The Real Business Cycle paradigm. The RBC model emphasizes supply (technology) disturbances as the main source of

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1 Prof. Harris Dellas Advanced Macroeconomics Winer 2001/01 The Real Business Cycle paradigm The RBC model emphasizes supply (echnology) disurbances as he main source of macroeconomic flucuaions in a world wih raional individuals and perfecly flexible prices. I. How did i come ino exisence? A. Two empirical findings concerning moneary policy and economic shocks suggesed a dominan role for he supply side of he economy and led o he RBC model a) Mos macroeconomic series seem o follow a random walk (Nelson and Plosser, 1981) Changes in macroeconomic aciviy are mosly permanen (business cycles have a large permanen componen) AD canno (?) induce permanen changes in quaniies AS shocks mus be behind macroeconomic flucuaions x() =x(-1) + u() +... = u() + u(-1) + u(-2) +.. Random walk: Sochasic rend, shocks have permanen effecs b) Money did no seem o maer for economic aciviy in VARs (Sims): Bu wha is he insrumen of moneary policy? B. Disaisfacion wih he flexible price RE model (Lucas). The informaional lags i requires are no plausible 1

2 II. An imporan mehodological developmen: Se up, calibraion, soluion and simulaion of sochasic, dynamic, general equilibrium models. Seps 1. Consruc an arificial economy (a model) 2. Derive he opimaliy condiions (FOC) 3. Compue he seady sae 4. Posulae values for he parameers of he model and he disribuion of he shocks (calibraion) 5. Solve he model numerically as a funcion of he sae variables and he shocks 6. Simulae: Feed in random values for he shocks (according o heir disribuion) in he derived soluions and generae ime series for he variables of ineres (oupu, invesmen, consumpion, inflaion...) 7. Calculae various momens of he join probabiliy disribuion of hese arificially generaed ime series (variances, covariances, auocorrelaion..) 8. Calculae he same momens using acual daa (sylized facs) 9. Model evaluaion: Compare he wo ses of momens III. Main difficulies: a) Selecion of parameer values (calibraion) b) Technology shocks are unobservable. How large are hey in realiy? The model needs large and persisen shocks in order o deliver saisfacory resuls Compuaion of echnology shocks The Solow-Presco residual: Supply shocks = Mulifacor produciviy 2

3 Y = Z K a H 1-a z = y α k ( 1 a) h Problems wih he Solow residual 1. I can be forecased using irrelevan hings (miliary spending, moneary variables..) 2. I generaes an unreasonably high probabiliy of echnological regression (40%) 3. I is conaminaed by labor hoarding, capaciy uilizaion, imperfec compeiion c) Is he supply of labor sufficien elasic (ineremporal vs inraemporal)? d) Dynamics (Lack of inernal propagaion mechanism) e) Lack of formal saisical validaion of heories Empirical performance: How well does he sandard RBC model mach he behavior of acual economies? A grea deal of success. The bigges problems are found in accouning for labor marke behavior (e.g. for he lack of correlaion beween he real wage and employmen) Some oher properies Irrelevance of money for real economic aciviy (neuraliy) Opimaliy of business cycles (volunary unemploymen, creaive desrucion Unemploymen Worker-job mismach. Job creaion and desrucion. 3

4 Business Cycle Sylized Facs Lucas: Business cycles are all alike Volailiy Consumpion of non-durables and services flucuaes much less han oupu Consumpion-producion of durable goods exhibis greaer volailiy han oupu Governmen expendiure is less volaile han oupu Invesmen flucuaes much more han oupu Capial is much less volaile han oupu, bu capial uilizaion in manufacuring is more volaile han oupu Toal hours worked are abou as volaile as oupu Employmen is as volaile as oupu bu hours per worker are much less volaile han oupu. Tha is, flucuaions in hours are due more o flucuaions in employmen han o flucuaions in average hours Labor produciviy is less volaile han oupu The real wage is much less volaile han oupu Comovemens Mos macroeconomic series are procyclical (posiive conemporaneous correlaion wih oupu) Oupu across secors moves ogeher Toal hours worked and aggregae oupu are very highly correlaed Wages, Governmen Expendiure and he Capial Sock are un-correlaed wih oupu (acyclical) The rade balance is counercyclical Shor erm nominal ineres raes, moneary aggregaes and inflaion are procyclical The general price level is counercyclical The real ineres rae is counercyclical 4

5 Persisence All macroeconomic aggregaes display subsanial persisence (abou 0.9). This implies business cycle predicabiliy A successful heory of he business cycle ough o conform o he sylized facs Some growh sylized facs Sabiliy of he grea raios Invesmen/Oupu, Labor Income/Oupu, Consumpion/Income Implicaion: Similar rae of growh in many variables (common rend) Consancy of hours per person The model The driving process (quarerly daa) z = ρ z 1 ρ = e Soluion Resuls σ e = z = log Z Some key poins The imporance of iner-emporal elasiciy of subsiuion in labor supply The labor marke implicaions (srong pro-cyclicaliy of he real wage) The couner-cyclicaliy of he aggregae price level The requiremen of large and volaile echnology shocks 5

6 Exensions: a) To deal wih labor marke shorcomings of RBC predicions 1. Lack of correlaion beween employmen and he real wage 2. Variaion in oal hours is due o variaion in employmen raher han in hours worked per person The RBC model fails o mach hese wo fac because i uses a very high labor supply elasiciy (around 4). The micro evidence suggess a much smaller number Inensive vs exensive margin in employmen variaion. Labor supply shifs Indivisible labor Household producion Addiional shocks Fiscal policy u(c,g) g T c leisure work Moneary policy Oher Wage conracs b) To deal wih he Solow residual Variable capial uilizaion Y K = Z ( m K ) + 1 a ( X = (1 d( m )) K H 1 a + ) I Resul: Variable uilizaion scales down he volailiy of he Solow residual. Bu i sill generaes sufficien oupu volailiy z = y α ( k + m ) (1 a) h proxy for m: elecriciy uilizaion 6