An Assessment
In his Yrjo Jahnsson lectures, given in 1978, James Tobin noted that ‘there is no
economic business cycle theory, new or old, involved in assuming that waves of
economic activity simply mirror waves in underlying technology and taste’
(Tobin, 1980a, p. 37). This state of affairs was to change dramatically during
the 1980s when, following the widespread rejection of the monetary misperception
version of equilibrium theory, real business cycle models proliferated.
The research initiated by Nelson and Plosser provided substantial support for
the view that shocks to aggregate output tend to have long-lasting effects.
Output does not appear to revert to a deterministic trend. This finding has had a
profound influence on business cycle research, in that it suggests that much of
the disturbance to aggregate output that we witness is caused by supply-side
influences. By demonstrating that equilibrium models are not inconsistent with
aggregate instability, real business cycle theorists have challenged the conventional
wisdom and forced theorists on all sides to recognize just how deficient
our knowledge is of business cycle phenomena. The real business cycle approach
has therefore performed a useful function in raising profound questions
relating to the meaning, significance and characteristics of economic fluctuations.
We have seen in this chapter how REBCT is a continuation of the research
programme, stimulated in the modern era by Lucas, that aims to explore the
general equilibrium intertemporal characteristics of macroeconomics (Wickens,
1995). In doing so, REBCT has integrated the theory of growth and fluctuations
and irreversibly changed the direction of business cycle research. New insights
have been gained, along with innovative modelling techniques.
More than 30 years ago, Harry Johnson (1971), in his lecture to the 1970
meeting of the American Economic Association, attempted to provide reasons
for the rapid propagation of the Keynesian revolution in order to better
understand the monetarist counter-revolution which during the late 1960s and
early 1970s had begun to fill the intellectual vacuum created by the retreat of
the Keynesian orthodoxy in the face of accelerating inflation. In Johnson’s
highly perceptive article, attention was drawn to the shared characteristics of
both the Keynesian revolution and the monetarist counter-revolution which
appear important in explaining the success of these developments. According
to Johnson, there are two types of factor which can help explain the rapid
acceptance and propagation of new ideas among professional economists.
The first factor relates to the ‘objective social situation in which the new
theory was produced’. The second important factor encompasses the ‘internal
scientific characteristics of the new theory’. We would argue that these factors
can help in understanding the rapid propagation of new classical ideas,
both the MEBCT and the REBCT (see Snowdon and Vane, 1996).
Although an established orthodoxy, such as trend-reverting cycles, which
is in apparent contradiction to the ‘most salient facts of reality’ is the ‘most
helpful circumstance for the rapid propagation of a new and revolutionary
theory’, Johnson also identified five internal scientific characteristics which
in his view were crucial because it was these aspects of the new theory which
appealed to the younger generation of economists. In summary, the five main
characteristics Johnson identified involved:
1. ‘a central attack, on theoretically persuasive grounds, on the central
proposition of the orthodoxy of the time’;
2. ‘the production of an apparently new theory that nevertheless absorbed
all that was valid in the existing theory’;
3. a new theory having an ‘appropriate degree of difficulty to understand’
that would ‘challenge the intellectual interest of younger colleagues and
students’;
4. ‘a new more appealing methodology’ than that prevailing;
5. ‘the advancement of a new and important empirical relationship suitable
for determined estimation’ by econometricians.
To what extent have these five internal scientific characteristics played an
important role in explaining the success of new classical macroeconomics, in
particular the REBCT?
The first characteristic (that is, an attack on a central proposition of the
established orthodoxy) can be straightforwardly identified in REBCT. Before
1980 the established consensus regarded business cycles as socially undesirable.
In sharp contrast, the main policy implication of real business cycle
theory is that because the existence of fluctuations in aggregate output does
not imply the failure of markets to clear, the government should refrain from
any attempt to reduce such fluctuations not only because such policies are
unlikely to achieve their desired objective, but also because reducing instability
would reduce welfare!
