Journal of Economics Literatute Vol. XXXII (December 1994), pp. 1750–1783

Stadler: Real Business Cycles Real Business Cycles

By GEORGE W. STADLER University of Newcastle upon Tyne

I have received numerous valuable comments from many indi- viduals, comprising a list that is too long to acknowledge here, but special thanks are due to Jeremy Greenwood and David Laidler. I also wish to acknowledge the excellent comments I re- ceived from the reviewers, which also substantially improved this article.

I. Introduction The development of the New Classical macroeconomics brought about the re- HE 1970S saw a distinctive shift in vival of business cycle theory. The New macroeconomic research. The tradi- T Classical paradigm tried to account for tional Keynesian research program was the existence of cycles in perfectly com- concerned with the determination of petitive economies with rational expecta- output and employment at a point in tions. It emphasized the role of imper- time and with how to alter and stabilize fect information, and saw nominal the time paths of major macroeconomic shocks, in the form of monetary misper- variables. In the 1970s this research pro- ceptions, as the cause of cycles. The New gram increasingly gave way to business Classical theory posed a challenge to cycle theory, that is, the theory of the Keynesian economics and stimulated the nature and causes of economic fluctua- development of both the New Keynesian tions. This paper is a summary and as- economics and RBC theory. The New sessment of Real Business Cycle (RBC) Keynesian economics has generally ac- theory.1 cepted the idea of rational expectations, 1 There have been a number of surveys of Real but emphasizes the importance of imper- Business Cycle Theory, including Jean-Pierre fect competition, costly price adjustment Danthine and John Donaldson (1993), Chan Huh and externalities and considers nominal and Bharat Trehan (1991), Gregory Mankiw (1989), and Bennett McCallum (1989). These sur- shocks as the predominant impulse veys do not always consider recent developments mechanism. and extensions, which have gone some way to- RBC theory has developed alongside wards mitigating some of the early criticisms of this theory. However, even where they do consider recent developments, they tend to focus on par- cycles is referred to Thomas Cooley (forthcom- ticular aspects of RBC research. For example, ing), which covers a number of areas of RBC re- Danthine and Donaldson focus on developments search, that are dealt with only briefly in this sur- concerning the labor market, while Huh and Tre- vey, in greater depth, and provides an excellent han focus on the role of money in these models. introduction to the techniques required for build- Anyone interested in further reading on business ing RBC models. 1750 Stadler: Real Business Cycles 1751 the New Keynesian economics, but, actions, and traded goods. Section IV ex- unlike it, RBC theory views cycles as amines the criticisms that have been lev- arising in frictionless, perfectly competi- eled against RBCs. The strongest criti- tive economies with generally complete cisms are first, there is no independent markets subject to real shocks. RBC corroborating evidence for the large models demonstrate that, even in such technology shocks that are assumed to environments, cycles can arise through drive business cycles and second, RBC the reactions of optimizing agents to real models have difficulty in accounting for disturbances, such as random changes in the dynamic properties of output be- technology or productivity.2 Further- cause the propagation mechanisms they more, such models are capable of mim- employ are generally weak. Thus, while icking the most important empirical RBC models can generate cycles, these regularities displayed by business cycles. are, as a general rule, not like the cycles Thus, RBC theory makes the notable observed. Section V surveys the empiri- contribution of showing that fluctuations cal evidence, and finds little to mitigate in economic activity are consonant with these criticisms. The final section sums competitive general equilibrium environ- up, and considers the challenges that ments in which all agents are rational RBC theory still faces. The strong aggre- maximizers. Coordination failures, price gation assumptions these models make stickiness, waves of optimism or pessi- by relying on representative agents cast mism, monetary policy, or government doubt on their ability to assess policy policy generally are not needed to ac- questions, and also on their claim to have count for business cycles. provided a more rigorous microfounda- The following section of the paper de- tion for macroeconomics than competing scribes the background of RBC theory, paradigms. the key features of RBC models and out- lines a simple, prototype RBC model. II. The Basic Real Business Cycle Model Section III considers some of the many A. Historical Background and recent developments that have built on Development this basic RBC model. It finds that a number of cyclical phenomena cannot be Business cycles vary considerably in explained by a model driven only by terms of amplitude and duration, and no technology shocks. Increasingly, this has two cycles appear to be exactly alike. lead to the development of models Nevertheless, these cycles also contain where technology shocks are supple- qualitative features or regularities that mented by additional disturbances that persistently manifest themselves. Among are analogous to taste shocks. It also as- the most prominent are that output sesses extensions of the basic model that movements in different sectors of the incorporate money, government policy economy exhibit a high degree of coher- ence; that investment, or production of 2 An alternative way of classifying these models durables generally, is far more volatile is through the location of the dominant impulses than output; consumption is less variable driving the cycle: do they arise on the demand than output; and the capital stock much side or the supply side of the economy? New Clas- sical and New Keynesian models are driven by de- less variable than output (Robert Lucas mand-side shocks, while RBCs are driven by sup- 1977). Velocity of money is countercycli- ply-side shocks. Some writers question the cal in most countries, and there is con- usefulness of this distinction, pointing out that any supply-side innovation causes a change in demand siderable variation in the correlation be- and vice versa. tween monetary aggregates and output 1752 Journal of Economic Literature, Vol. XXXII (December 1994)

