The Real Business Cycle School

Major Currents in Contemporary Economics The Real Business Cycle School Mariusz Próchniak Department of Economics II Warsaw School of Economics 1 Background During 1972-82,the dominant new classical theory was the monetary surprise model developed by Lucas in 1972 and 1973. This model implies that unanticipated changes in nominal money supply cause temporary deviations of output and employment from the potential level. Some supporters of the new classical school began looking for a modified concept of the business cycle, which would be free from theoretical and empirical weaknesses. The outcome was a real business cycle theory. 2 1

Background The real business cycle theory replaces the impulse mechanism of the previous models (i.e. unanticipated growth of money supply) with the supply-side shocks in the form of random technological changes. Since the early 1980s, the main new classical explanation of the business cycle began to focus on real rather than nominal shocks. The basis of the real business cycle theory: Kydland and Prescott (1982), Long and Plosser (1983). 3 1. Business cycle theories in historical perspective Real business cycle theory assumes that there are large random changes in the pace of technological progress. Such supply-side shocks in the production function cause fluctuations of output and employment. The idea that business cycles are caused by real, not nominal forces,is certainly not a new idea. E.g. changes in technology were important in Schumpeterian analysis of short-run instability and long-run dynamics. In 1939, Schumpeter like real business cycle theorists treated business cycles and economic growth as interrelated phenomena (because the introduction of a new technology affects long-run productivity growth as well as short-term fluctuations of output). 4 2

1. Business cycle theories in historical perspective Following Keynes General Theory, business cycle models were based on the multiplier-accelerator mechanism. These models also had a real character, but included the demand-side perspective: business cycles resulted from fluctuations in real aggregate demand, which were primarily caused by unstable investment expenditures. The real business cycle theory, developed in the 1980s, was a competition not only for earlier Keynesian models (focusing on fluctuations in aggregate demand), but also for monetarist models and the early new classical models (that highlight the monetary approach to the business cycle). 5 2. Cycles versus random walks (1) The traditional approach to business cycle and economic growth The economy exhibits a long-run trend of output, but real GDP fluctuates around this trend. These fluctuations havea short-run nature and, in the long run, GDP returns to a trend path. Such a traditional approach is supported by Keynesians, monetarists, and new classical economists, although there are some differences (sometimes very significant) between these schools. 6 3

2. Cycles versus random walks The time path for GDP in the traditional approach: where: GDP = g + α GDP + ε t t t 1 t g t - the average GDP growth rate (a deterministic trend), ε t - random factor (with a zero mean) showingrandom shocks, α - parameter in the interval (0;1). Suppose that in period t there is a positive shock, lasting one period. It means that ε t increases. This causes the deviation of output above the trend line. As time passes, however, output will return to the trend. This is because the parameter αranges between 0 and 1. 7 2. Cycles versus random walks GDP GDP t 0 t 1 (t) t 0 (t) (a) Figure 1 Business cycle: (a) the traditional approach, (b) a random walk (b) 8 4

In 1982, Nelson and Plosser criticized the traditional approach to the business cycle. They showed that monetary disturbances do not explain much of the observed fluctuations in output. The primary source of output fluctuations is stochastic variation due to real factors. The majority of changes in output is permanent, not temporary. After the shock, the economy does not return to the previous trend path. GDP behaves in line with a random walk. 2. Cycles versus random walks (2) The real business cycleapproachto business cycle and economic growth 9 2. Cycles versus random walks A random walk path with drift is described by the following equation: where: g t - a drift of output. GDP = g + GDP + ε t t t 1 t Main difference: The parameter on GDP from the previous period equals 1. Any shocks in productivity are permanent. They bring the economy to a new path. The increase in output lasts forever (the economy does not return to the previous trend line). 10 5

2. Cycles versus random walks GDP GDP t 0 t 1 (t) t 0 (t) (a) Figure 1 Business cycle: (a) the traditional approach, (b) a random walk (b) 11 2. Cycles versus random walks Implications of the real business cycle approach If the shocks due to technological changes are random and frequent, GDP that follows a random walk path behaves as it would reveal cyclical fluctuations. Fluctuations in GDP reflect fluctuations in the potential output; not deviations of the actual output from the deterministic trend. That what seems to be fluctuations around the trend is the volatility of the trend itself, as a result of various supply-side shocks that have permanent nature and put the economy on a new path of economic growth. 12 6

2. Cycles versus random walks Implications of the real business cycle approach (cont.) In traditional terms,the analysis of economic growth was separated from the business cycle analysis. Nelson and Plosser indicate that such analyses cannot be treated separately. The forces that yield economic growth are the same as those that cause cyclical fluctuations. Proponents of the real business cycle theory integrated the growth theory with the theory of cyclical fluctuations. Since permanent changes in the level of GDP cannot result from monetary shocks (the neutrality proposition supported by new classical economists), the main sources of output fluctuations are real shocks. Proponents of the real business cycle theory point out that, in well-developed market economies, supply-side shocks arise primarily from technological changes. These include changes in productivity caused by changes in labour and capital quality, new management strategies, inventing new products, and introduction of new production techniques. 13 3. Real business cycle theory Real business cycle theory is based on the following assumptions: Prices are flexible. It implies a continuous market clearing and a permanent equilibrium. Expectations are rational and there is no information asymmetry. Information on the general price level is publicly available. Consumers maximize utility and firms maximize profits. Changes in employment reflect voluntary decisions of workers. Fluctuations in output and employment are due to random technological changes. Money is neutral, so that monetary policy does not affect real variables. The distinction between the short run and the long run in the analysis of trend and cyclical fluctuations is abandoned. 14 7