The application of Johnson’s second internal characteristic (that is, the
ability of a new theory to absorb as much as possible of the valid components
of the existing orthodox theory) can also be applied to REBCT, which has
pioneered the use of the orthodox neoclassical growth model as a framework
for the quantitative analysis of aggregate fluctuations as well as absorbing
much of the methodology advocated by Lucas in the 1970s.
Johnson’s third characteristic (that is, an intellectually challenging new
theory with appeal to the younger generation of economists) is one that again
can be readily applied to REBCT. There is no question that the new classical
revolution pushed macroeconomic theory into new, more abstract directions
involving the introduction of techniques not found in the ‘kit bags of the
older economists’ (Blinder, 1988b). Being better trained mathematically, the
younger generation has been able to absorb the new techniques, such as
calibration, giving them a ‘heavy competitive edge’ over the ‘older’ economists.
Turning to the fourth characteristic (that is, a new methodology), the
REBCT programme has wholeheartedly embraced a methodological framework
involving a formal general equilibrium approach. Responding to the
‘Lucas critique’ has fostered an emphasis on a return to first principles in the
quest to establish sound microfoundations for general equilibrium macroeconomic
models. Since real business cycle methodology is in principle
ideologically neutral, it has the capability of fostering models with enormous
diversity.
The fifth characteristic (concerning a ‘new and important empirical relationship’
for estimation) is more difficult to apply to REBCT developments.
Rather than attempting to provide models capable of conventional econometric
testing, real business cycle theorists have instead developed the ‘calibration
method’ in which the simulated results of their specific models (when hit by
random shocks) in terms of key macroeconomic variables are compared with
the actual behaviour of the economy. Unfortunately calibration does not
provide a method that allows one to judge between the performance of real
and other (for example Keynesian) business cycle models.
From the above discussion it should be evident that while Johnson put
forward five main ‘internal’ characteristics to help explain the success of the
Keynesian revolution and monetarist counter-revolution, the first four of these
same characteristics also help in understanding why REBCT has made such
an important impact on the development of macroeconomics since the early
1980s. In assessing whether or not REBCT has constituted a ‘fashion’ or a
‘revolution’ in macroeconomics, Kirschner and Rhee (1996) conclude from
their statistical analysis of the spread of scientific research that data on
publications and researchers in the REBCT field exhibit ‘mini-revolution’
characteristics.
A distinguishing feature of the early REBCT is the downplaying of monetary
influences as a major cause of business cycles. Instead random shocks
to technology play the major role in creating disturbances, and the desire of
economic agents for consumption smoothing and ‘time to build’ constraints
acts as a major propagation mechanism leading to persistence. While the
early REBCT models had too narrow a focus, more recent work has also
begun to add monetary and financial variables into the model, as well as to
extend this line of research to include government and open economy influences
(see Mendoza, 1991; Backus et al., 1992; Hess and Shin, 1997). Going
further and adding market imperfections to REBCT will provide a bridge
between new classical and new Keynesian approaches to business cycle research
(Wickens, 1995). We should also note that the real business cycle
approach has furthered the cause of those economists who insist that macro
models need to be based on a firmer microeconomic base. This in turn has
strengthened the general move to improve our understanding of the supply
side. If anyone seriously questioned it before, no one now doubts that macroeconomics
is about demand and supply and their interaction. As Blinder
(1987b) notes, ‘events in the 1970s and 1980s demonstrated to Keynesian
and new classical economists alike that Marshall’s celebrated scissors also
come in a giant economy size’.