(Danthine and Donaldson 1993). Long- or tax rates, or monetary policy, have term interest rates are less volatile than been generally regarded by RBC theo- short-term interest rates, and the latter rists as having at best minor influence on are nearly always positively correlated the business cycle. It is this emphasis on with output, but the correlation of longer- productivity changes as the predominant term rates with output is often negative source of cyclical activity that distin- or close to zero. Prices appear to be guishes these models from their pre- countercyclical, but I argue below that decessors and rivals. In particular, the this evidence is tenuous. Employment is absence of a role for demand-side inno- approximately as variable as output, vations coupled with the assumption of while productivity is generally less vari- competitive markets marks a clear break able than output, although certain coun- from the traditional Keynesian theory tries show deviations from this pattern. where changes in investment, consump- RBC models demonstrate that at least tion, or government spending are the some of these characteristics can be rep- main determinants of output in the short licated in competitive general equilib- run. rium models where all agents maximize The importance of exogenous produc- and have rational expectations. Further- tivity changes in economic theory can be more, this research program originated traced to the seminal work of Robert in the U.S.A. and usually American data Solow (1956, 1957) on the neoclassical have been used as the benchmark against growth model that appeared in the which these models are judged. 1950s. Solow postulated a one-good Real Business Cycle theory regards economy, in which the capital stock is stochastic fluctuations in factor produc- merely the accumulation of this compos- tivity as the predominant source of fluc- ite commodity. The technical possibili- tuations in economic activity. These ties facing the economy are captured by theories follow the approach of Ragnar a constant returns to scale aggregate pro- Frisch (1933) and Eugen Slutzky (1937), duction function. Technical progress which clearly distinguishes between the proceeds at an exogenous rate in this impulse mechanism that initially causes a theory, and augments the productivity of variable to deviate from its steady state labor. (Technical change is Harrod neu- value, and the propagation mechanism, tral, so ensuring the constancy of relative which causes deviations from the steady shares and sustained steady-state state to persist for some time. Exogenous growth.) productivity shocks are the only impulse However, it is Solow’s work on esti- mechanism that these models originally mating the sources of economic growth incorporated. Other impulse mecha- that has proved most influential in the nisms, such as changes in preferences,3 RBC literature. If markets are competi- tive and there exist constant returns to scale, then the growth of output from 3 Taste or preference shocks, by themselves, cannot explain cycles. Olivier Jean Blanchard and the aggregate production function is: Stanley Fischer (1989b, p. 336) argue that, in an = α + ( −α) + equilibrium framework, taste shocks lead to large gy g1 1 gk z, fluctuations in consumption relative to output (in reality consumption is much less variable than out- where gy, g1 and gk are the growth rates put) and fail to generate the procyclical movement of output, labor, and capital respectively, in inventories and investment that is observed in α is the relative share of output of labor, the data. Furthermore, it is difficult to believe that most agents suffer recurrent changes in their pref- and z measures the growth in output that erences that are large enough to drive cycles. cannot be accounted for by growth in la- Stadler: Real Business Cycles 1753 bor and capital. Thus z represents multi- Typically, RBC models contain the fol- factor productivity growth and has been lowing features: dubbed the “Solow residual.” Rearrang- i) They adopt a representative agent ing the above equation one obtains: framework, focusing on a representative firm and household, and in so doing the 1 − α ( − ) =   ( − ) + ( α) gy g1 gk gy 1/ z. models circumvent aggregation prob-  α  lems. ii) Firms and households optimize ex- This states that growth of output per plicit objective functions, subject to the capita depends on the growth of the resource and technology constraints that capital-output ratio and on the Solow re- they face. sidual, z. The Solow residual has ac- iii) The cycle is driven by exogenous counted for approximately half the shocks to technology that shift produc- growth in output in the U.S.A. since the tion functions up or down. The impact of 1870s (Blanchard and Fisher 1989b, pp. these shocks on output is amplified by 3–5). This residual is not a constant, but intertemporal substitution of leisure—a fluctuates significantly over time. It is rise in productivity raises the cost of lei- well described as a random walk with sure, causing employment to increase. drift plus some serially uncorrelated iv) All agents have rational expecta- measurement error (Edward Prescott tions and there is continuous market 1986a). clearing. There are complete markets The neoclassical model of capital accu- and no informational asymmetries. mulation, augmented by shocks to pro- v) Actual cycles are generated by pro- ductivity, is the basic framework for viding a propagation mechanism for the RBC analysis. RBC theorists contend effects of shocks. This can take several that the same theory that explains long- forms. First, agents generally seek to run growth should also explain business smooth consumption over time, so that a cycles. Once one incorporates stochas- rise in output will manifest itself partly tic fluctuations in the rate of technical as a rise in investment and in the capital progress into the neoclassical growth stock. Second, lags in the investment model, it is capable of displaying business process can result in a shock today af- cycle phenomena that match reasonably fecting investment in the future, and closely those historically observed in the thus future output. Third, individuals U.S.A. Thus, RBC theory can be seen as will tend to substitute leisure intertem- a development of the neoclassical growth porally in response to transitory changes theory of the 1950s. in wages—they will work harder when B. The Basic Features of Real Business wages are temporarily higher and com- Cycle Models pensate by taking more leisure once wages fall to their previous level. Fourth, The evolution of RBC theory is nota- firms may use inventories to meet unex- ble for its emphasis on microfounda- pected changes in demand. If these are tions: macroeconomic fluctuations are depleted, then, if firms face rising mar- the outcome of maximizing decisions ginal costs, they would tend to be re- made by many individual agents. To ob- plenished only gradually, causing output tain aggregates, one adds up the decision to rise for several periods. outcomes of the individual players, and The first propagation mechanism is imposes a solution that makes those deci- likely to be weak, while focusing on in- sions consistent. ventories yields negative serial correla- 1754 Journal of Economic Literature, Vol. XXXII (December 1994) tion for output–output movements are where yt is output, kt is capital carried strongly positively serially correlated in over from the previous period, and nt is reality (Fischer 1988). Most RBC models labor. zt is a strictly positive stochastic focus on the second and third propaga- parameter that shifts the production tion mechanisms. function, altering total factor productiv- The intertemporal substitution mecha- ity, and is assumed to follow a stationary nism is also likely to be weak. Most inno- Markov process (the distribution of zt vations in technology are regarded as depends on zt-1 but is otherwise constant highly persistent or even permanent, over time). The capital stock evolves ac- raising the real wage permanently. This cording to: is unlikely to elicit a large labor supply k + = (1 − δ)k + i response, because the substitution effect t 1 t t (3) δ of the higher wage is likely to be offset where is the depreciation rate and it is by the income effect. Only in response to gross investment. In a one-good model, temporary shocks is significant intertem- that part of output not consumed be- poral substitution likely to occur. How- comes part of the capital stock the next ever, to fit the data, RBC models assume period. The resource constraints that that most of the technology innovation is agents face restrict consumption and in- highly persistent. This points to the gen- vestment in any one period to output, eral difficulty of trying to reconcile ob- and labor plus leisure time to the time served labor market data with a technol- endowment: ogy driven equilibrium theory, and is + = examined in more detail in Section III.A ct it yt + = below. nt lt ht (4) or n = 1 − l if h is normalized to unity, C. A Simple Prototype RBC Model t t t where ht is the total endowment of time. Consider an economy populated by Because all agents are identical, one identical, infinitely lived agents that pro- can solve for the equilibrium quantities duce a single good as output. There are and prices by solving the agent’s optimi- no frictions or transactions costs, and, for zation problem. It is assumed that expec- simplicity we abstract from the existence tations are rational, so that the agent’s of money and government. Each agent’s expectations are based on the probability preferences are distributions implied by the economy’s structure. All households are alike,  ∞  =  β j ( ) < β < ( ) agents know the probability distribution Ut MaxEt ∑ u ct+j, 1t+j , 0 1 1 j=0  generating zt as well as the current value   of z , and all markets clear. Thus, maxi- β t where , ct and lt are a discount factor, mizing (1) subject to constraints (2)–(4) consumption, and leisure and E is the ex- provides a set of first-order conditions pectations operator. The technology which characterize market equilibrium: available to the economy is described by ( ) − λ = a conventional constant-returns-to-scale u1 ct, 1t t 0 (5) production function and an equation that ( ) − λ ( ) = gives the law of motion of the capital u2 ct, 1t tzt f2 kt, nt 0 (6) stock over time. The production function −λ + E βλ + [z f (k ,n ) − (1 − δ)] = 0 is: t t t 1 t 1 t t (7) = ( ) + = ( ) + ( − δ) yt zt f kt,nt (2) ct kt+1 zt f kt,nt 1 kt (8) Stadler: Real Business Cycles 1755 where ui and fi denote the partial deriva- temporary change in zt around its long- • • tives of u( ) and f( ) with respect to their run value produces not only a change in ith argument, and ␭t is the Lagrange current consumption, but also translates multiplier. The first of the above equa- into a change in the capital stock, which tions equates the marginal utility of con- propagates the effects of the shock. A sumption to the shadow price of output, rise in productivity will raise the capital the second equates the marginal disutil- stock and consumption for several peri- ity of labor to labor’s marginal product— ods, causing the model to exhibit cycles. the real wage—while the third equates Consider the case where zt follows a first the marginal product of capital to its op- order autoregressive (AR(1)) process. In portunity cost in terms of foregone con- this case, as illustrated by McCallum, sumption. These equations determine consumption and the capital stock will the time paths of the economy’s values of follow AR(2) processes. This is signifi- labor, capital, consumption, and ␭. cant because the detrended quarterly Given explicit forms for the utility and time series of various macroeconomic production functions, it is possible to variables are well described by AR(2) solve for the time paths of the three processes for U.S. data. choice variables, ct, kt, and nt. In order to However, normally the utility and pro- obtain a specific solution, assume, for ex- duction functions used are more compli- ample (as in McCallum 1989) that capital cated than (9) and (10), and do not admit depreciates fully within a single period of an analytical solution for the decision (δ = 1), utility is log-linear in form and rules. The approach followed in such a the production function is Cobb-Douglas: case is to take linear approximations of • = θ + ( − θ) ( − ) the equivalent of equations (5) to (8) u( ) log ct 1 log 1 nt (9) around a stationary point, which is usu- • = α 1−α ally assumed to be the steady state of the ztf( ) ztnt kt . (10) system, that is, those values of the vari- = Under these assumptions the utility ables when zt 1 for all t, given some function ensures that the income and initial value of the capital stock. This lin- substitution effects of a wage change ear system can then be solved for time cancel each other, so that labor is con- paths of the endogenous variables. stant in the solution. Using the method The next stage is to choose specific β of undetermined coefficients, one can values for the parameters (␣, , etc.), solve for the values of consumption and usually by referring to previous econo- the capital stock:4 metric studies. One then generates a set of artificial data from the model. This in- = − ( − α)β α 1−α ct [1 1 ]ztnt kt (11) volves specifying a stochastic process for the technology parameter (generally a = ( − α)β α 1−α kt+1 1 ztnt kt . (12) random walk with drift or a highly per- sistent AR(1) process with positive These time paths satisfy the first-order trend) and generating many different se- conditions and consequently represent ries of values of the innovation in the optimal decision rules for the agents in technology parameter. One then feeds this model economy. The intertemporal these series of shocks into the model to nature of the decision rules given by yield samples of artificial time series for equations (11) and (12) is obvious. A ct,kt, etc. The model is judged by com- 4 See McCallum (1989, p. 22) for further details paring the average properties of the sam- on this solution method. ples of artificial, model-generated data 1756 Journal of Economic Literature, Vol. XXXII (December 1994)

TABLE 1 KYDLAND AND PRESCOTT’S (1982) MODEL,

U.S. Economy1 Model’s Results (a)2 (b)3 (a) (b) Real Output 1.8 — 1.8 — Consumption 1.3 0.74 0.63 0.94 Investment 3.1 0.71 6.45 0.80 Inventories 1.7 0.51 2.00 0.39 Capital Stock 0.7 −0.24 0.63 -0.07 Hours 2.0 0.85 1.05 0.93 Productivity 1.0 0.1 0.90 0.90

1 Quarterly, data, 1950:1–1979:2, logged and detrended using the Hodrick-Prescott filter. 2 Column (a) shows standard deviations, in percentages. 3 Column (b) shows correlations with output. with an actual data set. Normally the the fact that consumption is less volatile properties of interest are the second mo- than output and investment much more ments of output, consumption, invest- volatile than output. However, like many ment, etc. as well as the comovements of RBC models, it greatly overpredicts the these series with output. correlation between productivity and As an example, Table 1 reproduces output. The standard deviation of output some results from Finn Kydland and generated by the model and the data are Prescott (1982) (hereafter KP), one of identical, because the variance of the the seminal papers on RBC theory. KP’s productivity shock has been chosen to model departs from the simple prototype ensure that the volatility of the model- model in two important ways. First, KP generated output series matches that of assume it takes four quarters to build the actual data set, which is fairly com- capital (hence their model has become mon practice among RBC theorists. known as the time-to-build model). This Thus, the model is constructed so that all imparts greater persistence to the effects volatility in output is accounted for by of shocks. Second, KP assume that labor stochastic productivity movements, and suffers from a fatigue effect. The harder the model must consequently be judged one has worked in the past, the more one by how well it mimics properties of the values leisure today. This increases the data other than the variance of output. intertemporal substitution of leisure.5 Table 1 shows that the model captures III. Extensions of the Basic RBC Model