3. Real business cycle theory The differences between the real business cycle theory and the new classical school concern mainly three aspects: The real business cycle theory ignores the distinction between the short run and the long run, integrating the theory of economic growth with the business cycle theory. In the real business cycle theory there is no incomplete information on the general price level (while in the Lucas surprise supply model the lack of knowledge on the general price level caused expectational errors made by both firms and workers). The real business cycle theory assumes that shocks result from technological changes, and not as in the new classical economics from monetary sources. 15 3. Real business cycle theory (1) Technological shocks Real business cycle theorists argue that shocks are primarily caused by technological changes. Technical progress according to the real business cycle theory looksslightly different than in the standard Solow model. The Solow model: technological progress is exogenous and occurs smoothly over time. The real business cycle theory:changes in the level of technology fluctuate randomly, so that economy behaves as if it showed business cycles. The effects of a positive supply-side shock: 16 8

3. Real business cycle theory Output (Y) Y2 Y = A2?F(K,L) Y = A1?F(K,L) Y1 L 1 L 2 Labour (L) Real wage (W) S L W2 W 1 2 DL D L 1 L 1 L 2 Labour (L) Figure 2 The effects of a positive technological shock 17 3. Real business cycle theory In explaining how the economy responds to shocks, it is worth noting that real business cycle theorists argue that unemployment is entirely voluntary and the labour market is continuously in equilibrium. Changes in employment reflect voluntary decisions of workers and firms. This phenomenon can be explained based on the intertemporal substitution model of labour and leisure, discussed in the previous chapter. 18 9

3. Real business cycle theory (2) The IS-LM and AD-AS model according to the real business cycle theory Real interest rate (R) RAS LM/P R* IS (RAD) Y* Output, GDP (Y) Figure 3 The IS-LM model according to the real business cycle theory 19 3. Real business cycle theory The LM/P function always intersects the IS curve at the potential output. This results from immediate price adjustments so that changes in money supply do not affect real variables. In further analysis, we can thus ignore the LM function. The equilibrium will be determined only by real forces represented by the RAD and RAS functions. The RAS curve will beupward sloping but still every point on this curve corresponds to full employment. The positive slope follows from the fact that, given higher real interest rate, individuals supply more labour in the current period, which leads to an increase in output and employment (the rise in real interest rate positively affects the valueof income earned today in relation to income earned tomorrow). 20 10

3. Real business cycle theory Real interest rate (R) RAS 1 RAS 2 R 1 R 2 E F G Temporary technological shock: E --> F Permanent technological shock: E --> G RAD 2 RAD 1 RAD 3 Y 1 Y 2 Y 3 Output, GDP (Y) Figure 4 The AS-AD model according to the real business cycle theory: the effects of a positive technological shock 21 3. Real business cycle theory The effects of a positive supply-side shock due to technical progress Technological progress shifts the RAS curve rightwards from RAS 1 to RAS 2. The RAD curve shifts rightwards as well. The magnitude of the shift of the RAD depends on the size of the wealth effect. Real interest rate (R) R1 R2 E F Y1 Y2 Y3 RAS1 G RAD 2 RAD1 RAS2 RAD3 Output, GDP (Y) Temporary technological shock: E --> F Permanent technological shock: E --> G Figure 4 The AS-AD model according to the real business cycle theory: the effects of a positive technological shock If technological shock is temporary, the wealth effect is small and consumer demand increases only slightly. If technological shock is permanent, the strength of the wealth effect is large and the RAD curve moves from RAD 1 to RAD 3 (the change in consumer demand is of similar size as the increase in output due to technological shock). 22 11

3. Real business cycle theory The real business cycle model presented here can be summarized in several points. There is no distinction between short-run and long-run aggregate supply functions. The model is completely real because both the nominal money supply and price level do not affect the real economy. All points on the RAS curve correspond to full employment. Output and employment fluctuations are caused by technological shocks that shift the RAS curve. However, the model suggests that changes in real aggregate demand may also yield output fluctuations. 23 4. Real business cycle theory and stylized facts Price fluctuations are counter-cyclical: Prices (P) AS3 AS1 AS2 P3 G P1 E P2 F AD Y3 Y1 Y2 Output, GDP (Y) Figure 5 Counter-cyclical behaviour of prices in the real business cycle model By contrast, Keynesian, monetarist, and the new classical models assume that prices behave rather procyclically. Empirical evidence is mixed (see the text). 24 12