While recognizing the achievements of the real business research programme,
the critics remain convinced that this approach has serious
deficiencies. A majority of economists believe that the short-run aggregate
demand disturbances that arise from monetary policy can have significant
real effects because of the nominal price and wage rigidities which characterize
actual economies (see Chapter 7). This important line of criticism
challenges the new classical assumption that markets continuously clear,
even in a recession. If markets do not clear quickly and the world is characterized
by both aggregate demand and aggregate supply disturbances, the
actual fluctuations that we observe will consist of a stochastic trend around
which output deviates as the result of demand shocks. This view is well
represented by Blanchard and Quah (1989) where they ‘interpret fluctuations
in GNP and unemployment as due to two types of disturbances: disturbances
that have a permanent effect on output and disturbances that do not. We
interpret the first as supply disturbances, the second as demand disturbances.’
Clearly the role of stabilization policy in such a world is immensely complicated,
even if we accept that demand disturbances are important. How, for
example, can a government make the requisite distinction between demand
and supply shocks, especially when such shocks are not independent but
interdependent? (see Friedman, 1992).
Further support for keeping an open mind on the causes of aggregate
instability is provided by G.M. Caporale (1993). In an investigation of business
cycles in the UK, France, Finland, Italy, Norway, Sweden and West
Germany, Caporale found that that neither demand nor supply shocks alone
could account for economic fluctuations. Recent empirical research by Temin
(1998) also finds a variety of causes responsible for US business cycles.
Temin suggests a four-way classification of the causes of US business cycles
over the twentieth century, namely Domestic Real, Domestic Monetary, Foreign
Real and Foreign Monetary. According to Temin’s data it appears that
domestic causes far outweigh foreign shocks (16.5 v. 7.5), and real disturbances
dominate monetary disturbances (13.5 v. 10.5). The real domestic
shocks are diverse and include all manner of real demand disturbance. Temin
concludes that ‘all four types of shock have acted as a source of the American
business cycle’ and the dominant conclusion of his enquiry is that ‘the sources
of instability are not homogeneous’. In his study of large recessions in the
twentieth century, Dow (1998) discusses three major findings. First, major
recessions and growth slowdowns are mainly due to aggregate demand shocks.
Second, these demand shocks can be identified, for example, the 1979–82
recession in the UK was largely the result of a decline in exports brought
about by an appreciation of the exchange rate in response to the new monetary
and fiscal regime under Prime Minister Margaret Thatcher. Third,
recessions are not predictable given economists’ present state of knowledge.
A balanced conclusion from the above discussion would seem to point
towards the advantage of taking an eclectic approach when analysing the
causes of business cycles. There is no evidence that the business cycle is dead
or that governments now have the ability and knowledge to offset the various
shocks that buffet every economy. While governments can never hope to
eliminate the business cycle, they should have the knowledge and capacity to
avert another Great Depression or Great Inflation.
In a recent assessment of the contribution of REBCT to twentieth-century
macroeconomics (see Snowdon, 2004a), Axel Leijonhufvud commented:
I think the legacy of Ed Prescott’s work will be in terms of the analytical machinery
available to technically minded economists, although those techniques are not
always appropriate and you cannot always apply them. In particular, you cannot
meaningfully run these dynamic stochastic general equilibrium models across the
great catastrophes of history and hope for enlightenment.
Even taking into account these important deficiencies, there is no doubt that
the REBCT research programme has been ‘extremely influential’ and current
The real business cycle school 343
work in the field is ‘a far cry’ from the initial representative agent competitive
(and unique) equilibrium model constructed by Kydland and Prescott in the
early 1980s (Williamson, 1996). However, while noting that new and controversial
ideas are often the most fruitful, even when false, Hartley et al. (1998)
conclude that ‘real business cycle models are bold conjectures in the Popperian
mould and that, on the preponderance of the evidence, they are refuted’.
However, for those economists who reject the real business cycle view that
stabilization policy has no role to play, there remains the theoretical difficulty
of explaining in a coherent way why markets fail to clear.
Beginning in the late 1970s, and continuing thereafter, many economists
have taken up this challenge of attempting to explain why the adjustment of
prices and wages in many markets is sluggish. ‘The rationality of rigidities’
theme is a major feature of the research of new Keynesian economists and it
is to this work that we turn in the next chapter.