5 The KP model adds two further features to This section is divided into five sub- the prototype model: (i) Inventories are included sections. The first focuses on the labor as a factor of production. This improves the match market and deals with attempts to repli- of the model’s serial correlation properties with the U.S. data. (ii) Agents observe a noisy signal of cate labor market phenomena concern- the productivity shock which contains a permanent ing hours worked, productivity, and un- and a transitory component. This noise is neces- employment. Subsequent subsections sary to create a role for inventories to act as a buffer stock when expectations about productivity examine the introduction of new sectors, are not fulfilled. namely money, government, and interna- Stadler: Real Business Cycles 1757 tionally traded goods. A final subsection that the marginal product of labor will considers other extensions. move quite closely with the average product of labor, or productivity. Thus, A. The Labor Market although they generally do not generate There are a number of labor market artificial data series for real wages, these regularities that are inconsistent not only models imply that real wages (and pro- with the simple prototype RBC model of ductivity) are much more procyclical 7 Section II, but also with KP’s model. than in reality. The first troublesome fact is the “em- Third, labor’s share of income moves ployment variability puzzle.” Employ- countercyclically over the cycle. How- ment (or total hours worked) is almost as ever, if technology is Cobb-Douglas, la- variable as output, and strongly procycli- bor’s share is constant over the cycle. cal, while real wages are at best mildly A fourth labor market regularity that procyclical. If most shocks hitting the poses problems for RBC models is the economy shift the production function so-called “productivity puzzle.” If pro- and alter the marginal product of labor ductivity shocks drive the cycle, employ- then, ceteris paribus, the shifts in labor ment and productivity would be highly demand should trace out an upward- correlated, and this is exactly what RBC sloping labor supply function in real models predict—usually the correlation wage-employment space. Because micro between hours and productivity in these studies suggest that the wage elasticity of models is above 0.9. In reality, produc- labor supply is low, much of the adjust- tivity and employment are negatively ment to a productivity shock should be correlated for most economies. For the borne by wages, rather than employ- United States the correlation is roughly 8 ment. Consequently, RBC models like zero. KP’s predict that employment is less Finally, there is no unemployment in variable than in reality. KP’s model. All variation in employment Second, in a world where cycles are is due to variation in hours worked by caused by productivity shocks, the corre- the representative worker. Even where lation between productivity and output RBC models do succeed in accommodat- should be high. In reality the correlation ing unemployment, it is always voluntary, is moderate for most economies—for the unless the Walrasian assumptions that U.S. estimates range from 0.4 to 0.6, de- underpin these models are dropped. pending on the sample period.6 In KP’s The remainder of this section deals model the correlation is 0.90, and corre- with attempts to overcome these prob- lations of similar magnitude occur in lems. The assumption that labor supply many RBC models. As McCallum (1989) is indivisible goes a long way toward re- points out, the production function most solving the employment puzzle. How- RBC models (including KP) employ is 7 Kydland and Prescott (1993) argue that the essentially Cobb-Douglas. This implies implicit return to labor is much more procyclical than the aggregate data suggest. They define real 6 The correlation between productivity and out- wages as total labor compensation divided by ag- put given by Kydland and Prescott in Table 1 is gregate, quality adjusted labor input derived from only 0.1. In Prescott (1986a), using data from 1954 panel data, and find this is significantly procycli- I to 1982 IV, the correlation is 0.34, and for stud- cal. ies using more recent data it is higher still. This 8 See Danthine and Donaldson (1993, table 6, suggests that the size of some of these correlations p. 13). For the United States (and possibly for may be sensitive to the sample period employed, other countries as well) the magnitude of this cor- and is not a robust feature of the postwar U.S. relation also seems to vary with the sample period economy. and definition of employment. 1758 Journal of Economic Literature, Vol. XXXII (December 1994) ever, the productivity puzzle and the be- However, even if one accepts that the havior of wages cannot be reconciled short-run labor elasticity is much higher with a model driven solely by technology than micro studies suggest, Kennan finds shocks. These facts can only be repli- that, in an equilibrium framework, cated by models that contain shocks to shocks to labor demand alone cannot labor supply as well as labor demand. generate the observed time series. Be- A.1 The Employment Variability Puz- cause innovations in real wages and em- zle. Under what conditions will RBC ployment both show great persistence, models display realistic real wage-em- two separate impulse mechanisms are re- ployment correlations? Within an equi- quired to explain the data. Thus, Ken- librium framework, large movements in nan’s analysis also suggests that produc- employment accompanied by only small tivity shocks must be augmented by wage changes suggest that the labor sup- labor supply shocks, although the latter ply function is fairly flat, that is, there can have much smaller variance than the must be a high degree of intertemporal former. substitution over the business cycle. In reality about two thirds of the vari- However, many critics (e.g., Lawrence ation in total hours worked appears to be Summers 1986; Mankiw 1989) regard the due to movements into and out of em- reliance on a high degree of intertempo- ployment, while the remainder is due to ral substitution as a weakness of these adjustments in hours worked by employ- models, partly because there is no con- ees. This contrasts with the basic RBC vincing empirical evidence for this. models where all variation in hours is Generally, quarterly data are used to due to changes in intensity of work effort assess the performance of RBCs, while by the employed. micro studies of the elasticity of labor A different case occurs when a worker supply use annual data and are based on is constrained to work for a fixed amount life cycle models. John Kennan (1988) of time or not at all, so that all changes argues that life cycle models, which esti- in hours are brought about by changing mate low elasticities, are not designed to employment (Gary Hansen 1985). Be- measure responses to temporary wage cause the length of the working week is changes within short periods of less than fixed, the marginal utility of leisure is a year. He says that “these models as- constant. In this case the marginal bene- sume that leisure in February 1989 is a fit of working cannot be brought into perfect substitute for leisure in October equality each period by adjusting labor 1989.” He goes on to argue that supply smoothly between periods. Under these circumstances, a representative a short-run elasticity of 0.1 is not credible: a agent will want to work as much as possi- 30 percent wage increase is not needed to call forth a 3 percent increase in hours ble when the wage is high, so that the worked (this would mean that in order to get economy as a whole behaves like a hypo- someone to stay 15 minutes longer on the job thetical agent with infinite elasticity of today, he would have to be paid 30 percent substitution of leisure, even though indi- 9 more for the whole day). vidual agents have diminishing marginal utility of leisure. Thus, this type of non- 9 Kennan (1988, pp. 196–97). Kennan also points out that hours worked at the individual convexity in labor supply can reconcile level tend to be very variable, with a standard de- viation of year-to-year changes of around 20 per- cent for the U.S. In a typical downturn, the de- larger than is necessary to explain cyclical vari- cline in aggregate hours is less than 3 percent. The ations, but the sources of these large variations are magnitude of individual variations is thus much not pinned down in the microdata. Stadler: Real Business Cycles 1759

TABLE 2 HANSEN’S (1985) INDIVISIBLE LABOR MODEL

U.S. Economy1 Model’s Results (a)2 (b)3 (a) (b) Real Output 1.76 — 1.76 — Consumption 1.29 0.85 0.51 0.87 Investment 8.60 0.92 5.71 0.99 Capital Stock 0.63 0.04 0.47 0.05 Hours 1.66 0.76 1.35 0.98 Productivity 1.18 0.42 0.50 0.87

1 Quarterly data, 1955:3–1984:1, logged, seasonally adjusted, and detrended using the Hodrick-Prescott filter. 2,3 See Table 1 above. the disparity in micro and macro findings ductivity. Thus, an RBC model like KP’s with respect to the labor supply elastic- or G. Hansen’s (1985) predicts that pro- ity, as Prescott (1986b) emphasizes in his ductivity is highly positively correlated rebuttal of Summers’ (1986) criticisms, with both hours and output. In reality, and goes a long way towards resolving the the first correlation is zero or negative, employment puzzle. G. Hansen finds that while the second is moderate (0.5 rather in the presence of this nonconvexity the than 0.9). One way of reducing the cor- variability of hours rises considerably: in- relation between employment and pro- deed, in his model hours turn out to be ductivity is to introduce factors that will far more variable relative to productivity shift the labor supply function. Shifts in than in the U.S. economy.10 The results labor supply may arise through nominal of Hansen’s model are shown in Table 2. wage stickiness, taste shocks, shocks to A.2 The Productivity Puzzle. If all home or nonmarket production, or gov- shocks impinging on the economy are ernment spending shocks. productivity shocks that shift labor de- A traditional way of causing shifts in mand, hours and productivity will move labor supply is through nominal wage together closely, for changes in employ- stickiness and money supply shocks. If ment result only from changes in pro- wages are preset, a nominal innovation shifts the effective supply of labor func- tion. If both labor demand and labor 10 G. Hansen’s model suggests all changes in hours are due to changes in employment, which is supply are shifting, there is no a priori clearly counterfactual. Jang-Ok Cho and Thomas reason to expect a strong positive corre- Cooley (1988) address this problem by allowing lation between productivity (or wages) agents to decide both on hours and whether to participate in the labor force at all. This extension and hours or productivity and output. improves the performance of the model in some Shifts in labor supply can also occur as areas. In particular, the ratio of the standard de- a result of preference shocks that di- viation of aggregate hours to the standard devia- tion of productivity produced by the model is vir- rectly alter the willingness of agents to tually identical to that found in American data, supply labor (Valerie Bencivenga 1992). around 1.4, whereas in Hansen’s model the figure However, there is no independent evi- is around 2.7, because hours are so volatile in his framework. However, there is insufficient variabil- dence that agents in aggregate suffer ity in all of Cho and Cooley’s artificial time series. from large, recurrent fluctuations in 1760 Journal of Economic Literature, Vol. XXXII (December 1994) preferences, and Bencivenga herself rec- 1991), but negatively correlated in home ognizes that such shocks might more production models unless the correlation plausibly be interpreted as shocks to the between home and market disturbances technology of home production. is very high, in which case the productiv- Home production is potentially impor- ity puzzle reappears. Second, these mod- tant because the household sector is els suggests that business cycle episodes large: home produced output relative to largely represent voluntary movements measured GNP is estimated to range be- between home and market activities, tween twenty and fifty percent, and in- which must be somewhat unsettling to cludes such things as preparation of the traditional macro theorist. meals, cleaning and transportation ser- Two further factors that can help to vices, and some residential maintenance resolve the productivity puzzle are labor activity. Assume that households have ac- hoarding behavior by firms and shocks to cess to a home production function that government spending. Government con- uses time and capital to produce a non- sumption and private consumption are tradeable consumption good. A rise in not perfect substitutes in utility, so that market productivity leads not only to a a rise in government consumption fi- rise in hours to accumulate more capital, nanced by taxes results in a negative but also to a substitution of market for wealth effect that shifts labor supply. home consumption, which also causes Labor hoarding enables firms to hours spent in the market consumption change the effective labor supply with- sector to rise. In a model with home pro- out altering employment, so reducing duction agents do not just substitute in- the correlation between productivity and tertemporally, but also substitute labor measured labor input, because reported between home and market commodities hours worked are not an accurate mea- at a given date. Introducing this further surement of true labor input under these margin of substitution improves the circumstances. Labor hoarding can be model’s performance relative to models introduced into an RBC model by assum- without home production. Moreover, if ing that the firm must hire workers be- shocks to home productivity occur (pos- fore the current state of technology and sibly as the productivity of consumer demand are observed. Such a procedure durables changes) and these shocks are attempts, rather crudely, to capture the not perfectly correlated with shocks to fact that the firm cannot adjust the size market productivity, labor supply will of its workforce in response to every bit fluctuate as relative changes in home of new information it receives. Conse- productivity change the amount people quently, if productivity is higher than ex- are willing to work in the market at a pected, labor input is initially adjusted given wage, and this reduces the correla- only by varying labor effort, not by vary- tion between market productivity and ing the number of employees—employ- output and productivity and hours to val- ment can only be adjusted with a one-pe- ues close to those observed in reality riod lag. Thus labor effort will be (Jess Benhabib, Richard Rogerson, and procyclical, rising during booms and fall- Randall Wright 1991). ing during recessions, so that the Solow Two criticisms can be leveled against residual captures changes in labor effort household production models. In reality that are not reflected in the labor input investment in market and nonmarket statistics. Both government expenditure capital is positively correlated over the shocks and labor hoarding cause fluctua- cycle (Greenwood and Zvi Hercowitz tions in the effective supply of labor Stadler: Real Business Cycles 1761 which, acting in conjunction, signifi- A.3 Unemployment and Labor’s Share. cantly reduce the positive productivity- RBC models can readily account for vol- hours correlation that is implied by untary and frictional unemployment. standard RBC models (Craig Burnside, This can be accomplished by the intro- Martin Eichenbaum, and Sergio Rebelo duction of labor market search, where 1990). A model of this kind is also impor- matching workers to jobs depends on ag- tant because, as is discussed below, it gregate search and recruiting effort. In can account for the dynamics of output, search equilibrium, changes in employ- unlike most RBC models. ment tend to respond positively to per- This section has examined several fac- manent, rather than temporary, innova- tors that can shift the effective supply of tions in productivity. (By contrast, labor: the existence of a nonmarket pro- intertemporal substitution occurs in re- duction sector also subject to technology sponse to temporary shocks.) Further in- shocks, the existence of nominal wage teresting features of this analysis are that contracts, taste shocks, government searching increases the effect of a pro- spending shocks, and labor hoarding be- ductivity shock on output and increases havior by firms. It is likely that in reality the persistence displayed by the cyclical these factors have acted in conjunction component of macroeconomic time se- in determining the pattern of employ- ries (Dale Mortenson 1990; David An- ment, which makes it difficult to deter- dolfatto 1994).11 mine how significant each mechanism is In order to account for involuntary un- empirically. For instance, it is question- employment, one must assume that the able whether government spending wage no longer clears the labor market, shocks have a significant impact on labor but performs a different allocative role, supply, as opposed to labor demand (as for example, that it determines the level is the case in traditional Keynesian mod- of labor effort, or is used to provide in- els). I know of no empirical evidence to surance against risk or must be set above support this, and the low responsiveness a legal minimum level that is perceived of labor supply to tax changes that to be “fair.” Suppose that within an RBC emerges from micro studies suggests that framework risk averse older workers are responses to changes in the govern- covered by risk sharing wage contracts, ment’s provision of goods and services but young workers must find employ- will also be low. (However, as discussed ment in the casual labor market. If mini- above, these micro studies are generally mum wage legislation exists, it provides a not informative about labor supply be- floor to the wage in the casual labor mar- havior over short horizons.) The fact that ket, allowing involuntary unemployment introducing government spending shocks to occur in unfavorable states of the into an RBC model in this way appears world. Results of simulations from a to have a significant effect on the model model similar to this due to Danthine (as Lawrence Christiano and Eichen- and Donaldson (1991) are presented in baum 1992, find), does not prove that Table 3. this mechanism has any relevance in re- RBC models with real wage rigidity ality. The same, unfortunately, applies equally to the other mechanisms consid- 11 Indivisibilities in labor supply (discussed ered and highlights the need for inde- above) also result in voluntary unemployment, pendent corroborating evidence, not with workers receiving the same income in both good and bad states of the world. (There is com- only for shocks to labor demand, but also plete unemployment insurance in G. Hansen’s shocks to labor supply. model.) 1762 Journal of Economic Literature, Vol. XXXII (December 1994)

