s

Two OPEC oil increasesTwo OPEC oil increases Apparent failure of Demand-side Apparent failure of Demand-side

Keynesian modelKeynesian model Political emphasis of “new supply-side Political emphasis of “new supply-side

economics” of Reagan Administrationeconomics” of Reagan Administration Tax cuts and deregulationTax cuts and deregulation

Renewed interest in statistical properties Renewed interest in statistical properties of economic time-seriesof economic time-series

Seminal work of Nelson and PlosserSeminal work of Nelson and Plosser

Cycles and Random Cycles and Random WalksWalks

Conventional ApproachConventional Approach Imagines economy evolving along a Imagines economy evolving along a

growth path reflecting underlying trendgrowth path reflecting underlying trend Fluctuations about trend due to Fluctuations about trend due to

demand shocksdemand shocks Shocks “die out” over time, so Shocks “die out” over time, so

economic time-series are “trend-economic time-series are “trend-reverting”reverting”

YYtt = g = gtt(Y(Y00) + b (Y – Y) + b (Y – YTT))t-1t-1 + z + ztt

Cycles and Random Cycles and Random WalksWalks

YYtt = g = gtt(Y(Y00) + b (Y – Y) + b (Y – YTT))t-1t-1 + z + ztt

At time t1, a shock of size z At time t1, a shock of size z occurs, but it dies out over occurs, but it dies out over time and the growth path time and the growth path reverts to the trendreverts to the trend

Conventional approach Conventional approach consistent with the natural consistent with the natural rate hypothesis rate hypothesis (unanticipated changes in (unanticipated changes in monetary growth produce monetary growth produce temporary deviations from temporary deviations from YYNN))

time

Y

Cycles and Random Cycles and Random WalksWalks

Nelson and Plosser, “Trends and Nelson and Plosser, “Trends and Random Walks in Macroeconomic Random Walks in Macroeconomic Time Series: Some Evidence and Time Series: Some Evidence and Implications,” Implications,” Journal of Monetary Journal of Monetary EconomicsEconomics (September 1982) (September 1982)Most changes in GDP are Most changes in GDP are permanentpermanent, , with no tendency for Y to revert to former with no tendency for Y to revert to former trendtrendGDP follows a GDP follows a random walk process with random walk process with driftdrift

Cycles and Random Cycles and Random WalksWalks

Nelson-Plosser ApproachNelson-Plosser Approach Value in one period still dependent on Value in one period still dependent on

previous value of the variable, but previous value of the variable, but shocks (z) change output permanentlyshocks (z) change output permanently

Rather than g being underlying growth Rather than g being underlying growth rate, g is “rate of drift;” b has value of rate, g is “rate of drift;” b has value of 1 – “unit root” hypothesis1 – “unit root” hypothesis

YYtt = g = gtt(Y(Y00) + (Y – Y) + (Y – YTT))t-1t-1 + z + ztt

Cycles and Random Cycles and Random WalksWalks

YYtt = g = gtt(Y(Y00) + (Y – Y) + (Y – YTT))t-1t-1 + z + ztt

At time t1, a shock of size At time t1, a shock of size z occurs and it z occurs and it permanentlypermanently changeschanges the the growth path of the growth path of the economyeconomy

time

Y

Implications of Nelson-Implications of Nelson-PlosserPlosser

Observed fluctuations Observed fluctuations are fluctuations in the are fluctuations in the trendtrend, not deviations from a trend., not deviations from a trend.

In NC world, permanent changes in GNP growth In NC world, permanent changes in GNP growth cannot occur cannot occur from monetary shocks since money from monetary shocks since money is neutral; therefore main forces causing is neutral; therefore main forces causing instability instability must be must be realreal shocks.shocks.

If shocks to productivity growth are If shocks to productivity growth are frequent and frequent and randomrandom, path of Y follows a , path of Y follows a random walkrandom walk that that resembles the business cycle.resembles the business cycle.

No distinction between trend and cycle, so theory No distinction between trend and cycle, so theory of growth and fluctuations of growth and fluctuations must be integratedmust be integrated..