In his Yrjo Jahnsson lectures, given in 1978, James Tobin noted that ‘there is no
economic business cycle theory, new or old, involved in assuming that waves of
economic activity simply mirror waves in underlying technology and taste’
(Tobin, 1980a, p. 37). This state of affairs was to change dramatically during
the 1980s when, following the widespread rejection of the monetary misperception
version of equilibrium theory, real business cycle models proliferated.
The research initiated by Nelson and Plosser provided substantial support for
the view that shocks to aggregate output tend to have long-lasting effects.
Output does not appear to revert to a deterministic trend. This finding has had a
profound influence on business cycle research, in that it suggests that much of
the disturbance to aggregate output that we witness is caused by supply-side
influences. By demonstrating that equilibrium models are not inconsistent with
aggregate instability, real business cycle theorists have challenged the conventional
wisdom and forced theorists on all sides to recognize just how deficient
our knowledge is of business cycle phenomena. The real business cycle approach
has therefore performed a useful function in raising profound questions
relating to the meaning, significance and characteristics of economic fluctuations.
We have seen in this chapter how REBCT is a continuation of the research
programme, stimulated in the modern era by Lucas, that aims to explore the
general equilibrium intertemporal characteristics of macroeconomics (Wickens,
1995). In doing so, REBCT has integrated the theory of growth and fluctuations
and irreversibly changed the direction of business cycle research. New insights
have been gained, along with innovative modelling techniques.
More than 30 years ago, Harry Johnson (1971), in his lecture to the 1970
meeting of the American Economic Association, attempted to provide reasons
for the rapid propagation of the Keynesian revolution in order to better
understand the monetarist counter-revolution which during the late 1960s and
early 1970s had begun to fill the intellectual vacuum created by the retreat of
the Keynesian orthodoxy in the face of accelerating inflation. In Johnson’s
highly perceptive article, attention was drawn to the shared characteristics of
both the Keynesian revolution and the monetarist counter-revolution which
appear important in explaining the success of these developments. According
to Johnson, there are two types of factor which can help explain the rapid
acceptance and propagation of new ideas among professional economists.
The first factor relates to the ‘objective social situation in which the new
theory was produced’. The second important factor encompasses the ‘internal
scientific characteristics of the new theory’. We would argue that these factors
can help in understanding the rapid propagation of new classical ideas,
both the MEBCT and the REBCT (see Snowdon and Vane, 1996).
Although an established orthodoxy, such as trend-reverting cycles, which
is in apparent contradiction to the ‘most salient facts of reality’ is the ‘most
helpful circumstance for the rapid propagation of a new and revolutionary
theory’, Johnson also identified five internal scientific characteristics which
in his view were crucial because it was these aspects of the new theory which
appealed to the younger generation of economists. In summary, the five main
characteristics Johnson identified involved:
1. ‘a central attack, on theoretically persuasive grounds, on the central
proposition of the orthodoxy of the time’;
2. ‘the production of an apparently new theory that nevertheless absorbed
all that was valid in the existing theory’;
3. a new theory having an ‘appropriate degree of difficulty to understand’
that would ‘challenge the intellectual interest of younger colleagues and
students’;
4. ‘a new more appealing methodology’ than that prevailing;
5. ‘the advancement of a new and important empirical relationship suitable
for determined estimation’ by econometricians.
To what extent have these five internal scientific characteristics played an
important role in explaining the success of new classical macroeconomics, in
particular the REBCT?
The first characteristic (that is, an attack on a central proposition of the
established orthodoxy) can be straightforwardly identified in REBCT. Before
1980 the established consensus regarded business cycles as socially undesirable.
In sharp contrast, the main policy implication of real business cycle
theory is that because the existence of fluctuations in aggregate output does
not imply the failure of markets to clear, the government should refrain from
any attempt to reduce such fluctuations not only because such policies are
unlikely to achieve their desired objective, but also because reducing instability
would reduce welfare!