TABLE 3 DANTHINE AND DONALDSON’S (1991) NON-WALRASIAN MODEL

U.S. Economy1 Model’s Results (a)2 (b)3 (a) (b) Real Output 1.76 — 1.76 Consumption 1.29 0.85 0.34 0.69 Investment 8.60 0.92 6.08 0.99 Capital Stock 0.63 0.04 0.54 0.03 Hours 1.66 0.76 1.26 0.98 Productivity 1.18 0.42 0.61 0.91 Unemployment rate 5%

1,2,3 See Table 2 above. have the advantage that the correlation tions (or financial) services can be pro- between wages and employment is lower duced more rapidly than goods, and than in standard models. A further ad- these services are used by both firms and vantage is that, like labor market search, households to save time. A positive shock real rigidities tend to amplify the impact to productivity that increases output will of shocks on output, so that the variance also increase the demand for financial of productivity shocks required to gener- services: a model with these features ate a certain standard deviation in output predicts that these services will covary is much lower than in, say, KP’s model. with output. Thus, the model explains The existence of risk-sharing contracts the money-output correlation by means can also help to resolve the problem of of a reverse causation argument: finan- the cyclical behavior of labor’s share of cial services change in response to out- income. Assume two types of agents in- put changes. Inside money is in fact habit an RBC model: entrepreneurs who much more closely correlated with out- provide optimal, risk-sharing contracts, put than outside money, which is exactly and workers who thus obtain insurance what this model predicts (Robert King against income losses due to cyclical and Charles Plosser 1984). fluctuations. In a bad state of the world Other studies consider whether mone- the real wage rises relative to profits as tary shocks can have a significant effect the insurance element of the wage rises. on output variability in an RBC frame- This results in a countercyclical labor work. These papers consider (1) a trans- share and roughly acyclical wages, as ob- actions technology, where changes in the served in reality (Paul Gomme and money supply alter the time or resources Greenwood forthcoming). needed to transact; (2) monetary shocks that affect output through price misper- B. Extensions: Money ceptions in a Lucas (1972) informational “island” framework, along with real The literature has explored several shocks (Kydland 1989); (3) a cash-in-ad- ways of introducing money into an RBC vance constraint on the purchase of con- model, and RBC models can readily ac- sumption goods, so inflation acts as a tax count for the procyclical movement of on consumption (Cooley and G. Hansen the money stock. Suppose that transac- 1989). None of these approaches lead to Stadler: Real Business Cycles 1763

TABLE 4 CHO AND COOLEY’S (1990) MODEL WITH NOMINAL CONTRACTS

U.S. Economy1 Model’s Results4 (a)2 (b)3 (a) (b) Real Output 1.74 — 1.80 — Consumption 0.81 0.65 0.37 0.53 Investment 8.49 0.91 6.54 0.95 Capital Stock 0.38 0.28 0.55 −0.09 Hours 1.80 0.87 1.31 0.84 Productivity 1.09 0.56 0.93 0.68 Prices (CPI) 1.60 −0.53 1.78 0.04

1 Quarterly data, 1955:3–1984:1. Series are logged, seasonally adjusted, and detrended using the Hodrick-Prescott filter. 2,3 See Table 1 above. 4 Results for the model with 2-period staggered contracts and shocks to technology and the monetary base. monetary innovations contributing sig- Cooley 1990). In particular, as was noted nificantly to output variability. above, this model can account for the Thus, the introduction of a transac- “productivity puzzle.” A summary of Cho tions technology or cash-in-advance con- and Cooley’s results with respect to two- straint, by themselves, do little to alter period staggered wage contracts is pre- the RBC model. For money to affect sented in Table 4. output significantly, it appears that one RBC models that incorporate some must depart from the Walrasian para- nominal rigidity are important for two digm and allow for some nominal fric- reasons. First, their properties suggest tions in the economy. Consider a world that nominal rigidity may well be an im- in which agents face a cash-in-advance portant missing element in standard constraint for consumption goods, and RBC models. Second, such models intro- money wages are set in advance for one duce important Keynesian features into or more periods to be equal to the ex- RBC analysis. They consequently bridge pected market clearing wage, but that the dichotomy between two very differ- output prices are flexible. In such a ent schools of thought in macroeconom- world, any unanticipated movements in ics, and are likely to be regarded as a the money supply cause relative wage more acceptable development by some changes that have real effects over and critics of RBCs. However, some aspects above inflation tax effects. Incorporating of the data generated by these models nominal wage rigidity into an otherwise appear to be inconsistent with the U.S. standard RBC model can amplify the ef- data. For instance, in Table 4 nominal fect of a monetary shock on output sev- prices are very slightly procyclical, while enty-fold, and incorporating only a small in reality they appear to be countercycli- amount of nominal wage rigidity (affect- cal, at least if detrended by the Hodrick- ing one third of wage settlements) im- Prescott filter. proves the performance of such an RBC This section has shown that it is quite model once both monetary and technol- possible to incorporate money into an ogy shocks are allowed for (Cho and RBC model, and to obtain the positive 1764 Journal of Economic Literature, Vol. XXXII (December 1994) correlations between money and output ever, in RBC models the impact policies that are observed in reality. However, in have over shorter horizons is very sensi- the absence of some nominal rigidity, tive to the model structure. A change in changes in the inflation rate or in trans- the assumptions, such as requiring the actions costs caused by changes in the government to balance the budget over real money supply appear to have a the business cycle as opposed to leaving negligible effect on real variables. Only the level of government debt a free vari- the existence of significant nominal ri- able, can reverse the welfare rankings of gidity results in significant non-neutral- alternative policies (V. V. Chari, Chris- ity of money in an RBC model, and im- tiano, and Patrick Kehoe 1994). Interest- proves the fit of the model in some ingly, it has been found that the pres- respects. ence of distortionary taxes amplifies the persistence effects shocks have on aggre- C. Extensions: Government gate time series and also increases the variability of these series (Greenwood RBC models containing a government and Gregory Huffman 1991). sector have been used to investigate the One can conclude from this that RBC impact of government expenditure on models can readily be used to evaluate the volatility of output. Generally, gov- the welfare costs of alternative policies. ernment spending is assumed to follow However, given the absence of agent an exogenous stochastic process that ap- heterogeneity in these models, and the proximates the real data on expenditure consequent absence of any distributions reasonably well. Innovations in govern- of income and wealth, the absence of ment spending appear to contribute market power, of transactions costs, of fairly little to output volatility (less than externalities, and public goods, it is dif- ten percent). Depending on the model ficult to regard these models as they structure, government spending shocks currently stand as providing plausible may even reduce the variability of out- vehicles to assess policy issues. In par- put, because they are negatively corre- ticular, the reliance on a representative lated with Solow residuals (Mary Finn, agent framework is regarded by some forthcoming).12 as especially damaging to the credibil- An increasing number of papers have ity of these models (see Section IV be- used RBC models to evaluate the bene- low). fits of alternative government policies. The long-run policy implications of these models are broadly consistent with the D. Extensions: The Open Economy Neoclassical growth model, because One of the most active areas of busi- RBC models are essentially extensions of ness cycle research in recent years has the Neoclassical growth model. How- been the development of open economy 12 Solow residuals derived from a conventional RBC models to explain patterns of trade production function like (2) above tend to be posi- and correlations across countries. Open tively correlated with government spending (Burn- economy RBC models have been suc- side, Eichenbaum, and Rebelo 1991). Finn mea- sures Solow residuals much more precisely, cessful in accounting for several stylized allowing for variable capital utilization and energy facts. First, the balance of trade moves as a separate input. Her residuals are negatively countercyclically and second, the trade correlated with government spending shocks, which is why they reduce output volatility under balance is positively correlated with the certain circumstances. terms of trade—the relative price of ex-