Productivity ShocksProductivity Shocks

Unfavorable changes in the physical Unfavorable changes in the physical environment that adversely affect environment that adversely affect agricultural outputagricultural output

Significant changes in price of energySignificant changes in price of energy War, political upheaval and labor unrestWar, political upheaval and labor unrest Government regulationsGovernment regulations Changes in the quality and quantity of Changes in the quality and quantity of

capital and labor; new management capital and labor; new management techniques; new products; new production techniques; new products; new production techniques techniques =>Technological change=>Technological change

RBC Models: Common RBC Models: Common FeaturesFeatures

(1)(1) Representative agent models; Representative agent models; agents maximize s.t. constraintsagents maximize s.t. constraints

(2)(2) Agents form Ratex; signal-extraction Agents form Ratex; signal-extraction problem re permanent v. temporary problem re permanent v. temporary productivity shocksproductivity shocks

(3)(3) Continuous market-clearingContinuous market-clearing

(4) Exogenous productivity shocks are (4) Exogenous productivity shocks are impulse mechanism for output and impulse mechanism for output and employment fluctuationsemployment fluctuations

RBC Models: Common RBC Models: Common FeaturesFeatures

(5)(5) Propagation mechanisms vary, Propagation mechanisms vary, include consumption smoothing, include consumption smoothing, “time-to-build,” and intertemporal “time-to-build,” and intertemporal labor substitutionlabor substitution

(6)(6) Fluctuations in employment Fluctuations in employment voluntary; labor and leisure highly voluntary; labor and leisure highly substitutable over timesubstitutable over time

(7)(7) Money is neutralMoney is neutral

(8) No distinction between SR and LR(8) No distinction between SR and LR

Changes from New Changes from New ClassicalismClassicalism

Impulse factor – productivity shocks Impulse factor – productivity shocks replace monetary shocksreplace monetary shocks

Abandon price level/relative price Abandon price level/relative price misperception emphasismisperception emphasis

Abandon long run/short run Abandon long run/short run distinctiondistinction

RBC: Model StructureRBC: Model Structure Production FunctionProduction Function

YYtt = A = Att F(K F(Ktt, L, Ltt))

Technology Evolution ParameterTechnology Evolution Parameter AAt+1t+1 = þA = þAtt + + єєt+1t+1 0 < þ < 1 0 < þ < 1

Representative Agent Utility FunctionRepresentative Agent Utility Function UUtt = f(C = f(Ctt, Le, Lett))

Resource ConstraintsResource Constraints CCtt + I + Itt ≤ Y ≤ Yt t ; L; Ltt + Le + Lett ≤ 1 ≤ 1

Capital Stock Accumulation EquationCapital Stock Accumulation Equation KKt+1t+1 = (1-∂) K = (1-∂) Ktt + I + Itt

Technology Shocks and Technology Shocks and EmploymentEmployment

Technology shocks change A, shifting Technology shocks change A, shifting the production function upward; the the production function upward; the demand for labor curve will also shift demand for labor curve will also shift upward.upward.

Increased labor demand will increase Increased labor demand will increase the real wage and employment.the real wage and employment. How much? Depends on supply elasticity!How much? Depends on supply elasticity! If labor supply is inelastic?If labor supply is inelastic? If labor supply is elastic?If labor supply is elastic?

Technology Shocks and Technology Shocks and EmploymentEmployment

Stylized facts of Business Cycles Stylized facts of Business Cycles indicate small procyclical variations in indicate small procyclical variations in real wage are associated with large real wage are associated with large procyclical variations in employmentprocyclical variations in employment

Is labor supply highly elastic or Is labor supply highly elastic or inelastic with respect to real wage?inelastic with respect to real wage?

What does that indicate about the What does that indicate about the intertemporal substitution of labor for intertemporal substitution of labor for leisure?leisure?