5. The policy implications Before 1980, economists agreed in the following areas: Business cycles are temporary fluctuations of output around the trend. The trend is an exogenous variable resulting from a smoothed technical progress. Business cycles (instability of output) are undesirable because they reduce economic welfare. Monetary forces are a major cause of cyclical fluctuations. These views were accepted by Keynesians, monetarists, and new classical theorists. However, these schools differ in many respects, including what actions should be taken to reduce output fluctuations. E.g. Keynesians support discretionary government policy while monetarists and new classical economists are in favour of constant growth in money supply. 25 5. The policy implications According to the real business cycle school: instability is not a bad outcome: it does not reduce economic welfare; the economy is in a Pareto optimal equilibrium during expansionary and contractionary periods, government should not reduce fluctuations in output and employment. The main policy implication: the government stabilization policy is counterproductive. If fluctuations are Pareto optimal responses to shocks in the production function due to changes in technology, monetary policy is not responsible for the economic instability and it does not influence the real economy. Hence, money is super-neutral. There is no room for government intervention aimed at achieving full employment, because the economy is still in that state. 26 13

6. Selected criticism The main criticism addresses the following issues: In the real business cycle model, unemployment is entirely voluntary, although this needn t be true in the real world (see, e.g., Great Depression duringthe 1930s or the Global Economic and Financial Crisis in 2009). Recessions are treated as periods of technological regress. However, it is difficult to agree that the level of technology declines during recessions. Technological shocks do not appear so often and they are not so large to fully explain the fluctuations in output. Observed employment fluctuations are too large to be fully explained by intertemporal substitution of labour and leisure. Demand-side policies may have long-run impact on the volume of output. E.g.technical progress may depend on the size of demand, R&D expenditure, or learning-by-doing. Empirical evidence shows that monetary policy does affect the real sphere of economy. For example, we could observe, based on historical data, that monetary disinflation policy in the UK led to a recession or economic slowdown. Real business cycle models ignore the issues related to e.g. information asymmetry. 27 7. Summary 1. The real business cycle theory is the economic school of thought that is derived form the new classical macroeconomics and assumes rational expectations and continuous market clearing. 2. The real business cycle school integrates the theory of business cycles with the theory of economic growth. It does not distinguish between the short run and long run. 3. Business cycles are caused by real forces, namely technological changes. Money is super-neutral it does not affect the real economy. Random technological changes yield permanent effects on potential output. In other words, GDP follows a random walk. 4. GDP fluctuations are treated as the fluctuations of potential output. During expansionary and contractionary periods the economy is at full employment level. 28 14

References Snowdon B., H. Vane, and P. Wynarczyk (2002), A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought, Cheltenham-Northampton: Edward Elgar. 29 Additional references Backus D.K. and P.J. Kehoe (1992), International Evidence on the Historical Properties of Business Cycles, American Economic Review, September. Barro R.J. (1981), Output Effects of Government Purchases, Journal of Political Economy, December. Barro R.J. (1993), Macroeconomics, 4 th ed., New York: John Wiley. Blackburn K. and M.O. Ravn (1992), Business Cycles in the UK: Facts and Fictions, Economica, November. Fischer S. (1988), Recent Developments in Macroeconomics, Economic Journal, June. Frisch R. (1933), Propagation and Impulse Problems in Dynamic Economics, in: Essays in Honour of Gustav Cassel, London: Allen and Unwin. Gordon R.J. (1993), Macroeconomics, 6 th ed., New York: Harper Collins. Kydland F.E. and E.C. Prescott (1982), to Build and Aggregate Fluctuations, Econometrica, November. Kydland F.E. and E.C. Prescott (1990), Business Cycles: Real Facts and the Monetary Myth, Federal Reserve Bank of Minneapolis Quarterly Review, Spring. Long J.B. and C.I. Plosser (1983), Real Business Cycles, Journal of Political Economy, February. Lucas R.E. (1972), Expectations and the Neutrality of Money, Journal of Economic Theory, April. Lucas R.E. (1973), Some International Evidence on Output-Inflation Tradeoffs, American Economic Review, June. Lucas R.E. (1981), Studies in Business Cycle Theory, Oxford: Basil Blackwell. Lucas R.E. and L.A. Rapping (1969), Real Wages, Employment and Inflation, Journal of Political Economy, September/October. Mankiw N.G. (1989), Real Business Cycles: A New Keynesian Perspective, Journal of Economic Perspectives, Summer. Nelson C.R. and C.I. Plosser (1982), Trends and Random Walks in Macroeconomic Series: Some Evidence and Implications, Journal of Monetary Economics, September. Phelps E.S. (1990), Seven Schools of Macroeconomic Thought, Oxford: Oxford University Press. Schumpeter J.A. (1939), Business Cycles, New York: McGraw-Hill. Smith R.T. (1992), The Cyclical Behaviour of Prices, Journal of Money, Credit and Banking, November. 30 15

Thank you very much for the attention!!! 31 16