1 LINE SHORT Stadler: Real Business Cycles 1765 ports to imports (David Backus, Kehoe, E. Extensions: Other and Kydland 1994). Third, savings and investment are positively correlated in RBC models have been extended in a open economies (Finn 1990). variety of other ways but, for reasons of However, there are two stylized facts space, only two further extensions are con- that these models cannot easily explain. sidered here—imperfect competition, RBC models with traded goods generally and RBC’s implications for asset prices. assume that each country experiences a Introducing imperfect competition different technology shock (though pos- into an RBC model has important conse- sibly positively correlated with the other quences. Under imperfect competition, country’s shock). Agents can participate productivity shocks have very little effect in international capital markets, so that on employment, so that the sizeable cy- consumption and investment are no clical variation in employment one ob- longer constrained to equal domestic serves must be due to other shocks. For output. Given the opportunities of inter- not implausible parameter values, a rise national risk sharing, one would expect in productivity can even reduce employ- consumption to be smoother than under ment slightly, because the wealth effect autarky. Furthermore, it is a property of of a productivity shock on employment is one-good economies with complete mar- greater than under perfect competition kets and additively separable preferences and offsets the substitution effect to a that consumptions of agents are posi- greater extent (Julio Rotemberg and Mi- tively correlated, even if their incomes chael Woodford 1994). Furthermore, are not. RBC models reflect this prop- with increasing returns and imperfect erty and predict that correlations of con- competition, the economy may exhibit sumption across countries are much multiple equilibria, which suggests that higher than correlations of output, in such models are closer in spirit to the contrast to what one observes in reality. New Keynesian theory than the RBC This has been referred to as the quantity paradigm. anomaly, because it is extremely robust The asset pricing implications of a to changes in parameter values and standard RBC model are generally at model structure. The second fact is that variance with the stylized facts, because the terms of trade are much more vari- it is more difficult to account for signifi- able and display greater persistence than cant risk premiums in a production econ- RBC models suggest. This volatility in omy than in an endowment economy. In real exchange rates is called the price an endowment economy, the repre- anomaly. sentative agent simply consumes her en- A large number of extensions to the dowment, but in a production economy theory have been proposed to deal with the consumption decision is endogenous. these two anomalies, including non- As the degree of risk aversion rises, con- traded goods, taste shocks, energy price sumption becomes smoother and risk shocks, incomplete asset markets, and premiums less variable across assets. money. While some of these extensions Thus, a standard RBC model cannot ac- have been able to account for the quan- count for cross-sectional differences in tity anomaly, they are much less able to returns on assets (such as the equity pre- account for the quantity and price mium puzzle) nor for the time series be- anomalies in conjunction (Backus, Ke- havior of returns (Geert Rouwenhorst hoe, and Kydland forthcoming). 1994). It has been conjectured that other

1 LINE SHORT 1766 Journal of Economic Literature, Vol. XXXII (December 1994) sources of shocks, or imperfect informa- formulations) equally, regardless of the tion, might be required to explain asset vintages of capital or the ages and skill prices within an RBC framework. levels of labor. Not surprisingly, many people regard such pervasive, economy- IV. Criticisms of RBC Theory wide changes in technology as implausi- ble. Normally, a technological or scien- Over the years a number of criticisms tific innovation affects only a few 13 have been leveled against RBCs. This products. This section considers alterna- section discusses five major criticisms. tive characterizations of technical First, there is no independent evidence change, by examining a multisectoral for the large, economy-wide distur- RBC model and a model where technol- bances that drive these models. Second, ogy shocks only affect new capital goods. the models are not subjected to formal It also assesses the importance of the econometric tests: there is no objective role of energy price shocks in accounting yardstick to measure how well RBC mod- for cycles. els account for cycles. Third, they cannot If productivity innovations primarily account for the periodicity of cycles: the affect only a particular sector, one must pattern of cycles generated by RBC consider a multisectoral economy that models does not match reality at all well, produces many heterogeneous goods. because the models contain such weak Suppose these goods can be either con- mechanisms for propagating shocks sumed or used as inputs into next pe- through time. Fourth, RBCs cannot ac- riod’s production process. If the differ- count for recessions, for this would re- ent sectors are subject to independent quire economy-wide reductions in pro- shocks to productivity that follow a ductivity. Fifth, the utilization of a Markov process, aggregate output will representative agent framework limits display damped oscillations about its the ability of these models to address steady state that are similar to the busi- welfare or policy issues. ness cycles observed in U.S. data (John A. The Nature of the Shocks Long and Plosser 1983). The problem with this approach is that much of the Perhaps most frequently heard objec- variation of individual sectors is averaged tion is that there is no independent evi- out: the variance of output aggregated dence for the impulse mechanism that across n sectors is much lower than the RBCs rely on. There is, says Summers variance within each sector.14 Using a (1986, p. 24) “no discussion of the source disaggregated approach therefore has or nature of these shocks,. . . nor any the drawback that the technology shocks microeconomic evidence of their impor- hitting each sector have to be even larger tance.” Furthermore, the way the shock than in a one-good model to result in the is introduced into the models places same variance of aggregate output.15 strong implicit restrictions on the pro- cess of technological change. Technology 14 In general, the variability of aggregate output shocks are assumed (a) to affect all sec- tends to decrease as the number of sectors rises. tors of the economy equally, and (b) to For a discussion, see Per Bak et al. (1992). They affect the productivity of all factors of argue that small, independent sectoral shocks can have significant aggregate effects only if costs are production (or of all labor inputs in some non-convex and there exist nonlinear, strongly lo- calized interactions between different parts of the 13 Papers critical of RBC theory include Sum- economy. mers (1986), Mankiw (1989), McCallum (1989), 15 Long and Plosser’s model also appears to be and Eichenbaum (1991). at odds with several empirical facts. Horst Entorf Stadler: Real Business Cycles 1767

