Real Business Cycle Theory in Historical Perspective
Real business cycle theory, as developed by its modern proponents, is built on
the assumption that there are large random fluctuations in the rate of technological
progress. These supply-side shocks to the production function generate
fluctuations in aggregate output and employment as rational individuals respond
to the altered structure of relative prices by changing their labour
supply and consumption decisions. While this development is in large part a
response to the demise of the earlier monetary misperception models and
Lucas’s call to construct ‘artificial economies’, it also represents a general
revival of interest in the supply side of the macro equation.
The idea that business cycles might be driven by real rather than monetary
forces is certainly not an entirely new idea. The real business cycle models
inspired by Kydland and Prescott’s (1982) seminal paper belong to a long
line of analysis which was prominent in the literature before Keynes’s (1936)
General Theory (see Haberler, 1963, for a superb survey of the interwar
business cycle literature). Whereas some economists such as Ralph Hawtrey
held to the extreme monetary interpretation of the business cycle, the work of
others, in particular Dennis Robertson, Joseph Schumpeter and Knut Wicksell,
emphasized real forces as the engine behind business fluctuations (see
Deutscher, 1990; Goodhart and Presley, 1991; T. Caporale, 1993). While the
work of Robertson was not as dismissive of monetary forces as modern real
business cycle theory, according to Goodhart and Presley there is a great deal
of similarity between the emphasis given by Robertson to technological
change and the recent work of the equilibrium theorists. Technological change
also played a pivotal role in Joseph Schumpeter’s analysis of the short-run
instability and long-run dynamics of capitalist development. Since the introduction
of new technology influences the long-run growth of productivity as
well as causing short-run disequilibrating effects, Schumpeter, like modern
real business cycle theorists, viewed cycles and growth as inseparably interrelated
(see Schumpeter, 1939). Caporale (1993) argues that Knut Wicksell
was also an early expositor of real business cycle theory. Caporale shows that
Wicksell attributed ‘trade cycles to real causes independent of movements in
commodity prices’. To Wicksell the main cause of the trade cycle is a supplyside
shock that raises the natural rate of interest above the loan rate of
interest. This is equivalent to a reduction in the loan rate of interest since the
banking system will typically fail to adjust the loan rate immediately to
reflect the new natural rate. Loan market disequilibrium acting as a propagation
mechanism leads to endogenous money creation by the banking system
in response to entrepreneurs’ demand for loans to finance investment. The
investment boom, by distorting the time structure of production, thereby
creates inflationary pressures. Eventually the money rate of interest catches
up with the natural rate and the boom comes to an end. While this story had a
major influence on later Swedish and Austrian monetary theories of the trade
cycle, Caporale highlights how the Wicksell trade cycle story begins with a
real shock to the marginal product of capital. Wicksell’s real shocks plus
endogenous money account of the trade cycle is therefore remarkably similar
to the modern versions of REBCT provided by, for example, King and
Plosser (1984); see below, section 6.12.
Following the publication of Keynes’s (1936) General Theory, models of
the business cycle were constructed which emphasized the interaction of the
multiplier–accelerator mechanism (Samuelson, 1939; Hicks, 1950; Trigg,
2002). These models were also ‘real’ in that they viewed fluctuations as being
driven by real aggregate demand, mainly unstable investment expenditures,
with monetary factors downgraded and supply-side phenomena providing the
constraints which give rise to business cycle turning points (see Laidler,
1992a). Whatever their merits, multiplier–accelerator models ceased to be a
focus of active research by the early 1960s. To a large extent this reflected the
impact of the Keynesian revolution, which shifted the focus of macroeconomic
analysis away from business cycle phenomena to the development of
methods and policies which could improve macroeconomic performance.
Such was the confidence of some economists that the business cycle was no
longer a major problem that by 1969 some were even considering the question:
‘Is the Business Cycle Obsolete?’ (Bronfenbrenner, 1969). Similar
conjectures about ‘The End of the Business Cycle’ appeared during the late
1990s, often framed in terms of discussions of the ‘new economy’; see, for
example, Weber (1997). We have already seen that during the 1970s and
1980s the business cycle returned with a vengeance (relative to the norm for
instability post 1945) and how dissatisfaction with Keynesian models led to
monetarist and new classical counter-revolutions.
The most recent developments in business cycle research inspired by equilibrium
theorists during the 1980s have proved to be a challenge to all the
earlier models relying on aggregate demand fluctuations as the main source
of instability. Hence real business cycle theory is not only a competitor to the
‘old’ Keynesian macroeconomics of the neoclassical synthesis period but also
represents a serious challenge to all monetarist and early MEBCT new classical
models.
