Real Business Cycle Theory
The modern new classical research programme starts from the position that
‘growth and fluctuations are not distinct phenomena to be studied with separate
data and different analytical tools’ (Cooley, 1995). The REBCT research programme
was initiated by Kydland and Prescott (1982), who in effect took up
the challenge posed by Lucas (1980a) to build an artificial imitation economy
capable of imitating the main features of actual economies. The artificial
economy consists of optimizing agents acting in a frictionless perfectly competitive
environment that is subject to repeated shocks to productivity. Although
the second phase of new classical macroeconomics has switched emphasis
away from monetary explanations of the business cycle, the more recently
developed equilibrium models have retained and refined the other new classical
building blocks.
Following Frisch (1933) and Lucas (1975, 1977), real business cycle theorists
distinguish between impulse and propagation mechanisms. An impulse
mechanism is the initial shock which causes a variable to deviate from its
steady state value. A propagation mechanism consists of those forces which
carry the effects of the shock forward through time and cause the deviation
from the steady state to persist. The more recent brand of new classical
equilibrium theories have the following general features (Stadler, 1994):
1. REBCT utilizes a representative agent framework where the agent/household/
firm aims to maximize their utility or profits, subject to prevailing
resource constraints.
2. Agents form expectations rationally and do not suffer informational
asymmetries. While expected prices are equal to actual prices, agents
may still face a signal extraction problem in deciding whether or not a
particular productivity shock is temporary or permanent.
3. Price flexibility ensures continuous market clearing so that equilibrium
always prevails. There are no frictions or transaction costs.
4. Fluctuations in aggregate output and employment are driven by large
random changes in the available production technology. Exogenous shocks
to technology act as the impulse mechanism in these models.
5. A variety of propagation mechanisms carry forward the impact of the
initial impulse. These include the effect of consumption smoothing, lags
in the investment process (‘time to build’), and intertemporal labour
substitution.
6. Fluctuations in employment reflect voluntary changes in the number of
hours people choose to work. Work and leisure are assumed to be highly
substitutable over time.
7. Monetary policy is irrelevant, having no influence on real variables, that
is, money is neutral.
8. The distinction between the short run and the long run in the analysis of
economic fluctuations and trends is abandoned.
It can be seen from the above that the major changes from MEBCT are with
respect to: (i) the dominant impulse factor, with technological shocks replacing
monetary shocks; (ii) the abandonment of the emphasis given to imperfect
information as regards the general price level which played such a crucial
role in the earlier monetary misperception models inspired by Lucas; and (iii)
the breaking down of the short-run/long-run dichotomy in macroeconomic
analysis by integrating the theory of growth with the theory of fluctuations.
The lack of clear supporting evidence from econometric work on the causal
role of money in economic fluctuations was generally interpreted as providing
a strong case for shifting the direction of research towards models where
real forces play a crucial role. As we have already seen, this case was further
strengthened by the findings of Nelson and Plosser (1982) that most macroeconomic
time series are better described as a random walk, rather than as
fluctuations or deviations from deterministic trends. Real business cycle theorists
also claim that their theories provide a better explanation of the ‘stylized
facts’ which characterize aggregate fluctuations. Indeed, they have challenged
much of the conventional wisdom with respect to what are the stylized facts
(see section 6.14 below).
The modern new classical research programme starts from the position that
‘growth and fluctuations are not distinct phenomena to be studied with separate
data and different analytical tools’ (Cooley, 1995). The REBCT research programme
was initiated by Kydland and Prescott (1982), who in effect took up
the challenge posed by Lucas (1980a) to build an artificial imitation economy
capable of imitating the main features of actual economies. The artificial
economy consists of optimizing agents acting in a frictionless perfectly competitive
environment that is subject to repeated shocks to productivity. Although
the second phase of new classical macroeconomics has switched emphasis
away from monetary explanations of the business cycle, the more recently
developed equilibrium models have retained and refined the other new classical
building blocks.
Following Frisch (1933) and Lucas (1975, 1977), real business cycle theorists
distinguish between impulse and propagation mechanisms. An impulse
mechanism is the initial shock which causes a variable to deviate from its
steady state value. A propagation mechanism consists of those forces which
carry the effects of the shock forward through time and cause the deviation
from the steady state to persist. The more recent brand of new classical
equilibrium theories have the following general features (Stadler, 1994):
1. REBCT utilizes a representative agent framework where the agent/household/
firm aims to maximize their utility or profits, subject to prevailing
resource constraints.
2. Agents form expectations rationally and do not suffer informational
asymmetries. While expected prices are equal to actual prices, agents
may still face a signal extraction problem in deciding whether or not a
particular productivity shock is temporary or permanent.
3. Price flexibility ensures continuous market clearing so that equilibrium
always prevails. There are no frictions or transaction costs.
4. Fluctuations in aggregate output and employment are driven by large
random changes in the available production technology. Exogenous shocks
to technology act as the impulse mechanism in these models.
5. A variety of propagation mechanisms carry forward the impact of the
initial impulse. These include the effect of consumption smoothing, lags
in the investment process (‘time to build’), and intertemporal labour
substitution.
6. Fluctuations in employment reflect voluntary changes in the number of
hours people choose to work. Work and leisure are assumed to be highly
substitutable over time.
7. Monetary policy is irrelevant, having no influence on real variables, that
is, money is neutral.
8. The distinction between the short run and the long run in the analysis of
economic fluctuations and trends is abandoned.
It can be seen from the above that the major changes from MEBCT are with
respect to: (i) the dominant impulse factor, with technological shocks replacing
monetary shocks; (ii) the abandonment of the emphasis given to imperfect
information as regards the general price level which played such a crucial
role in the earlier monetary misperception models inspired by Lucas; and (iii)
the breaking down of the short-run/long-run dichotomy in macroeconomic
analysis by integrating the theory of growth with the theory of fluctuations.
The lack of clear supporting evidence from econometric work on the causal
role of money in economic fluctuations was generally interpreted as providing
a strong case for shifting the direction of research towards models where
real forces play a crucial role. As we have already seen, this case was further
strengthened by the findings of Nelson and Plosser (1982) that most macroeconomic
time series are better described as a random walk, rather than as
fluctuations or deviations from deterministic trends. Real business cycle theorists
also claim that their theories provide a better explanation of the ‘stylized
facts’ which characterize aggregate fluctuations. Indeed, they have challenged
much of the conventional wisdom with respect to what are the stylized facts
(see section 6.14 below).
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