Furthermore, multisectoral models shocks, a conventional RBC shock to to- suffer from the same problems that af- tal factor productivity and a shock that is flict multicountry RBC models, because specific to the productivity of new capi- the basic structure of multisectoral and tal equipment, so the production of capi- multicountry models is the same. Hence tal goods becomes increasingly efficient the theory will predict that consumption with the passage of time. In such a across sectors is more highly correlated framework, about twenty percent of the than output across sectors, and produc- cyclical volatility of output is due to in- tivity more highly correlated than out- vestment-specific shocks, even though put, while in reality the reverse is much investment in new capital equipment is more likely to be true (the absence of only about seven percent of GNP on av- sectoral data on consumption makes this erage (Greenwood, Hercowitz, and Per difficult to test). This suggests that disag- Krussel 1992). This suggests that invest- gregating RBC models across sectors will ment-specific technical change is impor- prove challenging. tant even at cyclical frequencies. An alternative interpretation of tech- The interpretation of real shocks as nology shocks is that they are shocks to impinging primarily on new capital goods the marginal efficiency of investment. It is much more appealing than as a shock is natural to think of such shocks as af- to total factor productivity, so it is re- fecting the productivity of only new capi- grettable that this formulation has not tal, not existing capital. This is a more been adopted more widely. One reason plausible characterization of technology may be that models with vintage capital shocks, and provides a more Keynesian are computationally more difficult to an- view of the causes of cycles, because alyse than models with a single capital shocks to the future marginal efficiency good. A second reason may be that, at of capital can be interpreted as demand least within this framework, most of the shocks. cyclical volatility of output is still due to How successful is such a charac- the conventional RBC shock that im- terization of technology shocks in ac- pinges on total factor productivity. It counting for cycles? Consider an RBC would therefore be interesting to see the model with vintage capital subject to two effects of introducing other shocks (gov- ernment spending or nominal shocks, for example) into this model. (1991) argues that Long and Plosser’s model leads When asked for evidence of real to an inherent sectoral ordering, activity in some sectors leading that in others, with nonconsumer shocks, RBC theorists often point to the sectors as exogenous. He tests this using vector large oil price shocks of the 1970s and autoregressions and cross-spectral analysis, and the recessions that followed. Indeed, all finds that, contrary to the theory’s predictions, consumer sectors tend to precede nonconsumer but one of the postwar U.S. recessions sectors. He concludes that this is consistent with a have been preceded by a sharp rise in prominent role for demand disturbances. Kevin the price of crude petroleum (James Murphy, Andrei Shleifer, and Robert Vishny (1989) argue that the variability of relative prices Hamilton 1983). This raises the question provides evidence against a multisectoral RBC. whether the driving force behind RBCs They find that raw materials prices are more pro- is really energy price shocks. If so, these cyclical than intermediate goods prices, which in turn are more procyclical than finished goods shocks are unlike those RBC theory as- prices—the prices of outputs relative to inputs are sumes: the shocks RBCs contain shift the countercyclical. If cycles result from shocks to entire production function up or down, common inputs (as in Long and Plosser) one would expect intermediate goods prices to decline while a change in the relative price of an relative to final goods over the cycle. input would move one along the surface 1768 Journal of Economic Literature, Vol. XXXII (December 1994) of an existing production function, with- framework. This again suggests that ad- out any change in the state of technol- ditional shocks are essential to replicate ogy. Because RBCs consider only one cycles adequately. shock to productivity, this has to absorb B. Testing RBC Models and the Problem the role of both changes in productivity of Filtering and any omitted factors, such as changes in availability of factor inputs, that may Tests of RBC models are very infor- have played a role in reality but are not mal. Generally authors just present two really productivity shocks. It is conse- sets of statistics: second moments de- quently of interest to introduce energy rived from the model-generated data and price shocks separately into an RBC. moments from a real data set. Casual in- A number of RBC models have explic- spection determines how closely the two itly incorporated energy price shocks sets of moments correspond to each (In-Moo Kim and Prakash Loungani other, and this decides whether the 1992; Finn, forthcoming). Generally, the model is a good approximation of reality. relative price of energy is modeled as an No formal test statistics are presented. exogenous, stochastic ARMA process Furthermore, RBC models are not that fits the time series on energy price tested against alternative hypotheses. It shocks quite well. These models lead to is not clear what the value of testing a the conclusion that energy shocks seem highly abstract, but fully articulated, to account for between eight and eigh- model against a much less restrictive, teen percent of output variation, which, less comprehensively articulated alterna- while significant, suggests that, despite tive would be. In terms of predictive Hamilton’s findings, these shocks have power, one would expect a time series not been the dominant factor contribut- model that places few restrictions on the ing to business cycles in the U.S. data to reject an RBC model. The real Another omitted factor that the Solow issue here is how one should judge the residual might be capturing in closed- relative performance of alternative, fully economy RBC models is changes in a articulated business cycle models. The country’s terms of trade. It is possible to current informal method of testing RBC introduce the terms of trade as an exoge- models cannot resolve this issue and is nous process into an RBC model instead anyway subject to two pitfalls: first, the of endogenously determined by the data filtering procedure can result in model. Allowing the terms of trade pro- spurious inferences being made, and sec- cess to approximate real data for indus- ond, the method is purely subjective. trialized countries, one finds that innova- RBC models almost universally use the tions in the terms of trade account for Hodrick-Prescott (HP) filter to decom- just over half of output variability—they pose time series into long-run and busi- are even more important than productiv- ness cycle components.16 This filter has ity shocks (Enrique Mendoza 1992). This two problems. First, it “removes impor- suggests that changes in the terms of tant time series components that have trade may be an important omitted traditionally been regarded as repre- source of output fluctuations in a closed- senting business cycle phenomena” economy model. But, as noted above, (King and Rebelo 1993, p. 208). Thus models driven by productivity shocks alone cannot explain the volatility in 16 Kydland and Prescott (1990) provide a de- scription of this filter. Essentially, the filter ampli- terms of trade when these are endo- fies growth cycles at business cycle frequencies genously determined in a multicountry and dampens short- and long-run fluctuations. Stadler: Real Business Cycles 1769 this filter removes potentially valuable temporary deviations in output and em- information from time series. Second, ployment from their long-run paths, i.e., the HP filter can impart spurious cyclical detrended output and employment dis- patterns to the data. If one passes a ran- play no serial correlation (King, Plosser, dom walk through the HP filter, the fil- and Rebelo 1988a). In order to generate tered data will display cycles, even cycles, it is necessary to incorporate sub- though none was present in the raw data. stantial first-order autocorrelation in Similarly, HP filtering can induce spuri- productivity shocks, causing the shocks ous correlation patterns among two data themselves to exhibit cycles, and this is series that were not present in the prefil- what all RBC models do. tered data (Timothy Cogley and James The ability of KP’s widely used time- Nason, forthcoming). Application of the to-build construct to propagate shocks HP filter to real and model-generated has been studied by Rouwenhorst data sets causes them to display similar (1991), who finds that in the KP model cyclical properties that were not neces- sarily present in prefiltered data. This is the main determinant of these model dynam- ics is the stochastic process for the shocks illustrated by the fact that the raw data that hit the economy. Time-to-build, by itself generated by a typical RBC are almost contains only relatively weak material propa- white noise, but display cycles once gation mechanisms for transferring real passed through the HP filter (Cogley and shocks in terms of effects on output, labor Nason, forthcoming). Consequently, cor- input and consumption. For persistent devia- tions in output and investment to occur in the respondence between real and artificial neoclassical model it is required that the time data may simply reflect common proper- series of shocks that hit the economy behave ties induced by the HP filter. very much like the fluctuations which the This suggests that the properties of model seeks to explain. This conclusion is ro- real and artificial data sets should be ex- bust to allowing for nonseparabilities in pref- erences . . . time to build does not seem to amined to see how sensitive they are to be central to the explanation of business cy- the filter employed. Second, goodness of cles. (1991, p. 242, my emphasis) fit statistics invariant to the HP filter, as used by Cogley and Nason (forthcom- The ability of KP’s fatigue effect to ing), should begin to be more widely em- propagate shocks is also barely signifi- ployed. Such formal test statistics would cant: “Labor input responds slightly also facilitate objective comparison be- more elastic[ally] than in the model with tween different RBC models. time separability, but the differences ap- pear quantitatively small” (Rouwenhorst C. Output Dynamics and the Problem of 1991, p. 252). Thus, despite being widely Propagation Mechanisms used, neither time-to-build nor fatigue Can RBC models generally account for effects contain strong propagation the output dynamics displayed by U.S. mechanisms for translating uncorrelated GNP? The answer is no, because the shocks into serial correlation in output propagation mechanisms they incorpo- and investment. Instead, the artificial rate are so weak. time series generated by the model In RBC models, cycles in output are largely reflect the properties of the ex- driven by cycles in the exogenous tech- ogenous shocks that are meant to initiate nology disturbance. A purely temporary the cycle. shock to productivity does not result in This is a serious problem, for it is not cyclical activity in output or employ- confined to the KP model. Even if one ment: a temporary shock only causes accepts that exogenous technological in- 1770 Journal of Economic Literature, Vol. XXXII (December 1994) novations are highly autocorrelated, counting for the impulse response func- RBC models generally cannot replicate tion of transitory shocks. In all the other the dynamics of the U.S. GNP growth. models, output dynamics are nearly the The extensive literature on the time same as impulse dynamics (just as Rou- series properties of U.S. output docu- wenhorst found for the KP model). ments two sylized facts. First, output Why, then, do RBC models appear to growth displays significant positive auto- conform fairly well to real data? The correlations at short horizons, and weak answer is contained in the aforegoing negative autocorrelations at longer hori- subsection: both the real and model- zons (Charles Nelson and Plosser 1982). generated data are HP filtered, and may Second, if one decomposes output into contain some common cyclical properties permanent and transitory components, induced by this filter. One is led to con- output displays a hump-shaped response clude that the great majority of RBC to a transitory innovation, and thus ap- models studied in this survey cannot rep- pears to have an important trend-revert- licate the periodicity of output: they do ing component (Blanchard and Danny generate cycles, but these are quite un- Quah 1989). like the business cycles experienced by In order to account for these features, the postwar United States. This inability RBC models must propagate shocks over to account for the dynamics of output time in a particular way. Cogley and Na- growth remains a major challenge to son (1993) examine the properties of RBC theory. eight different models: (i) A “baseline” RBC model (King, Plosser, and Rebelo D. Recessions in RBC Models 1988b); (ii) A time-to-build model; (iii) Christiano and Eichenbaum’s (1992) Many critics also express skepticism model with government expenditure about the ability of RBCs to account for shocks; (iv) A variant of Christiano and recessions. Why should there be aggre- Eichenbaum’s model that also incorpo- gate declines in productivity that cause rates quadratic costs of adjusting the output to fall? Most people do not find capital stock; (v) A further variant of the interpretation of recessions as peri- Christiano and Eichenbaum’s model that ods of technological regress convincing. incorporates distortionary taxes on labor RBC theorists tend to interpret tech- and capital; (vi) Greenwood, Hercowitz, nology shocks fairly broadly as “changes and Huffman’s (1988) model with vari- in the production functions, or, more able capacity utilization and shocks only generally, the production possibility affecting the productivity of new capital sets of the profit centers” (G. Hansen goods; (vii) Benhabib, Rogerson, and and Prescott 1993, p. 280). However, Wright’s (1991) model with home pro- changes in the stock of public technical duction; and (viii) Burnside, Eichen- and scientific knowledge alone cannot baum, and Rebelo’s (1993) model with account for business cycles, because labor hoarding. even though the rate of inventions may They find that only the labor hoarding vary, the stock of knowledge should not and home production models generate decrease. Instead, RBC theorists have serial correlation in output endo- drawn attention to the legal and institu- genously, but that in the latter case it is tional framework which, in part, deter- negative, instead of positive, at short ho- mines the incentives to adopt particular rizons. Furthermore, the labor hoarding technologies. Changes in this framework, model is also partially successful in ac- for instance tighter pollution laws, can, it Stadler: Real Business Cycles 1771 is argued, be interpreted as a negative downturns in output do not require technology shock.17 negative technology shocks. Downturns The improvements in health, safety, are caused by increased allocation of re- and environmental standards that many sources to innovation in the face of in- Western economies have experienced in creased opportunity ex ante that fails to recent decades may well be one explana- materialize ex post, leaving fewer re- tion why these economies have grown sources for production with last period’s slowly over the past twenty years. How- (unchanged) technology. ever, some RBC theorists claim that the E. The Representative Agent and the cyclical component of output can also be Problem of Aggregation explained by such changes: taken liter- ally, they suggest that recessions are in- All macroeconomic models face aggre- duced by rashes of bureaucratic inter- gation problems. RBC models overcome vention in the market process, and are these by using “representative agents.” likely to occur when the stock of knowl- The entire economy is collapsed into a edge is growing only slowly. Thus, they single utility specification and a single see recessions as periods when there are production specification. This solution is no large technological innovations to off- radical, and consequently leaves even set regulatory changes that depress prof- some economists working within the its.18 mainstream neoclassical tradition un- An alternative explanation of reces- easy. sions is due to Louis Corriveau (1994), Alan Kirman (1992) has launched a who has examined the conditions under strong attack on the representative agent which an economy driven solely by tech- construct. His case rests on a number of nological advances will exhibit reces- well known results. The Debreu-Mantel- sions. He assumes technical change is Sonnenschein result demonstrates that endogenous and occurs through innova- individual maximization imposes only the tion races. Each period resources are al- weakest restrictions on the properties of located between production and innova- aggregate functions.19 tion. A potential innovator cannot know Even introducing a small amount of in advance whether he will succeed, but agent heterogeneity can have destructive chances of success increase with factors consequences. If agents have identical devoted to innovation. He shows that preferences, and differ only in terms of the income they receive, the “repre- 17 This is stated quite explicitly by G. Hansen sentative agent” for such an economy and Prescott: “It would not be surprising then, need not be well behaved and the econ- that changes in the legal and regulatory system omy can manifest a large number of un- within a country often induce negative as well as positive changes in technology” (1993, p. 281). stable equilibria. Optimization at the 18 This hypothesis has some testable implica- tions. Economies with relatively static institutional 19 More specifically, consider a pure exchange and regulatory frameworks should, in principle, economy where each individual has a well-be- experience less cyclical activity than those econo- haved textbook excess demand function. Summing mies where these frameworks are more subject to over the finite number of individuals provides the change. Furthermore, because different countries aggregate excess demand function. Generally only have very different regulatory frameworks, and three properties carry over from the individuals’ to legislation to change them is seldom introduced at the aggregate excess demand function: it must be the same time, and because G. Hansen and continuous, it must satisfy Walras Law (aggregate Prescott argue the stock of technical knowledge is excess demand must equal zero at positive prices) broadly similar across countries, a priori one and it is homogeneous of degree zero in absolute would not expect the incidence of recessions to be prices. This is not sufficient to obtain uniqueness significantly correlated across countries. and stability of equilibrium. 1772 Journal of Economic Literature, Vol. XXXII (December 1994) level of (very similar) individuals cannot (Jean-Michel Grandmont 1992). Well- ensure that the economy as a whole will behaved aggregate relationships do not behave like an optimizing individual. require individual optimization: even There is not necessarily a clear corre- economies whose agents have bounded spondence between the preferences and rationality or follow simple rules of reactions to policy changes of the indi- thumb can display well-behaved aggre- vidual agents and the preferences and gate functions, a result that appears de- reactions of the hypothetical “average” structive of the claim of RBC theorists to or representative agent. This can lead to have provided a more rigorous micro- paradoxical situations where every indi- economic foundation for macroeconom- vidual in the economy may prefer situ- ics than competing paradigms.21 ation a to situation b, but the repre- sentative agent prefers situation b to a. V. The Empirical Evidence Consequently, changes in the welfare of the representative agent need not corre- The previous section showed that RBC spond to changes in society’s welfare. models as a rule are not subjected to for- Secondly, many writers (e.g., Lucas mal statistical tests against competing al- 1987) regard one of the strengths of the ternatives, and that there is no micro- RBC paradigm as being that it provides a economic evidence for the large real rigorous microfoundation for macro- shocks that drive these models. How- economic behavior. Aggregate outcomes ever, a number of studies and empirical are explained as resulting from optimiz- facts, to which we now turn, act as indi- ing actions at the individual level. But rect tests of these models. the aforementioned arguments imply A. The Empirics of Business Cycles that the reliance on a representative agent deprives these models of much of Philip Cagan (1991) argues that the their explanatory power: aggregate fluc- traditional view of the sources of busi- tuations result from the responses of the ness cycles has tended to focus on nomi- average agent to stochastic change in nal demand. In this view, sluggish price productivity; one cannot say that they re- adjustment causes output to react to sult from the responses of maximizing in- changes in nominal demand brought dividuals to productivity shocks.20 about by changes in private sector confi- To take the argument further, it is well dence, government spending, or mone- known that constrained maximization by tary policy. This view has several impli- all individuals is not sufficient to gener- cations for the behavior of certain time ate a well-behaved representative. In- series over the business cycle. First, it deed, it is not even a necessary condi- implies prices and output will covary tion: one can obtain a well-behaved positively over the cycle. Second, one aggregate excess demand function pro- would expect real wages to be countercy- vided agents have no money illusion and clical since the rise in output depresses comply with their budget constraints the marginal product of labor. Third, un- der perfect competition the more inten- 20 An illustration of this lack of correspondence sive use of capital and labor during within the RBC paradigm is provided by G. Han- sen (1985) who shows that a small change, like booms suggests, ceteris paribus, that fixing the hours an agent may work at some num- ber “x” or zero, causes the representative to ex- 21 RBC models are also subject to the criticisms hibit infinite intertemporal substitution of leisure, that can be leveled against the use of aggregate even though the individual agents are assumed to production functions. For an overview of this is- have conventional labor supply functions. sue, see Geoffrey Harcourt (1969). Stadler: Real Business Cycles 1773 productivity should be countercyclical. omy. RBC theorists typically regard the Fourth, the traditional view is that the technology parameter as having a unit or classical dichotomy holds in the long run: near unit root. Because output inherits one would not expect nominal changes to the trend properties of technology, RBC alter the long-run time profile of out- models can readily account for nonsta- put—nominal shocks should only cause tionarity, with transitory (though possi- transitory deviations from this long-run bly long lasting) deviations from this path. trend determining the cycle. Nominal RBCs predict different patterns for shocks, by contrast, seem unable to ac- prices, wages, productivity, and output. count for the nonstationary trend. If cycles are driven by real shocks, then This argument is weakened by three in the absence of a consistently procycli- points. First, in finite samples it is not cal monetary policy, prices will be coun- possible to discriminate between the hy- tercyclical—for a given money stock, pothesis that a series is nonstationary (or prices should fall as productivity and difference stationary) and has a unit output rise. Furthermore, because ex- root, and the hypothesis that it is station- pansions are induced by positive innova- ary but has a root that is less than, but tions in productivity, real wages and pro- close to unity.22 Second, David DeJong ductivity will be procyclical. Finally, and Charles Whiteman (1991) have ar- some real shocks are permanent and will gued from a Bayesian perspective that alter the long-run path of output. most economic time series are in fact The models’ different time series pre- more likely to be trend stationary than dictions have led a number of writers to difference stationary—given reasonable conclude that the “stylized facts” about priors, the relative support the data give these series can be used to discriminate to a trend stationary representation is between RBCs and competing theories. I stronger than that given to a nonstation- examine the evidence for the pattern of ary representation. Third, if technology output, wages, prices, and productivity is endogenous to the economic system, a below, and consider the implications this monetary theory of the business cycle has for RBCs. can account for nonstationarity just as A.1 Nonstationarity. Before the influ- well as an RBC model can (Stadler ential work of Nelson and Plosser (1982), 1990). Despite the original claims of it had been common practice to treat Nelson and Plosser, their work does not macro time series as stationary move- provide unequivocal support for RBCs.23 ments around a deterministic linear trend. Nelson and Plosser found the 22 The widely used Augmented Dickey-Fuller trends of most series to be nonstationary test of nonstationarity will actually reject the hy- pothesis of stationarity in series that are stationary stochastic processes, often well de- but have an autoregressive component close to scribed as a random walk with trend. unity (John Campbell and Pierre Perron 1991). Their findings also led them to conclude 23 A further factor that creates problems for RBCs is that macroeconomic time series may con- that most output movements appear to tain non-linearities. For instance, Hamilton (1989) result from changes in the secular, or finds that the growth rate of output is better de- permanent component of output, rather scribed by a regime-switching model than a linear model. Hamilton’s findings can be replicated than the transitory cyclical component. within an RBC model if the productivity shocks Many writers (including Nelson and follow a Markov process with asymmetric transi- Plosser) argued that these time series tion probabilities. However, this implies that the Solow residuals should exhibit heteroscedasticity, properties are most easily explained by a for which there is no evidence in the data (Rou- predominance of real shocks in the econ- wenhorst 1994, fn. 5). 1774 Journal of Economic Literature, Vol. XXXII (December 1994)