In addition to the above influences, the transition from monetary to real
theories of the business cycle was further stimulated by two other important
developments. First, the supply shocks associated with the two OPEC oil price
increases during the 1970s made macroeconomists more aware of the importance
of supply-side factors in explaining macroeconomic instability (Blinder,
1979). These events, together with the apparent failure of the demand-oriented
Keynesian model to account adequately for rising unemployment accompanied
by accelerating inflation, forced all macroeconomists to devote increasing research
effort to the construction of macroeconomic theories where the supply
side has coherent microfoundations (see Chapter 7). Second, the seminal work
of Nelson and Plosser (1982) suggested that real shocks may be far more
important than monetary shocks in explaining the path of aggregate output over
time. Nelson and Plosser argue that the evidence is consistent with the proposition
that output follows a path, which could best be described as a ‘random
walk’.
Before examining the contribution of Nelson and Plosser in more detail it
is important to note that the desire of both Keynesian and new classical
economists to build better microfoundations for the supply side of their
models should not be confused with the emergence during the late 1970s and
1980s of a distinctive ‘supply-side school’ of economists, particularly in the
USA during the presidency of Ronald Reagan. Writing in the mid-1980s,
Feldstein distinguished between ‘traditional supply-siders’ and the ‘new supply-
side economics’ (Feldstein, 1986). Traditional supply-siders base their
analysis on mainstream neoclassical economic analysis and emphasize the
efficiency of markets, the importance of incentives for economic growth, and
the possibility of government failure. A large consensus of economists would
subscribe to this form of supply-side economics, including Keynesians, monetarists
and new classicists (see Friedman, 1968a; Tobin, 1987; Lucas, 1990a).
In contrast, the new supply-siders, such as Arthur Laffer, Jude Wanniski and
President Reagan himself, made ‘extravagant claims’ relating to the impact of
tax cuts and deregulation on the rate of economic growth. While supplysiders
claimed that the incentive effects of the Reagan tax cuts were responsible
for the US recovery after 1982, Tobin (1987) argued that Reagan’s policies
amounted to ‘Keynesian medicine, demand tonics masquerading as supplyside
nostrums, serendipitously administered by anti-Keynesian doctors’. For
discussions of ‘Reaganomics’ and the influence of ‘new supply-siders’ during
the 1980s see Samuelson (1984); Blanchard (1986); Feldstein (1986); Levacic
(1988); Modigliani (1988b); Roberts (1989); and Minford (1991).
Real business cycle theory, as developed by its modern proponents, is built on
the assumption that there are large random fluctuations in the rate of technological
progress. These supply-side shocks to the production function generate
fluctuations in aggregate output and employment as rational individuals respond
to the altered structure of relative prices by changing their labour
supply and consumption decisions. While this development is in large part a
response to the demise of the earlier monetary misperception models and
Lucas’s call to construct ‘artificial economies’, it also represents a general
revival of interest in the supply side of the macro equation.
The idea that business cycles might be driven by real rather than monetary
forces is certainly not an entirely new idea. The real business cycle models
inspired by Kydland and Prescott’s (1982) seminal paper belong to a long
line of analysis which was prominent in the literature before Keynes’s (1936)
General Theory (see Haberler, 1963, for a superb survey of the interwar
business cycle literature). Whereas some economists such as Ralph Hawtrey
held to the extreme monetary interpretation of the business cycle, the work of
others, in particular Dennis Robertson, Joseph Schumpeter and Knut Wicksell,
emphasized real forces as the engine behind business fluctuations (see
Deutscher, 1990; Goodhart and Presley, 1991; T. Caporale, 1993). While the
work of Robertson was not as dismissive of monetary forces as modern real
business cycle theory, according to Goodhart and Presley there is a great deal
of similarity between the emphasis given by Robertson to technological
change and the recent work of the equilibrium theorists. Technological change
also played a pivotal role in Joseph Schumpeter’s analysis of the short-run
instability and long-run dynamics of capitalist development. Since the introduction
of new technology influences the long-run growth of productivity as
well as causing short-run disequilibrating effects, Schumpeter, like modern
real business cycle theorists, viewed cycles and growth as inseparably interrelated
(see Schumpeter, 1939). Caporale (1993) argues that Knut Wicksell
was also an early expositor of real business cycle theory. Caporale shows that
Wicksell attributed ‘trade cycles to real causes independent of movements in
commodity prices’. To Wicksell the main cause of the trade cycle is a supplyside
shock that raises the natural rate of interest above the loan rate of
interest. This is equivalent to a reduction in the loan rate of interest since the
banking system will typically fail to adjust the loan rate immediately to
reflect the new natural rate. Loan market disequilibrium acting as a propagation
mechanism leads to endogenous money creation by the banking system
in response to entrepreneurs’ demand for loans to finance investment. The
investment boom, by distorting the time structure of production, thereby
creates inflationary pressures. Eventually the money rate of interest catches
up with the natural rate and the boom comes to an end. While this story had a
major influence on later Swedish and Austrian monetary theories of the trade
cycle, Caporale highlights how the Wicksell trade cycle story begins with a
real shock to the marginal product of capital. Wicksell’s real shocks plus
endogenous money account of the trade cycle is therefore remarkably similar
to the modern versions of REBCT provided by, for example, King and
Plosser (1984); see below, section 6.12.