The application of Johnson’s second internal characteristic (that is, the
ability of a new theory to absorb as much as possible of the valid components
of the existing orthodox theory) can also be applied to REBCT, which has
pioneered the use of the orthodox neoclassical growth model as a framework
for the quantitative analysis of aggregate fluctuations as well as absorbing
much of the methodology advocated by Lucas in the 1970s.
Johnson’s third characteristic (that is, an intellectually challenging new
theory with appeal to the younger generation of economists) is one that again
can be readily applied to REBCT. There is no question that the new classical
revolution pushed macroeconomic theory into new, more abstract directions
involving the introduction of techniques not found in the ‘kit bags of the
older economists’ (Blinder, 1988b). Being better trained mathematically, the
younger generation has been able to absorb the new techniques, such as
calibration, giving them a ‘heavy competitive edge’ over the ‘older’ economists.
Turning to the fourth characteristic (that is, a new methodology), the
REBCT programme has wholeheartedly embraced a methodological framework
involving a formal general equilibrium approach. Responding to the
‘Lucas critique’ has fostered an emphasis on a return to first principles in the
quest to establish sound microfoundations for general equilibrium macroeconomic
models. Since real business cycle methodology is in principle
ideologically neutral, it has the capability of fostering models with enormous
diversity.
The fifth characteristic (concerning a ‘new and important empirical relationship’
for estimation) is more difficult to apply to REBCT developments.
Rather than attempting to provide models capable of conventional econometric
testing, real business cycle theorists have instead developed the ‘calibration
method’ in which the simulated results of their specific models (when hit by
random shocks) in terms of key macroeconomic variables are compared with
the actual behaviour of the economy. Unfortunately calibration does not
provide a method that allows one to judge between the performance of real
and other (for example Keynesian) business cycle models.
From the above discussion it should be evident that while Johnson put
forward five main ‘internal’ characteristics to help explain the success of the
Keynesian revolution and monetarist counter-revolution, the first four of these
same characteristics also help in understanding why REBCT has made such
an important impact on the development of macroeconomics since the early
1980s. In assessing whether or not REBCT has constituted a ‘fashion’ or a
‘revolution’ in macroeconomics, Kirschner and Rhee (1996) conclude from
their statistical analysis of the spread of scientific research that data on
publications and researchers in the REBCT field exhibit ‘mini-revolution’
characteristics.
A distinguishing feature of the early REBCT is the downplaying of monetary
influences as a major cause of business cycles. Instead random shocks
to technology play the major role in creating disturbances, and the desire of
economic agents for consumption smoothing and ‘time to build’ constraints
acts as a major propagation mechanism leading to persistence. While the
early REBCT models had too narrow a focus, more recent work has also
begun to add monetary and financial variables into the model, as well as to
extend this line of research to include government and open economy influences
(see Mendoza, 1991; Backus et al., 1992; Hess and Shin, 1997). Going
further and adding market imperfections to REBCT will provide a bridge
between new classical and new Keynesian approaches to business cycle research
(Wickens, 1995). We should also note that the real business cycle
approach has furthered the cause of those economists who insist that macro
models need to be based on a firmer microeconomic base. This in turn has
strengthened the general move to improve our understanding of the supply
side. If anyone seriously questioned it before, no one now doubts that macroeconomics
is about demand and supply and their interaction. As Blinder
(1987b) notes, ‘events in the 1970s and 1980s demonstrated to Keynesian
and new classical economists alike that Marshall’s celebrated scissors also
come in a giant economy size’.