RBC and Lucas-Rapping RBC and Lucas-Rapping ASHASH

Lucas-Rapping: in making labor-Lucas-Rapping: in making labor-supply decisions, workers consider supply decisions, workers consider future and current C and Lefuture and current C and Le Substitution and income effects of Substitution and income effects of

changed real wagechanged real wage Temporary v. permanent changes in Temporary v. permanent changes in

real wagesreal wages

RBC and Lucas-Rapping RBC and Lucas-Rapping ASHASH

RBCRBC temporary technology shocks will temporary technology shocks will

lead to temporary changes in real lead to temporary changes in real wages; no income effect and large wages; no income effect and large supply responsesupply response

Permanent technology shocks will Permanent technology shocks will lead to permanent changes in real lead to permanent changes in real wages; large income effect and wages; large income effect and small supply responsesmall supply response

Labor Supply and Interest Labor Supply and Interest RatesRates

Change in the real interest rate affects Change in the real interest rate affects labor supply by altering relative price of labor supply by altering relative price of income earned today v. futureincome earned today v. future

LLss = L = Lss(W/P, r)(W/P, r) Intertemporal price-ratio Intertemporal price-ratio

(1+r) (W/P(1+r) (W/Ptt))

(W/P(W/Pt+1t+1)) Increase in r increases labor supply; Increase in r increases labor supply;

reduction in r reduces labor supplyreduction in r reduces labor supply

RBC AD and ASRBC AD and AS An IS-LM model conforming An IS-LM model conforming

to Ratex, Continuous Market to Ratex, Continuous Market Clearing, and Full-Clearing, and Full-information Minformation Mss

Output and employment Output and employment due to real forces; RAS due to real forces; RAS determined by production determined by production function and labor supplyfunction and labor supply

Tech improvement shifts Tech improvement shifts RAS to right and LM/P RAS to right and LM/P adjusts so full employment adjusts so full employment existsexists

Problem with model: Labor Problem with model: Labor supply not dependent on rsupply not dependent on r

r

Y

RAS

IS (RAD)

LM/P

RBC AD and ASRBC AD and AS

If labor supply is If labor supply is dependent on r, an dependent on r, an increase in r increase in r increases labor increases labor supply and supply and increases outputincreases output

The RAS curve is The RAS curve is positively slopedpositively sloped

r

Y

RAS

RAD

Ye

re

Characteristics of ModelCharacteristics of Model

Model entirely real (M and P have no Model entirely real (M and P have no impact on Y or L)impact on Y or L)

No LR-SR distinctionNo LR-SR distinction RAS traces out labor market equilibriaRAS traces out labor market equilibria r equilibrates goods marketr equilibrates goods market Shifts in RAS lead to variations in Y and Shifts in RAS lead to variations in Y and

LL Temporary variations in RAD can cause Temporary variations in RAD can cause

Y and L variationsY and L variations

Technology Shock: RAD-Technology Shock: RAD-RASRAS

Begin in equilibrium. Begin in equilibrium. Labor market clears at Labor market clears at real wage wreal wage w11 for given for given production function Y. production function Y. At current rAt current r11, RAS and , RAS and RAD clear at YRAD clear at Y11..

Favorable productivity Favorable productivity shock increases A and shock increases A and production function production function increases to Y*.increases to Y*.

RAS increases, driving RAS increases, driving down the interest rate.down the interest rate.

The lower interest rate The lower interest rate lowers the supply of lowers the supply of labor and favorable labor and favorable productivity shock productivity shock increases labor increases labor demand.demand.

Labor market Labor market equilibrium moves to equilibrium moves to b, employment b, employment increases and output increases and output increases at the lower increases at the lower interest rate.interest rate.

r

Y

RAS1

RAD

Y1

r1

Y

YY

w

L

RAS2

Y = Y

SL2 (r2)

SL1 (r1)

DL2

DL1

Y

Y*

L2L1

w2

w1 r2

Y2

a

aa

a

b

b

b

b

Expenditure Shock: RAD-Expenditure Shock: RAD-RASRAS

Begin in equilibrium. Begin in equilibrium. Labor market clears at Labor market clears at real wage wreal wage w11 for given for given production function Y. production function Y. At current rAt current r11, RAS and , RAS and RAD clear at YRAD clear at Y11..

Increase in Increase in government government purchases shifts RAD purchases shifts RAD to the right, to the right, increasing the real increasing the real interest rate.interest rate.

The higher interest The higher interest rate increases the rate increases the supply of labor and supply of labor and reduces the real wage reduces the real wage rate.rate.

