# The Real Business Cycle model

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1 The Real Business Cycle model Spring Historical introduction Modern business cycle theory really got started with Great Depression Keynes: The General Theory of Employment, Interest and Money Keynesian economics and the study of aggregate demand You may have seen something like an Aggregate Demand / Aggregate Supply model in ECON 1B Dissatisfaction with the Keynesian model Practical: stagflation of the 1970s Theoretical: where are the microfoundations? Theoretical: are the model predictions robust to policy changes (the Lucas critique)? Theoretical: model not so useful for normative questions since there are no utility functions Real business cycle model tried to remedy these deficiencies, especially in terms of microfoundations New-Keynesian models blend some of the logic of the Keynesian model with the from-firstprinciples approach of the RBC We ll study New Keynesian model later in the course Key questions Positive: what causes economic fluctuations? Normative: what should we do about it? 1

2 ECON 52, Spring THE RBC MODEL 2 The RBC model RBC = Neoclassical model plus shocks Are market economies fundamentally unstable? RBC approach: no, the internal mechanisms are stable but there are exogenous disturbances ( shocks ) that move things around Maybe the existence of shocks is a fundamental feature of a market economy? Do we lose understanding if we model the shocks as exogenous? RBC is a Real model as opposed to nominal : no role for money or nominal variables Since RBC is a version of the Neoclassical model, First Welfare Theorem holds. What should we do about business cycles? A two-period RBC model Special case of the neoclassical general equilibrium model that we have studied but with just two periods: t = 0 represents the present t = 1 represents the future Pros and cons of doing 2 periods instead of : Pro: easier to solve and interpret Con: we need to adjust the model a little bit for the fact that the world ends after t = 1, eg. capital fully depreciates after t = 1. If we want to put numbers of the model we need to be careful: 2! Households max u (c 0 ) + v (l 0 ) + β [u (c 1 ) + v (l 1 )] c 0,l 0,a 1,c 1,l 1 s.t. a 1 = w 0 (1 l 0 ) c 0 + (1 + r 0 ) a 0 c 1 = w 1 (1 l 1 ) + (1 + r 1 ) a 1 a 0 given 2

3 ECON 52, Spring THE RBC MODEL FOC: Euler equation and consumption-leisure equation u (c 0 ) = β (1 + r 1 ) u (c 1 ) (1) v (l t ) = w t u (c t ) (2) Firms (static problem) r K t = F K (K t, L t ) (3) w t = F L (K t, L t ) (4) Arbitrage between lending and holding capital r 0 = r0 K δ r 1 = r1 K 1 (because the world ends after t = 1) (5) Market clearing L t = 1 l t K 1 = a 1 Equilibrium conditions: u (c 0 ) = βf K (K 1, L 1 ) u (c 1 ) v (l t ) = F L (K t, L t ) u (c t ) (for both t = 0 and t = 1) (because the world ends after t = 1) L t = 1 l t (for both t = 0 and t = 1) Now we have 7 equations in 7 unknowns: c 0, c 1, l 0, l 1, K 1, L 0 and L 1 Replacing L t = 1 l t, we have 5 equations in 5 unknowns: c 0, c 1, l 0, l 1, K 1 : u (c 0 ) = βf K (K 1, L 1 ) u (c 1 ) v (1 L 1 ) = F L (K 1, L 1 ) u (c 1 ) 3

4 ECON 52, Spring THE RBC MODEL The Williamson textbook (ch. 10) tries to do a graphical version of this system of equations, which I find hard to follow Using the model to talk about business cycles Exogenous variables in the model 1. The production function. For instance, if F (K t, L t ) = A t K α t L 1 α t the parameter A t is exogenous Also, if the production function is F (K t, L t ) = A t K α t L 1 α t + e t (i.e. it has an endowment component), then e t is exogenous. 2. Intertemporal preferences, measured by β 3. Preferences for consumption/leisure. For instance, if the parameter θ is exogenous 4. The initial capital stock K 0 v (l) = θɛ 1 + ɛ l 1+ɛ ɛ Steps in using the model to think of business cycles: 1. Define some basic values for the exogenous variables and call that normal (e.g.: middle of the business cycle) 2. Compute the values for the endogenous variables: c 0, c 1, l 0, l 1, K 1 3. Suppose an exogenous shock moves one or more of the exogenous variables 4. Compute the values for the endogenous variables: c 0, c 1, l 0, l 1, K 1 in response to the shock 5. Ask: does this look like what we see in business cycles? In particular, we should check whether in the model it s true that output, employment, consumption, investment and productivity more or less move in the same direction when there is a shock. 4

5 ECON 52, Spring PRODUCTIVITY SHOCKS 3 Productivity shocks Consider a shock to A 0 in the production function F (K 0, L 0 ) = A 0 K α 0 L 1 α 0 An improvement in technology, that lasts only for today. In the equations: u (c 0 ) = βf K (K 1, L 1 ) u (c 1 ) v (1 L 0 ) = F L (K 0, L 0 ) u (c 0 ) v (1 L 1 ) = F L (K 1, L 1 ) u (c 1 ) K 1 = Y 0 c 0 + (1 δ) K 0 Shock improves the marginal product of labour, which raise wages (other things being equal) Graphically, you can see this as an increase is labour demand (but remember that other things change as well) Adjust by c 0, L 0, or both Economically, higher wages induce: income effect - why? substitution effect - why? Does it matter if the shock is temporary or permanent? Suppose: Shock is temporary Income effect exists but is small Substitution effect is strong Under these assumptions c 0 goes up a little bit L 0 goes up quite a lot 5

