Real Business Cycle Theory and the Stylized Facts
The rapidly expanding business cycle literature during the 1980s provoked
considerable controversy and discussion with respect to the ability of different
macroeconomic models to explain the ‘stylized facts’. As Danthine and
Donaldson (1993) point out, the real business cycle programme ‘has forced
theorists to recognise how incomplete our knowledge of business cycle phenomena
actually was’, and a major achievement of this literature has been to
‘free us to reconsider what we know about the business cycle’. Research in
this area has called into question much of the conventional wisdom with
respect to what are the established stylized facts. Controversy also exists over
which model of the business cycle best explains the agreed stylized facts. For
a detailed discussion of this debate, the reader is referred to Greenwald and
Stiglitz (1988), Kydland and Prescott (1990), Hoover (1991), Blackburn and
Ravn (1992), Smith (1992), Zarnowitz (1992b), Danthine and Donaldson
(1993); Judd and Trehan (1995); Ryan and Mullineux (1997); and Ryan
(2002). Here we will briefly discuss the controversy relating to the cyclical
behaviour of real wages and prices.
In both orthodox Keynesian and monetarist macroeconomic theories where
aggregate demand disturbances drive the business cycle, the real wage is
predicted to be countercyclical. In Keynes’s General Theory (1936, p. 17) an
expansion of employment is associated with a decline in the real wage and
the Keynesian models of the neoclassical synthesis era also assume that the
economy is operating along the aggregate labour demand curve, so that the
real wage must vary countercyclically.
Referring back to Figure 2.6 panel (b) in Chapter 2, we can see that for a
given money wage W0 the real wage must vary countercyclically as aggregate
demand declines and the economy moves into a recession. The fall in aggregate
demand is illustrated by a shift of the AD curve from AD0 to AD1. If
prices are flexible but nominal wages are rigid, the economy moves from e0
to e1 in panel (b). With a fall in the price level to P1, and nominal wages
remaining at W0, the real wage increases to W0/P1 in panel (a) of Figure 2.6.
At this real wage the supply of labour (Ld) exceeds the demand for labour (Lc)
and involuntary unemployment of cd emerges. With the money wage fixed, a
falling price level implies a countercyclical real wage.
The theories associated with Friedman’s monetarism, as well as some early
new classical and new Keynesian models, also incorporate features which
imply a countercyclical real wage (see Fischer, 1977; Phelps and Taylor,
1977). In Gordon’s (1993) view, apart from the big oil shocks of the 1970s,
there is no systematic movement of real wages but, if anything, ‘there is
slight tendency of prices to rise more than wages in booms, implying counter-
cyclical real wages’. However, Kydland and Prescott (1990) find that the
real wage behaves in a ‘reasonably strong’ procyclical manner, a finding that
is consistent with shifts of the production function. The current consensus is
that the real wage is mildly procyclical, and this poses problems for both
traditional monetary explanations of the business cycle and real business
cycle theory (see Fischer, 1988; Brandolini, 1995; Abraham and Haltiwanger,
1995; Snowdon and Vane, 1995). If the real wage is moderately procyclical,
then shocks to the production function can significantly influence employment
only if the labour supply curve is highly elastic (see panel (b) of Figure
6.3). However, the empirical evidence does not offer strong support for the
significant intertemporal substitution required for real business cycles to
mimic the large variations in employment which characterize business cycles
(see Mankiw et al., 1985; Altonji, 1986; Nickell, 1990).
While the behaviour of the real wage over the cycle has been controversial
ever since Dunlop (1938) and Tarshis (1939) debated this issue with Keynes
(1939a), the assumption that prices (and inflation) are generally procyclical
was accepted by economists of varying persuasions. The procyclical behaviour
of prices is a fundamental feature of Keynesian, monetarist and the
monetary misperception version of new classical models (Lucas, 1977).
Mankiw (1989) has argued that, in the absence of recognizable supply shocks,
such as the OPEC oil price rises in the 1970s, the procyclical behaviour of the
inflation rate is a ‘well documented fact’. Lucas (1977, 1981a) also lists the
procyclical nature of prices and inflation as a basic stylized fact. In sharp
contrast to these views, Kydland and Prescott (1990) show that, in the USA
during the period 1954–89, ‘the price level has displayed a clear countercyclical
pattern’. This leads them to the following controversial conclusion:
‘We caution that any theory in which procyclical prices figure crucially in
accounting for postwar business cycle fluctuations is doomed to failure.’ This
conclusion is supported by Cooley and Ohanian (1991) and also in a study of
UK data by Blackburn and Ravn (1992), who describe the conventional
wisdom with respect to the procyclical behaviour of the price level as ‘a
fiction’. In their view the traditional presumption that prices are procyclical is
overwhelmingly contradicted by the evidence and they interpret their findings
as posing a ‘serious challenge’ for monetary explanations of the business
cycle. The evidence presented by Backus and Kehoe (1992), Smith (1992)
and Ravn and Sola (1995) is also supportive of the real business cycle view.
