Overhead 2 Real Business Cycle Theory

Real Business Cycle Theory

  • Presenter: Lukas Mayr

Introduction to Economic Fluctuations

  • IS-LM Model: Explains short-run fluctuations of output due to shocks in IS or LM curve.

    • Key Shocks: Changes in fiscal or monetary policy.

    • All fluctuations attributed to changes in aggregate demand.

  • AD-AS Model: Similar to IS-LM but also includes short-run aggregate supply shocks.

    • Temporary Nature of Shocks: All shocks are considered temporary; long-run output returns to natural level, unchanged by shocks.

  • Main Question: Are the shocks affecting real output permanent or temporary?

  • Implications:

    • If shocks are temporary, IS-LM or AD-AS models are appropriate.

    • If shocks are permanent, a different model is necessary.

Temporary vs. Permanent Shocks

Nelson and Plosser (1982) highlighted evidence that output shocks are long-lasting.

  • Comparison of two models: Time trend vs. Random Walk with Drift.

  • Findings: Random walk model better fits US time series data.

  • Conclusions:

    • Shocks affecting real GDP should be viewed as permanent (e.g., supply shocks).

    • Demand shocks, being temporary, carry less weight in analysis.

  • Real Business Cycle Theory (RBC): Attributes output fluctuations to changes in aggregate supply.

Key Features of Real Business Cycle Theory

  • Price Flexibility: Prices are completely flexible leading to a vertical aggregate supply curve.

    • Impact of Shocks:

      • Shifts in aggregate supply alter natural output.

  • Say's Law: Supply inherently creates its own demand; demand-side shocks are ignored.

Main Components of RBC Theory

  • Determinants of Real GDP:

    • Output is influenced by the aggregate production function:[ Y = A \times F(K, L) ]

      • Output ( Y): Produced via Capital (K) and Labor (L).

      • Technology ( A): Total factor productivity influences output.

  • Fluctuations: Arising primarily from variations in A (Total Factor Productivity).

Measurement of Total Factor Productivity (TFP)

  • Cobb-Douglas Production Function:

    • Model:[ Y_t = A_t K_t^{\alpha} L_t^{\beta} ]

    • Log Transformation:[ log Y_t = \alpha log K_t + \beta log L_t + log A_t ]

    • Solow Residual: Use OLS regression of log output on log inputs to determine TFP.

Components of RBC Theory

  1. Economic Fluctuations: Driven by changes in TFP growth rates.

  • Result from technological progress.

  • Negative changes may occur as technologies render existing capital obsolete.

  1. Market Conditions: Assumes perfectly competitive markets with flexible prices and rational expectations.

  • Policy ineffectiveness proposition holds; passive government intervention recommended.

  1. Microfoundations: Derived from the behavior of households (utility maximization) and firms (profit maximization).

  2. Dynamic Model: Decision-makers optimize choices over time.

  3. Complex Solutions: Uses numerical methods due to the complexity of deriving closed-form solutions.

Propagation Mechanism of RBC Model

  1. Initial Shock: Surges from an unexpected positive TFP shock.

  2. Increased Demand: Marginal Product of Capital (MPK) and Marginal Product of Labor (MPL) rise, leading to higher investment and labor demand.

  3. Market Responses:

  • Increased interest rates and wages boost labor supply.

  • Positive feedback magnifies the initial shock's effect on output (Amplification).

  1. Future Investments: Drives higher capital accumulation, influencing future outputs (Propagation).

RBC Model within the AD-AS Framework

  • Integration of concepts between RBC and AD-AS models highlighted (See projector).

Main Implications of RBC Theory

  • Optimal Responses: Fluctuations seen as the efficient response of agents to technological shocks (e.g., recessions viewed as optimal reactions to negative shocks).

  • Market Efficiency: Competitive markets and flexible prices ensure equilibrium efficiency.

    • First Welfare Theorem applies.

  • Policy Stance: Advocates against governmental intervention that could create inefficiencies in market responses.

RBC Theory vs. Data Analysis

  • Data Variances:

    • Consumption: Less volatile compared to GDP.

    • Investment: Approximately thrice as volatile.

    • Employment: Matches GDP volatility.

    • Wage: Less volatile than GDP.

  • Data Co-Movements:

    • Consumption: Procyclical.

    • Investment: Very procyclical.

    • Employment: Procyclical.

    • Wage: Weakly procyclical.

  • Overall Fitting: RBC model aligns qualitatively with variances, yet underpredicts labor variance.

Critiques of RBC Theory

  • Measurement Concerns:

    • Technological progress (Solow residual) may be biased.

  • Labour Factors: Labour hoarding leads to overestimated labor inputs, hence underestimating TFP.

  • Elasticity Issues: Requires large intertemporal elasticity of labor supply for shock effects, contrary to micro data suggesting lower elasticities.

  • Unemployment Representation: Proposes that all unemployment is voluntary, lacking real-world applicability.

  • Money Neutrality: Contradicted by observed economic behaviors; real-world price and wage rigidity challenges the assumption of perfect flexibility.