6 ECON 52, Spring PRODUCTIVITY SHOCKS Y 1 goes up for two reasons: direct effect of shock on productivity and additional labour input K 1 goes up (you can see this from resource constraint) - households smooth consumption by building capital for tomorrow Interpretation and implications Success! The model gives you a simultaneous rise in output productivity hours worked consumption investment Booms are times when households choose to work more in response to temporarily high wages Symmetrically, recessions are times when households choose to work less in response to temporarily low wages The model can explain a large fraction of the fluctuations in GDP 1. Construct an infinite-horizon version of the RBC model 2. Do a growth accounting exercise with data from the US economy and find the Solow residuals for each period (usually one quarter) Solow Residual g Y αg K + (1 α) g L 3. Assume that the Solow residuals are an accurate measure of a series of exogenous technological shocks 4. Simulate the response of the model when you ask it to respond to the shocks the you estimated from the data 5. Compare GDP, etc. in the model to the same variables in the data Result: the model generates (explains?) about 2 3 in the data. of the fluctuations in GDP that we observe 6

7 ECON 52, Spring PRODUCTIVITY SHOCKS Implications for policy The government shouldn t do anything about the business cycle By the 1st Welfare Theorem, the allocation is efficient If people aren t working because there is a recession, this is an efficient response to the fact that productivity is low today: people take time off when productivity is low and work harder when productivity is high This is an assumption of the model, not a conclusion To be precise: competitive markets are an assumption of the model and whenever we have competitive markets the FWT holds BUT the model does say that it is possible to observe fluctuations in GDP, etc. in a world where there is nothing wrong (i.e. no inefficiency) Observing fluctuations does not prove that there is something wrong that should be fixed (But it s also possible that this is the wrong model and in the right model business cycles are indeed inefficient) The only thing the government should do about a recession is to try to improve productivity Encourage competition Lower transaction costs Promote innovation All of these things are desirable anyway, not just when there is a recession Criticisms and limitations Where are the technology shocks? Moreover, where are the negative technology shock? Elasticity of labour supply Remember we talked about this being a very important number when we talked about the effects of taxes A high elasticity of labour supply is an important ingredient of BOTH: the argument that taxes have large effects 7

8 ECON 52, Spring OTHER SHOCKS the RBC model (which are views often held by the same people) Cyclicality of wages. In general, the model does better on quantities than on prices. No unemployment? Measurement of TFP with unobserved capacity utilization Measured productivity has become less cyclical than it used to be 4 Other shocks Impatience shocks: sudden decreases in β Has some appeal because it means households want goods now rather than later, an effect that is important in Keynesian models, as we ll see later In the equations: u (c 0 ) = βf K (K 1, L 1 ) u (c 1 ) v (1 L 1 ) = F L (K 1, L 1 ) u (c 1 ) Adjust by c 0, c 1 F K (which means lower investment), or all at the same time If c 0, this implies L 0! Consumption increases but people work less! Therefore output must fall If consumption increases and output falls, it means investment goes down This shock DOES NOT produce the co-movement of business cycles: consumption goes up but output, investment and hours of work go down! 8

9 ECON 52, Spring OTHER SHOCKS Laziness shocks Suppose households temporarily don t want to work, i.e. the marginal utility of leisure goes up (You could also think of the opposite: households temporarily don t mind working) In the equations: u (c 0 ) = βf K (K 1, L 1 ) u (c 1 ) v (1 L 1 ) = F L (K 1, L 1 ) u (c 1 ) Adjust by L 0 Y 0 goes down because L 0 goes down If r 1 didn t change, households would c 0 and c 1 to smooth consumption In order to smooth consumption, households save less so K 1 goes down Output, consumption, investment and hours worked all go down together This shock DOES produce the co-movement of business cycles But do we really want a theory based on waves of laziness? Maybe other things that look like laziness: disruption in labour markets, prices not adjusting... Optimism / news about the future Keynes had this idea about animal spirits : businessmen become very confident about the future and things start to go well Strict interpretation: news. The economy reacts to what people think about the future (and then what people expect actually happens, at least on average) Less strict interpretation: optimism 9

10 ECON 52, Spring OTHER SHOCKS The economy reacts to what people think about the future (and maybe they are completely wrong, but we still care about how their expectations affect things) Good news about future wealth: Y 1 = F (K 1, L 1 ) + e 1 and we ask what happens if e 1 changes In the equations: u (c 0 ) = βf K (K 1, L 1 ) u (c 1 ) v (1 L 1 ) = F L (K 1, L 1 ) u (c 1 ) Adjust by c 0 Therefore L 0 and K 1 Future wealth makes households consume more, but also work less and invest less, so it DOES NOT produce the co-movement we observe in business cycles. Good news about future productivity: and we ask what happens if A 1 changes Y 1 = A 1 K α 1 L 1 α 1 u (c 0 ) = β F K (K 1, L 1 ) u (c 1 ) v (1 L 1 ) = F L (K 1, L 1 ) u (c 1 ) Effect on current consumption depends on income vs. substitution effects If c 0, then L 0 (and vice-versa) 10

12 ECON 52, Spring CONCLUSION The key is in the equation Unless something happens to v or F L, consumption and hours of work will move in opposite directions! Consumption and leisure are normal goods. The alternative explanation is that there are some market imperfections missing from our model Other shocks combined with market imperfections could be part of the story. In particular, we have to look for market imperfections such that does NOT hold. 12

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