Labor market Labor market equilibrium moves to equilibrium moves to b, employment b, employment increases and output increases and output increases at the increases at the higher interest rate.higher interest rate.

r

Y

RAS

RAD1

Y1

r1

Y

YY

w

L

Y = Y

SL2 (r2)

SL1 (r1)

DL1

Y

L2L1

w2

w1

r2

Y2

a

aa

a

b

bb

b

RAD2

Temporary v. Permanent Temporary v. Permanent ShocksShocks

In the previous model, wealth effects were ignored.In the previous model, wealth effects were ignored. If shocks are permanent, wealth effects can’t be If shocks are permanent, wealth effects can’t be

ignored. When permanent shocks occur, induced ignored. When permanent shocks occur, induced changes in the real wage also will led to additional changes in the real wage also will led to additional changes in RAD.changes in RAD.

A change in technology will cause RAS and RAD to A change in technology will cause RAS and RAD to move in the same direction.move in the same direction. A positive technology shock that raises RAS raises the real A positive technology shock that raises RAS raises the real

wage, increases real income and increases RAD.wage, increases real income and increases RAD. A change in expenditures will moderate the change in A change in expenditures will moderate the change in

RAD.RAD. An increase in government purchases that reduces the real An increase in government purchases that reduces the real

wage reduces real income and decreases RAD.wage reduces real income and decreases RAD.

Temporary v. Permanent Temporary v. Permanent ShocksShocks

A positive technology shock A positive technology shock increases RAS to RAS2.increases RAS to RAS2.

If the shock is temporary, If the shock is temporary, the wealth effect is small the wealth effect is small and RAD increases by a and RAD increases by a small amount.small amount.

The real interest rate falls The real interest rate falls as higher output is as higher output is achieved.achieved.

This does not change the This does not change the prediction of the model prediction of the model which ignores wealth which ignores wealth effects. effects.

r

Y

RAS

RAD

Ye

re

RAS2

RAD2

Y2

r2

Temporary v. Permanent Temporary v. Permanent ShocksShocks

A positive technology shock A positive technology shock increases RAS to RAS2.increases RAS to RAS2.

If the shock is permanent, If the shock is permanent, the wealth effect on the wealth effect on expenditures will be large expenditures will be large and increase RAD by and increase RAD by roughly the same amount roughly the same amount as the increase in Y.as the increase in Y.

Out put increases but the Out put increases but the interest rate remains interest rate remains approximately the same.approximately the same.

This prediction of the model This prediction of the model is is differentdifferent than that which than that which ignores wealth effects. ignores wealth effects.

r

Y

RAS

RAD

Ye

re

RAS2

RAD2

Y2

“Testing” RBC Models

Kydland and Prescott were first to show that RBC models could generate time-series data that possessed statistical properties similar to actual US business fluctuations.

RBC theorists generally have not attempted to provide models capable of econometric testing.

Instead, RBC theorists have developed the method of calibration to test their models.

Calibration Method

(1) Construct RBC equilibrium model(2) Provide specific functional forms(3) Calibrate the model

- simulate random shocks with computer generated random numbers

(4) Trace out key macroeconomic variables from exercise and compare with actual time-series

Calibration Method

Such exercises are able to mimic the actual economy with respect to important time-series data and replicate the stylized facts of business fluctuations

Problem: How to choose between competing models? No criteria equivalent to significance testing in econometrics to answer such a question.

RBC and Money

Accepted stylized fact: Positive correlation between money and output.

Generally accepted (Friedman and Schwartz) by Keynesians, Monetarists and New Classicalists that changes in monetary growth cause changes in real output growth.

In RBC models, money is “super” neutral.How do RBC models account

for the accepted stylized fact?

RBC and Money Caveat: Positive correlation between

money and output may indicate that money responds to output.

But then why does it look like monetary growth comes before output growth? Expectations of future output growth may lead

to increases in money demand that increase the quantity of money supplied.

Bank money (demand deposits) is endogenous; bank money can be produced faster than real output.

Money supply changes before output but output changes cause money supply changes.

