The Policy Implications of Real Business Cycle Theory

The Policy Implications of Real Business Cycle Theory
Before 1980, although there was considerable intellectual warfare between
macroeconomic theorists, there was an underlying consensus relating to three
important issues. First, economists viewed fluctuations in aggregate output as
temporary deviations from some underlying trend rate of growth. An important
determinant of this trend was seen to be an exogenously determined
smooth rate of technological progress. Second, aggregate instability in the
form of business cycles was assumed to be socially undesirable since they
reduced economic welfare. Instability could and therefore should be reduced
by appropriate policies. Third, monetary forces are an important factor when
it comes to explaining the business cycle. Orthodox Keynesian, monetarist
and new classical economists accepted all three of these pillars of conventional
wisdom. Of course these same economists did not agree about how
aggregate instability should be reduced. Neither was there agreement about
the transmission mechanism which linked money to real output. In Keynesian
and monetarist models, non-neutralities were explained by adaptive expectations
and the slow adjustment of wages and prices to nominal demand shocks.
In the new classical market-clearing models of the 1970s, non-neutralities
were explained as a consequence of agents having imperfect information.
When it came to policy discussions about how to stabilize the economy,
monetarists and new classical economists favoured a fixed (k per cent) monetary
growth rate rule, whereas Keynesian economists argued in favour of
discretion (see Modigliani, 1986; Tobin, 1996). The main impact of the first
wave of new classical theory on policy analysis was to provide a more robust
theoretical case against activism (see Kydland and Prescott, 1977). The political
business cycle literature also questioned whether politicians could be
trusted to use stabilization policy in order to reduce fluctuations, rather than
as a means for maximizing their own interests (see Nordhaus, 1975 and
Chapter 10).
During the 1980s everything changed. The work of Nelson and Plosser
(1982) and Kydland and Prescott (1982) caused economists to start asking
the question, ‘Is there a business cycle?’ Real business cycle theorists find the
use of the term ‘business cycle’ unfortunate (Prescott, 1986) because it suggests
there is a phenomenon to explain that is independent of the forces
determining economic growth. Real business cycle theorists, by providing an
integrated approach to growth and fluctuations, have shown that large fluctuations
in output and employment over relatively short time periods are ‘what
standard neoclassical theory predicts’. Indeed, it ‘would be a puzzle if the
economy did not display large fluctuations in output and employment’
(Prescott, 1986). Since instability is the outcome of rational economic agents
responding optimally to changes in the economic environment, observed
fluctuations should not be viewed as welfare-reducing deviations from some
ideal trend path of output. In a competitive theory of fluctuations the equilibria
are Pareto-optimal (see Long and Plosser, 1983; Plosser, 1989). The idea that
the government should in any way attempt to reduce these fluctuations is
therefore anathema to real business cycle theorists. Such policies are almost
certain to reduce welfare. As Prescott (1986) has argued, ‘the policy implication
of this research is that costly efforts at stabilisation are likely to be
counter-productive. Economic fluctuations are optimal responses to uncertainty
in the rate of technological progress.’ Business cycles trace out a path
of GDP that reflects random fluctuations in technology. This turns conventional
thinking about economic fluctuations completely on its head. If
fluctuations are Pareto-efficient responses to shocks to the production function
largely resulting from technological change, then monetary factors are
no longer relevant in order to explain such instability; nor can monetary
policy have any real effects. Money is neutral. Since workers can decide how
much they want to work, observed unemployment is always voluntary. Indeed,
the observed fluctuating path of GNP is nothing more than a continuously
moving equilibrium. In real business cycle theory there can be no meaning to
a stated government objective such as ‘full employment’ because the economy
is already there! Of course the real business cycle view is that the government
can do a great deal of harm if it creates various distortions through its taxing
and spending policies. However, as we have already noted, in real business
cycle models a temporary increase in government purchases will increase
output and employment because the labour supply increases in response to
the higher real interest rate brought about by higher (real) aggregate demand.
If technological change is the key factor in determining both growth and
fluctuations, we certainly need to develop a better understanding of the factors
which determine the rate of technological progress, including institutional
structures and arrangements (see Chapter 11). To real business cycle theorists
the emphasis given by Keynesian and monetarist economists to the issue of
stabilization has been a costly mistake. In a dynamic world instability is as
desirable as it is inevitable.
Finally, Chatterjee (1999) has pointed out that the emergence of REBCT is
a legacy of successful countercyclical policies in the post-Second World War
period. These policies, by successfully reducing the volatility of GDP due to
aggregate demand disturbances compared to earlier periods, has allowed the
impact of technological disturbances to emerge as a dominant source of
modern business cycles.