(For a defence of the conventional view, see Chadha and Prasad, 1993.)
To see why evidence of a countercyclical price level is supportive of real
business cycle models, consider Figure 6.10. Here we utilize the conventional
aggregate demand and supply framework with the price level on the vertical
axis. Because prices and wages are perfectly flexible, the aggregate supply
curve (AS) is completely inelastic with respect to the price level (although it
will shift to the right if technology improves or the real rate of interest
increases, leading to an increase in labour supply and employment; see Jansen
et al., 1994). The economy is initially operating at the intersection of AD and
AS0. If the economy is hit by a negative supply shock which shifts the AS
curve from AS0 to AS2, the equilibrium level of output falls from Y0 to Y2 for a
given money supply. Aggregate demand and supply are brought into equilibrium
by a rise in the price level from P0 to P2. A favourable supply shock
which shifts the AS curve from AS0 to AS1 will lead to a fall in the price level
for a given money supply. The equilibrium positions a, b and c indicate that
the price level will be countercyclical if real disturbances cause an aggregate
supply curve to shift along a given aggregate demand curve. Referring back
to panel (b) of Figure (2.6), it is clear that fluctuations brought about by shifts
of the aggregate demand curve generate observations of a procyclical price
level. Keynesians argue that the countercyclical behaviour of the price level
following the clearly observable oil shocks of the 1970s does not present a
problem for the conventional aggregate demand and supply model and that
such effects had already been incorporated into their models by 1975 (see
Gordon, 1975; Phelps, 1978; Blinder, 1988b). What Keynesians object to is
the suggestion that the business cycle is predominantly caused by supply
shocks. The consensus view that prices are sometimes procyclical and sometimes
countercyclical indicates to an eclectic observer that both demand and
supply shocks are important in different periods. Judd and Trehan (1995) also
show that this debate is further complicated by the fact that the observed
correlations between prices and output in response to various shocks reflect
complex dynamic responses, and it is ‘not difficult to find plausible patterns
that associate either a demand or a supply shock with either negative or
positive correlations’.
The rapidly expanding business cycle literature during the 1980s provoked
considerable controversy and discussion with respect to the ability of different
macroeconomic models to explain the ‘stylized facts’. As Danthine and
Donaldson (1993) point out, the real business cycle programme ‘has forced
theorists to recognise how incomplete our knowledge of business cycle phenomena
actually was’, and a major achievement of this literature has been to
‘free us to reconsider what we know about the business cycle’. Research in
this area has called into question much of the conventional wisdom with
respect to what are the established stylized facts. Controversy also exists over
which model of the business cycle best explains the agreed stylized facts. For
a detailed discussion of this debate, the reader is referred to Greenwald and
Stiglitz (1988), Kydland and Prescott (1990), Hoover (1991), Blackburn and
Ravn (1992), Smith (1992), Zarnowitz (1992b), Danthine and Donaldson
(1993); Judd and Trehan (1995); Ryan and Mullineux (1997); and Ryan
(2002). Here we will briefly discuss the controversy relating to the cyclical
behaviour of real wages and prices.
In both orthodox Keynesian and monetarist macroeconomic theories where
aggregate demand disturbances drive the business cycle, the real wage is
predicted to be countercyclical. In Keynes’s General Theory (1936, p. 17) an
expansion of employment is associated with a decline in the real wage and
the Keynesian models of the neoclassical synthesis era also assume that the
economy is operating along the aggregate labour demand curve, so that the
real wage must vary countercyclically.
Referring back to Figure 2.6 panel (b) in Chapter 2, we can see that for a
given money wage W0 the real wage must vary countercyclically as aggregate
demand declines and the economy moves into a recession. The fall in aggregate
demand is illustrated by a shift of the AD curve from AD0 to AD1. If
prices are flexible but nominal wages are rigid, the economy moves from e0
to e1 in panel (b). With a fall in the price level to P1, and nominal wages
remaining at W0, the real wage increases to W0/P1 in panel (a) of Figure 2.6.
At this real wage the supply of labour (Ld) exceeds the demand for labour (Lc)
and involuntary unemployment of cd emerges. With the money wage fixed, a
falling price level implies a countercyclical real wage.