A.2 Real Wages. Are real wages pro- and output to move in the same direc- cyclical? Until the mid-1980s, empirical tion, but in opposite directions sub- work on this issue was inconclusive, and sequently. The correlation coefficient sometimes contradictory. For instance, depends both on the initial and later Patrick Geary and Kennan (1982) found movements, and may consequently be wages and employment to be statistically negative (John Judd and Trehan, forth- independent. Subsequent papers, using coming). Thus, there need be no system- micro data on individuals, found a sig- atic relationship between the price-out- nificant but mild procyclical movement put correlation and the cyclical pattern (Michael Keane, Robert Moffit, and prices actually follow. Because similar David Runkle 1988). However, discrep- reasoning applies to other variables as ancies between the findings of these and well, it suggests that correlation coeffi- other studies actually result from cients may not be very informative about changes in the sample period, rather cyclical comovements. than the data set, employed. Periods A.4 Productivity. A further feature of dominated by demand disturbances ex- the cycle that has arguably lent support hibit countercyclical real wages, while to RBC theory is that productivity is pro- periods dominated by supply distur- cyclical. The conventional neoclassical bances manifest procyclical movements theory of the firm suggests that as output in real wages, which accounts for the low rises and firms move down their demand correlation between wages and employ- for labor functions, productivity and ment (Scott Sumner and Stephen Silver wages should fall, ceteris paribus (there 1989). This finding is hardly unexpected, are short-run decreasing returns to la- but does not lend strong support to RBC bor). However, Robert Hall (1988) ar- theory. gues that productivity is procyclical be- A.3 Prices. Are prices procyclical? The cause firms in imperfectly competitive actual pattern prices follow is difficult to markets operate on the downward-slop- determine. When variables have been ing portion of their average cost curves. detrended using the HP filter, regression In an interesting paper, Ben Bernanke analysis invariably yields a negative cor- and Martin Parkinson (1991) find that relation between prices and output, as procyclical productivity was as marked stressed by Kydland and Prescott (1990). during the Great Depression and its af- However, there is some evidence that termath (1929–1939) as in the postwar the sign of this correlation is sensitive to period. Because the Great Depression the filter employed to detrend the data hardly can have been caused by technical (Keith Blackburn and Morten Ravn regress, they argue that these results 1991). Cagan (1991) eschews detrending show that procyclical productivity cannot and visually inspects the time profile of always be due to procyclical technology the logarithm of prices over postwar shocks as RBC theorists claim. business cycles. He concludes that most The empirical “regularities” concern- of the movement is procyclical. ing nonstationarity, prices, and real However, the price-output correlation wages are clearly not robust. Further- is not necessarily informative about the more, the fact that the correlation be- cyclical behavior of prices. Even models tween output and productivity is posi- driven solely by demand shocks can ex- tive, and output and prices negative, is hibit a negative correlation. A change in not really informative about the underly- aggregate demand initially causes prices ing causes of cycles. While there is no

1 LINE SHORT Stadler: Real Business Cycles 1775 persuasive evidence against RBCs here, Solow residual. This is exactly what there is no clear evidence in their favor Kydland and Prescott (1991) undertake. either. They obtain measured Solow residuals from estimates of an aggregate produc- B. Testing First-Order-Condition tion function and use these residuals as Restrictions productivity shocks in the model.24 They One way of testing RBCs indirectly is then compare the resulting standard de- to test the restrictions that the first-or- viation of output to that of the actual der conditions which characterize mar- U.S. economy. They find that about 70 ket equilibrium in a competitive econ- percent of the variance of postwar U.S. omy impose on the data—i.e., equations output can be accounted for by fluctua- like (5) to (7) in the simple prototype tions in the Solow residual. RBC model outlined above. Studies us- This type of test is subject to two criti- ing a time separable utility function cisms. First, Solow residuals will reflect (Mankiw, Rotemberg, and Summers shifts in the production function accu- 1985) and a non-time separable utility rately only under conditions of perfect function (Eichenbaum, Lars Hansen, competition and constant returns to and Kenneth Singleton 1988) find that scale. Second, even with perfect compe- the restrictions imposed by first-order tition, Solow residuals will capture conditions are strongly rejected by the changes in total factor productivity only data. if there are no measurement errors in In the light of the above discussion of the indices of the capital and labor in- the representative agent, this is hardly puts that are used in estimating the ag- surprising, for these studies are testing a gregate production function: measure- joint hypothesis: first, that the economy ment errors in factor inputs will show up is well captured by a competitive general as variations in the estimated Solow re- equilibrium model of optimizing agents, sidual. If firms hoard labor, measure- and second, that the preferences of all ment errors in labor input may be impor- these agents are reasonably accurately tant. With labor hoarding, changes in captured by the particular preference real labor input are not captured by the specification ascribed to a single, fic- employment data, because labor effort is tional representative agent. The rejec- procyclical, rising during booms when tion of this joint hypothesis suggests that productivity is higher than expected, and the preferences of agents in real econo- falling during recessions, so that the pro- mies are not accurately captured by a cyclical Solow residual also captures single, reasonably tractable utility func- changes in labor effort not reflected in tion of the kind RBC models employ. the labor input statistics. This causes the C. Tests Using Solow Residuals 24 The aggregate production function is as- To test RBCs, one needs to uncover sumed to be Cobb-Douglas and labor’s share pa- what degree of fluctuation in output is rameter constant over the sample period, whereas really due to innovations in productivity. Solow originally treated the labor share parameter as variable, and it does vary over the cycle. Prescott first suggested that the Solow Clearly, a variable share parameter would fit the residual, which is highly procyclical, cap- observations more closely and reduce the residu- tures such innovations, and a natural test als. It is not clear which procedure is the more appropriate, although the latter would almost cer- of RBCs is to investigate what amount of tainly reduce the variance of output due to Solow output volatility is due to changes in the residuals.