While recognizing the achievements of the real business research programme,
the critics remain convinced that this approach has serious
deficiencies. A majority of economists believe that the short-run aggregate
demand disturbances that arise from monetary policy can have significant
real effects because of the nominal price and wage rigidities which characterize
actual economies (see Chapter 7). This important line of criticism
challenges the new classical assumption that markets continuously clear,
even in a recession. If markets do not clear quickly and the world is characterized
by both aggregate demand and aggregate supply disturbances, the
actual fluctuations that we observe will consist of a stochastic trend around
which output deviates as the result of demand shocks. This view is well
represented by Blanchard and Quah (1989) where they ‘interpret fluctuations
in GNP and unemployment as due to two types of disturbances: disturbances
that have a permanent effect on output and disturbances that do not. We
interpret the first as supply disturbances, the second as demand disturbances.’
Clearly the role of stabilization policy in such a world is immensely complicated,
even if we accept that demand disturbances are important. How, for
example, can a government make the requisite distinction between demand
and supply shocks, especially when such shocks are not independent but
interdependent? (see Friedman, 1992).
Further support for keeping an open mind on the causes of aggregate
instability is provided by G.M. Caporale (1993). In an investigation of business
cycles in the UK, France, Finland, Italy, Norway, Sweden and West
Germany, Caporale found that that neither demand nor supply shocks alone
could account for economic fluctuations. Recent empirical research by Temin
(1998) also finds a variety of causes responsible for US business cycles.
Temin suggests a four-way classification of the causes of US business cycles
over the twentieth century, namely Domestic Real, Domestic Monetary, Foreign
Real and Foreign Monetary. According to Temin’s data it appears that
domestic causes far outweigh foreign shocks (16.5 v. 7.5), and real disturbances
dominate monetary disturbances (13.5 v. 10.5). The real domestic
shocks are diverse and include all manner of real demand disturbance. Temin
concludes that ‘all four types of shock have acted as a source of the American
business cycle’ and the dominant conclusion of his enquiry is that ‘the sources
of instability are not homogeneous’. In his study of large recessions in the
twentieth century, Dow (1998) discusses three major findings. First, major
recessions and growth slowdowns are mainly due to aggregate demand shocks.
Second, these demand shocks can be identified, for example, the 1979–82
recession in the UK was largely the result of a decline in exports brought
about by an appreciation of the exchange rate in response to the new monetary
and fiscal regime under Prime Minister Margaret Thatcher. Third,
recessions are not predictable given economists’ present state of knowledge.
A balanced conclusion from the above discussion would seem to point
towards the advantage of taking an eclectic approach when analysing the
causes of business cycles. There is no evidence that the business cycle is dead
or that governments now have the ability and knowledge to offset the various
shocks that buffet every economy. While governments can never hope to
eliminate the business cycle, they should have the knowledge and capacity to
avert another Great Depression or Great Inflation.
In a recent assessment of the contribution of REBCT to twentieth-century
macroeconomics (see Snowdon, 2004a), Axel Leijonhufvud commented:
I think the legacy of Ed Prescott’s work will be in terms of the analytical machinery
available to technically minded economists, although those techniques are not
always appropriate and you cannot always apply them. In particular, you cannot
meaningfully run these dynamic stochastic general equilibrium models across the
great catastrophes of history and hope for enlightenment.
Even taking into account these important deficiencies, there is no doubt that
the REBCT research programme has been ‘extremely influential’ and current
The real business cycle school 343
work in the field is ‘a far cry’ from the initial representative agent competitive
(and unique) equilibrium model constructed by Kydland and Prescott in the
early 1980s (Williamson, 1996). However, while noting that new and controversial
ideas are often the most fruitful, even when false, Hartley et al. (1998)
conclude that ‘real business cycle models are bold conjectures in the Popperian
mould and that, on the preponderance of the evidence, they are refuted’.
However, for those economists who reject the real business cycle view that
stabilization policy has no role to play, there remains the theoretical difficulty
of explaining in a coherent way why markets fail to clear.
Beginning in the late 1970s, and continuing thereafter, many economists
have taken up this challenge of attempting to explain why the adjustment of
prices and wages in many markets is sluggish. ‘The rationality of rigidities’
theme is a major feature of the research of new Keynesian economists and it
is to this work that we turn in the next chapter.
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