The theories associated with Friedman’s monetarism, as well as some early
new classical and new Keynesian models, also incorporate features which
imply a countercyclical real wage (see Fischer, 1977; Phelps and Taylor,
1977). In Gordon’s (1993) view, apart from the big oil shocks of the 1970s,
there is no systematic movement of real wages but, if anything, ‘there is
slight tendency of prices to rise more than wages in booms, implying counter-
cyclical real wages’. However, Kydland and Prescott (1990) find that the
real wage behaves in a ‘reasonably strong’ procyclical manner, a finding that
is consistent with shifts of the production function. The current consensus is
that the real wage is mildly procyclical, and this poses problems for both
traditional monetary explanations of the business cycle and real business
cycle theory (see Fischer, 1988; Brandolini, 1995; Abraham and Haltiwanger,
1995; Snowdon and Vane, 1995). If the real wage is moderately procyclical,
then shocks to the production function can significantly influence employment
only if the labour supply curve is highly elastic (see panel (b) of Figure
6.3). However, the empirical evidence does not offer strong support for the
significant intertemporal substitution required for real business cycles to
mimic the large variations in employment which characterize business cycles
(see Mankiw et al., 1985; Altonji, 1986; Nickell, 1990).
While the behaviour of the real wage over the cycle has been controversial
ever since Dunlop (1938) and Tarshis (1939) debated this issue with Keynes
(1939a), the assumption that prices (and inflation) are generally procyclical
was accepted by economists of varying persuasions. The procyclical behaviour
of prices is a fundamental feature of Keynesian, monetarist and the
monetary misperception version of new classical models (Lucas, 1977).
Mankiw (1989) has argued that, in the absence of recognizable supply shocks,
such as the OPEC oil price rises in the 1970s, the procyclical behaviour of the
inflation rate is a ‘well documented fact’. Lucas (1977, 1981a) also lists the
procyclical nature of prices and inflation as a basic stylized fact. In sharp
contrast to these views, Kydland and Prescott (1990) show that, in the USA
during the period 1954–89, ‘the price level has displayed a clear countercyclical
pattern’. This leads them to the following controversial conclusion:
‘We caution that any theory in which procyclical prices figure crucially in
accounting for postwar business cycle fluctuations is doomed to failure.’ This
conclusion is supported by Cooley and Ohanian (1991) and also in a study of
UK data by Blackburn and Ravn (1992), who describe the conventional
wisdom with respect to the procyclical behaviour of the price level as ‘a
fiction’. In their view the traditional presumption that prices are procyclical is
overwhelmingly contradicted by the evidence and they interpret their findings
as posing a ‘serious challenge’ for monetary explanations of the business
cycle. The evidence presented by Backus and Kehoe (1992), Smith (1992)
and Ravn and Sola (1995) is also supportive of the real business cycle view.
(For a defence of the conventional view, see Chadha and Prasad, 1993.)
To see why evidence of a countercyclical price level is supportive of real
business cycle models, consider Figure 6.10. Here we utilize the conventional
aggregate demand and supply framework with the price level on the vertical
axis. Because prices and wages are perfectly flexible, the aggregate supply
curve (AS) is completely inelastic with respect to the price level (although it
will shift to the right if technology improves or the real rate of interest
increases, leading to an increase in labour supply and employment; see Jansen
et al., 1994). The economy is initially operating at the intersection of AD and
AS0. If the economy is hit by a negative supply shock which shifts the AS
curve from AS0 to AS2, the equilibrium level of output falls from Y0 to Y2 for a
given money supply. Aggregate demand and supply are brought into equilibrium
by a rise in the price level from P0 to P2. A favourable supply shock
which shifts the AS curve from AS0 to AS1 will lead to a fall in the price level
for a given money supply. The equilibrium positions a, b and c indicate that
the price level will be countercyclical if real disturbances cause an aggregate
supply curve to shift along a given aggregate demand curve. Referring back
to panel (b) of Figure (2.6), it is clear that fluctuations brought about by shifts
of the aggregate demand curve generate observations of a procyclical price
level. Keynesians argue that the countercyclical behaviour of the price level
following the clearly observable oil shocks of the 1970s does not present a
problem for the conventional aggregate demand and supply model and that
such effects had already been incorporated into their models by 1975 (see
Gordon, 1975; Phelps, 1978; Blinder, 1988b). What Keynesians object to is
the suggestion that the business cycle is predominantly caused by supply
shocks. The consensus view that prices are sometimes procyclical and sometimes
countercyclical indicates to an eclectic observer that both demand and
supply shocks are important in different periods. Judd and Trehan (1995) also
show that this debate is further complicated by the fact that the observed
correlations between prices and output in response to various shocks reflect
complex dynamic responses, and it is ‘not difficult to find plausible patterns
that associate either a demand or a supply shock with either negative or
positive correlations’.
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