Technology shocks
Although some versions of real business cycle theory allow for real demand
shocks, such as changes in preferences or government expenditures, to act as
the impulse mechanism, these models are more typically driven by exogenous
productivity shocks. These stochastic fluctuations in factor productivity
are the result of large random variations in the rate of technological change.
The conventional Solow neoclassical growth model postulates that the growth
of output per worker over prolonged periods depends on technological progress
which is assumed to take place smoothly over time. Real business cycle
theorists reject this view and emphasize the erratic nature of technological
change which they regard as the major cause of changes in aggregate output.
To see how aggregate output and employment vary in a real business cycle
model, consider Figure 6.3. Panel (a) of Figure 6.3 illustrates the impact of a
beneficial technology shock, which shifts the production function from Y to
Y*. The impact of this shift on the marginal product of labour and hence the
demand for labour is shown in panel (b). By increasing the demand for labour
a productivity shock raises employment as well as output. How much employment
expands will depend on the elasticity of labour supply with respect
to the current real wage. The ‘stylized facts’ of the business cycle indicate
that small procyclical variations in the real wage are associated with large
procyclical variations of employment. Thus a crucial requirement for real
business cycle theory to be consistent with these facts is for the labour supply
schedule to be highly elastic with respect to the real wage, as indicated in
panel (b) by SL2. In this case a technology shock will cause output to expand
from Y0 to Y2 with the real wage increasing from (W/P)a to (W/P)c, and
employment increasing from L0 to L2. If the labour supply schedule is relatively
inelastic, as shown by SL1, large variations of the real wage and small
changes in employment would result from a technology shock. However, this
does not fit the stylized facts.
It is clear that, in order for real business cycle theories to explain the
substantial variations in employment observed during aggregate fluctuations,
there must be significant intertemporal substitution of leisure. Since in these
models it is assumed that prices and wages are completely flexible, the labour
market is always in equilibrium. In such a framework workers choose unemployment
or employment in accordance with their preferences and the
opportunities that are available. To many economists, especially to those with
a Keynesian orientation, this explanation of labour market phenomena remains
unconvincing (Mankiw, 1989; Tobin, 1996).
Although some versions of real business cycle theory allow for real demand
shocks, such as changes in preferences or government expenditures, to act as
the impulse mechanism, these models are more typically driven by exogenous
productivity shocks. These stochastic fluctuations in factor productivity
are the result of large random variations in the rate of technological change.
The conventional Solow neoclassical growth model postulates that the growth
of output per worker over prolonged periods depends on technological progress
which is assumed to take place smoothly over time. Real business cycle
theorists reject this view and emphasize the erratic nature of technological
change which they regard as the major cause of changes in aggregate output.
To see how aggregate output and employment vary in a real business cycle
model, consider Figure 6.3. Panel (a) of Figure 6.3 illustrates the impact of a
beneficial technology shock, which shifts the production function from Y to
Y*. The impact of this shift on the marginal product of labour and hence the
demand for labour is shown in panel (b). By increasing the demand for labour
a productivity shock raises employment as well as output. How much employment
expands will depend on the elasticity of labour supply with respect
to the current real wage. The ‘stylized facts’ of the business cycle indicate
that small procyclical variations in the real wage are associated with large
procyclical variations of employment. Thus a crucial requirement for real
business cycle theory to be consistent with these facts is for the labour supply
schedule to be highly elastic with respect to the real wage, as indicated in
panel (b) by SL2. In this case a technology shock will cause output to expand
from Y0 to Y2 with the real wage increasing from (W/P)a to (W/P)c, and
employment increasing from L0 to L2. If the labour supply schedule is relatively
inelastic, as shown by SL1, large variations of the real wage and small
changes in employment would result from a technology shock. However, this
does not fit the stylized facts.
It is clear that, in order for real business cycle theories to explain the
substantial variations in employment observed during aggregate fluctuations,
there must be significant intertemporal substitution of leisure. Since in these
models it is assumed that prices and wages are completely flexible, the labour
market is always in equilibrium. In such a framework workers choose unemployment
or employment in accordance with their preferences and the
opportunities that are available. To many economists, especially to those with
a Keynesian orientation, this explanation of labour market phenomena remains
unconvincing (Mankiw, 1989; Tobin, 1996).
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