Following the publication of Keynes’s (1936) General Theory, models of
the business cycle were constructed which emphasized the interaction of the
multiplier–accelerator mechanism (Samuelson, 1939; Hicks, 1950; Trigg,
2002). These models were also ‘real’ in that they viewed fluctuations as being
driven by real aggregate demand, mainly unstable investment expenditures,
with monetary factors downgraded and supply-side phenomena providing the
constraints which give rise to business cycle turning points (see Laidler,
1992a). Whatever their merits, multiplier–accelerator models ceased to be a
focus of active research by the early 1960s. To a large extent this reflected the
impact of the Keynesian revolution, which shifted the focus of macroeconomic
analysis away from business cycle phenomena to the development of
methods and policies which could improve macroeconomic performance.
Such was the confidence of some economists that the business cycle was no
longer a major problem that by 1969 some were even considering the question:
‘Is the Business Cycle Obsolete?’ (Bronfenbrenner, 1969). Similar
conjectures about ‘The End of the Business Cycle’ appeared during the late
1990s, often framed in terms of discussions of the ‘new economy’; see, for
example, Weber (1997). We have already seen that during the 1970s and
1980s the business cycle returned with a vengeance (relative to the norm for
instability post 1945) and how dissatisfaction with Keynesian models led to
monetarist and new classical counter-revolutions.
The most recent developments in business cycle research inspired by equilibrium
theorists during the 1980s have proved to be a challenge to all the
earlier models relying on aggregate demand fluctuations as the main source
of instability. Hence real business cycle theory is not only a competitor to the
‘old’ Keynesian macroeconomics of the neoclassical synthesis period but also
represents a serious challenge to all monetarist and early MEBCT new classical
models.
In addition to the above influences, the transition from monetary to real
theories of the business cycle was further stimulated by two other important
developments. First, the supply shocks associated with the two OPEC oil price
increases during the 1970s made macroeconomists more aware of the importance
of supply-side factors in explaining macroeconomic instability (Blinder,
1979). These events, together with the apparent failure of the demand-oriented
Keynesian model to account adequately for rising unemployment accompanied
by accelerating inflation, forced all macroeconomists to devote increasing research
effort to the construction of macroeconomic theories where the supply
side has coherent microfoundations (see Chapter 7). Second, the seminal work
of Nelson and Plosser (1982) suggested that real shocks may be far more
important than monetary shocks in explaining the path of aggregate output over
time. Nelson and Plosser argue that the evidence is consistent with the proposition
that output follows a path, which could best be described as a ‘random
walk’.
Before examining the contribution of Nelson and Plosser in more detail it
is important to note that the desire of both Keynesian and new classical
economists to build better microfoundations for the supply side of their
models should not be confused with the emergence during the late 1970s and
1980s of a distinctive ‘supply-side school’ of economists, particularly in the
USA during the presidency of Ronald Reagan. Writing in the mid-1980s,
Feldstein distinguished between ‘traditional supply-siders’ and the ‘new supply-
side economics’ (Feldstein, 1986). Traditional supply-siders base their
analysis on mainstream neoclassical economic analysis and emphasize the
efficiency of markets, the importance of incentives for economic growth, and
the possibility of government failure. A large consensus of economists would
subscribe to this form of supply-side economics, including Keynesians, monetarists
and new classicists (see Friedman, 1968a; Tobin, 1987; Lucas, 1990a).
In contrast, the new supply-siders, such as Arthur Laffer, Jude Wanniski and
President Reagan himself, made ‘extravagant claims’ relating to the impact of
tax cuts and deregulation on the rate of economic growth. While supplysiders
claimed that the incentive effects of the Reagan tax cuts were responsible
for the US recovery after 1982, Tobin (1987) argued that Reagan’s policies
amounted to ‘Keynesian medicine, demand tonics masquerading as supplyside
nostrums, serendipitously administered by anti-Keynesian doctors’. For
discussions of ‘Reaganomics’ and the influence of ‘new supply-siders’ during
the 1980s see Samuelson (1984); Blanchard (1986); Feldstein (1986); Levacic
(1988); Modigliani (1988b); Roberts (1989); and Minford (1991).
No comments:
Post a Comment