RBC and Money RBC theorists divided into two camps

Kydland and Prescott, “Business Cycles: Real Facts and the Monetary Myth,” FRB Minneapolis Quarterly Review (Spring 1990)

Denial of stylized fact that money leads the cycle

Plosser, “Understanding Real Business Cycles,” Journal of Economic Perspectives (Summer 1989)

Role of money remains an “open question”

Measuring Technology Shocks

How does one measure technological progress?

“Solow residual” That part of ∆Y that can’t be explained

by ∆K or ∆L Y = A F (K, L) Y = A KβL1-β where 0 < β < 1 ∆Y/Y = ∆A/A + β ∆K/K + (1- β) ∆L/L ∆A/A = ∆Y/Y – [β ∆K/K + (1- β) ∆L/L]

Measuring Technology Shocks

Prescott (“Theory Ahead of Business Cycle Measurement”) suggested (∆A/A) is a random walk with drift plus serially uncorrelated error

Plosser (“Understanding Real Business Cycles”) uses (∆A/A) and (∆Y/Y) to show that aggregate fluctuations in Y are mainly due to fluctuations in technology

Measuring Technology Shocks

The Stylized Facts

RBC literature led to a renewed effort to discover and measure the stylized facts of business fluctuations

Forced a re-evaluation of existing theories in light of the new data

Central controversies over Real wages Price level

Real Wages and Business Cycles

Are real wages pro-cyclical or counter-cyclical? Orthodox Keynesianism and Orthodox

Monetarism Real wages are counter-cyclical Changes in AD with sticky or lagging wages (due to

adaptive expectations) RBC

Real wages are strongly pro-cyclical Changes in technology shift production function and

change the demand for labor Empirics

Real wages are slightly pro-cyclical Problem: procyclical wages require elastic labor supply

to produce observed variations in employment and output, but micro data does not support notion of elastic labor supply

Price Level and Business Cycles

Is the price level pro-cyclical or counter-cyclical? Orthodox Keynesianism, Monetarism, New

Classical Price level and inflation are pro-cyclical

RBC Evidence from entire 1954-89 period is that price level

and inflation are counter-cyclical Empirics and Impulse Mechanisms

Impulse determines behavior of price level and inflation Supply-side changes lead to counter-cyclical prices Demand-side changes lead to pro-cyclical prices

Policy Implications

(1) More robust case against activism“Costly efforts at stabilization are likely to

be counter-productive. Economic fluctuations are optimal responses to uncertainty in the rate of technological progress.”

- Prescott, “Theory Ahead of Business Cycle Measurement”

(2) Fiscal policy is more potent than monetary policy but should still be avoided.

RBC and AD Management

Aggregate demand management has been successful in reducing the volatility of business fluctuations from demand-side disturbances compared to earlier periods; technological disturbances have emerged as a dominant source of modern business fluctuations as a consequence.

- Chatterjee, “Real Business Cycles: A Legacy of Countercyclical Policies”

Criticisms of RBC Theory

(1) Evidence concerning labor supply elasticity weak

(2) Technology shocks are directly unobservable

Doubts concerning size and frequency to produce large variations in Y and L

Doubts that technological regression occurs to produce recessions

(3) Pro-cyclical Solow residual due to other reasons

Pro-cyclical utilization rates of labor and capital

Criticisms of RBC Theory

(4) Is large unemployment really voluntary? pro-cyclical movement of vacancy rates and

voluntary quits

(5) Is money neutral in the short-run? American and British dis-inflations of the

1980s

(6) Persistence (Unit-root hypothesis or lack of trend-reversion)

AD changes can produce permanent effects if it induces technological change

Hysteresis effects

Criticisms of RBC Theory

(7) No micro-economic foundation for technological change and innovation

Plausible models of demand conditions, R&D expenditures and “learning by doing” effects

(8) Representative agent models sidestep rather than address aggregation and coordination problems

(9) Lack of robust empirical testing

RBC: An Assessment RBC refocused attention on what we

actually know or don’t know about business fluctuations Output does not appear to be trend-reverting,

but rather follows a random walk with drift Re-integration of growth theory and theory

of fluctuations Furthered cause of building macro-models

with micro-foundations Renewal of interest concerning role of

supply-side in macroeconomics