1 LINE SHORT 1776 Journal of Economic Literature, Vol. XXXII (December 1994) measured Solow residuals to overstate terpretable as technology shocks. A pre- the importance of technology shocks. In dominant role for industry-specific a model that incorporates labor hoard- shocks would provide evidence in favor ing, Burnside, Eichenbaum, and Rebelo of RBCs. (1993) find that technology shocks can Generally, productivity growth is more account for between 30 percent and 60 strongly correlated across industries percent of aggregate fluctuations, de- within one country than across countries pending on the estimation procedure within one industry. As a result, these employed. This is significantly less than studies find that shocks at the national the figure of 70 percent claimed by level are at least as important as shocks Kydland and Prescott. at the industry-specific level. Estimates A further problem with Solow residu- of the amount of output volatility attrib- als is that they do not behave like an ex- utable to industry-specific shocks differ, ogenous impulse, but are Granger- but they cannot account for much more caused by money, interest rates, and than about a third of output volatility. government spending, and this finding These results suggest that cycles are not does not appear to be due to reverse- caused by worldwide technology shocks causation (Charles Evans 1992). Be- within a particular industry, for nation- tween one quarter and one half of the specific shocks are as important. Some of variation in the measured Solow residual the latter could be interpreted as tech- is attributable to variations in aggregate nology shocks if they capture changes in demand. This suggests that Solow residu- the infrastructure or human capital accu- als are not simply measures of productiv- mulation that impinge primarily on pro- ity shocks, but capture a variety of other ductivity within one country. Skeptics, factors at work in the economy as well however, may well view the importance and reflect both supply-side and de- of nation-specific shocks as evidence in mand-side impulses. Another reason for favor of traditional sources of business procyclical Solow residuals is that they cycles, such as changes in nominal de- may result from short-run increasing re- mand. turns. These could arise through cross- Econometric tests indicate that out- sectoral complementarities in demand put, consumption, and investment are and supply, whereby a rise in output in cointegrated—they share a common sto- one sector has favorable spillover effects chastic trend. King et al. (1991) identify on other sectors. permanent productivity shocks as shocks to the common stochastic trend of out- D. Tests Using Aggregate put, consumption, and investment. They Decompositions find that productivity shocks typically ex- plain less than half of the volatility in A number of studies (Donna Costello output, and considerably less of the vari- 1993; Stefan Norrbin and Don Schlagen- ability of investment. They also find that hauf 1988; Alan Stockman 1988) have innovations in inflation could account for decomposed the sources of output fluc- up to 20 percent of variability of invest- tuations into national (or aggregate), in- ment, but only for four percent of output dustry specific, and (in some cases) re- variability. Furthermore, a shock corre- gional shocks. These studies are sponding to permanent movements in motivated by the fact that industry-spe- real interest rates could account for cific shocks that are common across more of the short-run variation in output regions or countries are most readily in- than the productivity shocks, and for Stadler: Real Business Cycles 1777 much more of the variation in invest- profits. Schmookler concludes that, “In- ment than the productivity shock. This vention is governed by the extent of the suggests that impulse mechanisms omit- market,” and that, “The belief that in- ted from conventional RBCs may be im- vention, or the production of technology portant. generally, is in most instances a none- conomic activity, is false” (1966, p. E. Scientific Evidence 208).26 In considering the scientific evidence, One shortcoming of the RBC para- it is natural to ask whether there is evi- digm is that, in assuming productivity dence for large shocks to technology changes are purely exogenous, it ignores (which can be most easily thought of as the economic factors underlying techni- unexpected scientific discoveries) which cal change. But even if most scientific are generally exogenous to the economic progress were due to random and exoge- system, as RBC models assume.25 The nous discoveries, it does not follow that pioneering work of Jacob Schmookler the growth of productivity will be. The (1966) is of particular interest here. decision to adopt a new, low cost tech- Schmookler regards an innovation or in- nology is determined by economic crite- vention as essentially a response to profit ria. Shleifer (1986) has argued that firms opportunities. He finds the rate of tech- will innovate when they expect booms nological opportunity—given by the un- and aggregate demand and profits are derlying scientific base—to be of little high (so helping to fulfill the expectation significance, because chronologies of of a boom). Thus, productivity shocks hundreds of inventions typically reveal may manifest themselves as the optimiz- the stimulus to be a technical problem or ing response to innovations in the money opportunity conceived largely in eco- supply or government spending, and nomic terms. There is little evidence of hence may explain why Solow residuals scientific discovery initiating an inven- appear to be Granger-caused by money, tion. interest rates, and government spending Schmookler argues that invention is (Evans 1992). This suggests that the way largely an economic activity, pursued for technology is modeled in RBCs may be a profit. Using data from the railroad, poor approximation of how technology building, and petroleum refining indus- evolves in reality. Ignoring the endo- tries, he finds a strong positive correla- geneity of technology may well limit the tion between investment and capital usefulness and applicability to policy is- goods invention in each industry, invest- sues of RBC models, because the estima- ment acting as a proxy for expected fu- tion of welfare costs is sensitive to the ture sales and thus expected future endogeneity of technology (Gomme 1993). 25 If technology is exogenous, then the cycle can be considered independently of growth considera- 26 Further evidence is provided by James Utter- tions, because growth is determined by the (exoge- back in his survey of innovation and the diffusion nous) trend in technology, while the cycle is deter- of technology. He finds that “Market factors ap- mined by deviations from this trend. But if growth pear to be the primary influence on innovation. is endogenous, it raises the possibility that trend From sixty to eighty percent of important innova- and cycle will be correlated, because they are tions in a large number of fields have been in re- driven by the same forces. If this is the case, one sponse to market demands and needs. The remain- needs an underlying structural model to derive a der have originated in response to new scientific theoretical identifying restriction that will separate advances. . . .” Furthermore, “Firms tend to inno- cycle from trend. It is consequently not clear that vate primarily in areas where there is a fairly clear, the filters RBC theorists employ succeed in accu- short-term potential for profit” (1974, p. 621, my rately separating out the cyclical component. emphasis). 1778 Journal of Economic Literature, Vol. XXXII (December 1994)

F. An Empirical Assessment vest season. Thus, RBC theory has changed our view of cycles in a funda- As is often the case, the empirical evi- mental way. dence considered here is not sufficiently RBC theory has made considerable conclusive to tilt the balance either in fa- progress since the early 1980s. Neverthe- vor of or away from RBC theory. Real less, it still faces a number of challenges: shocks are important, and may be the it has difficulty in accommodating a cause of as much as one third of cyclical number of empirical facts, it cannot ade- fluctuations, but there is no persuasive quately account for the dynamics of out- evidence that they account for much put, and it cannot account for a signifi- more than this. There is certainly no co- cant degree of agent heterogeneity. gent evidence that they account for 70 Many empirical regularities that mani- percent, as Kydland and Prescott claim, fest themselves in labor markets, in asset let alone for 100 percent as some RBC markets, and in international trade can- models assume when they suppress all not be explained by RBC models that other sources of economic fluctuations. rely solely on productivity shocks to in- duce cycles. To explain numerous facts, VI. A Summing Up other shocks must be added to these Real Business Cycle Theory has models, such as shocks to tastes, govern- brought about a significant improvement ment spending, or the money supply. in our understanding of the causes and However, even such multi-shock RBC mechanisms that underlie business cy- models cannot account for a number of cles. RBC theory has shown that fairly important phenomena. Even if shocks simple general equilibrium models, in impinge on both labor demand and sup- which technical change is stochastic, are ply, RBC models cannot simultaneously capable of capturing many of the cyclical account for the productivity puzzle and features of economic time series. These the cyclical pattern of household invest- models provide the important insight ment. Nor can they readily account for that the existence of fluctuations in out- the volatility and persistence of the put does not imply any failure of markets terms of trade together with the fact that to clear. Even economies with complete output is more highly correlated than and efficient markets will display busi- consumption across countries. Further- ness cycles if technical change is stochas- more, RBC models have even more diffi- tic. Although government intervention culty than endowment economy models may be welfare-improving if equilibrium in explaining the cross-sectional and is not Pareto-optimal to begin with (say time series behavior of asset returns. Re- through the presence of distortionary solving these problems is the subject of taxes or money), the existence of cycles ongoing research. per se is not sufficient to justify stabiliza- A further problem is that the great tion policies. It is not necessarily sensi- majority of RBC models are unable to ble to try to increase output when factor account for output dynamics (and thus, productivity is low and decrease output by implication, for the cyclical pattern of when productivity is high, any more than most major macroeconomic time series). it is sensible to try to iron out seasonal They cannot propagate shocks through fluctuations (to use an analogy due to time in a manner that generates cycles McCallum) by stimulating economic ac- similar to those observed in reality. Fur- tivity in January and February and trying thermore, the emphasis on matching to decrease production during the har- model-generated with real correlation Stadler: Real Business Cycles 1779 coefficients may be misplaced, because are responsible for more than a third of these coefficients are not necessarily in- output fluctuations. What determines formative about the true cyclical co- the remaining two-thirds? There is no movements of variables. Accounting for clear answer to this at the present time. the dynamics of GNP and other major Since the work of Milton Friedman in macroeconomic time series will, I sus- the 1960s, the main alternative impulse pect, prove a major challenge to business mechanism has been nominal shocks, cycle theorists. particularly monetary shocks. As evi- If RBC models must be supplemented dence of their importance, economists by additional shocks, this raises the fun- often point to the recession of 1982–83 damental question of whether productiv- in the United States that followed closely ity shocks are really the dominant cause on the deflation induced by the Federal of cycles. The models surveyed above Reserve in 1981. This, and similar epi- demonstrate that, provided sufficiently sodes (see Christina Romer and David large, autocorrelated, economy-wide pro- Romer 1989) must cast some doubt on ductivity shocks exist, most fluctuations the proposition that real shocks are the could be due to such shocks. Introducing predominant cause of cycles. additional sources of shocks does not al- Finally, we must consider whether we ter this result—most of the models’ out- can use RBC models, containing repre- put volatility is still due to productivity sentative agents, to guide policy. In sur- shocks. However, there is no corroborat- veying the problems of aggregation over ing evidence for large shocks that im- individuals, Thomas Stoker says that pinge on most sectors of the economy. In to the author’s knowledge, there are no stud- this regard it is important to note that ies of disaggregated micro level data that fail the incorporation of certain features, to find strong systematic evidence of individ- such as distortionary taxes, real wage ri- ual differences in economic behaviour, gidity, or traded goods amplifies the im- whether one is concerned with demographic pact of shocks on output and causes their differences of families or industry effects in production . . . it matters how many house- effects to persist longer. For example, holds are large or small, how many elderly or KP’s model requires the economy-wide young and how many companies are capital real shock to have a standard deviation of intensive or labor intensive. Such heterogene- 0.0093. In Danthine and Donaldson’s ity of concerns is an essential feature of the (1991) model with wage rigidity, the re- overall impacts of . . . changes in interest rates on saving, or the impact of an invest- quired standard deviation is only 0.0027. ment tax credit. (1993, pp. 1827–28) It would be interesting to combine sev- eral features that reduce the required This suggests that representative agent volatility of the productivity shock. With models, by their very nature, are not well several factors acting in concert, the re- suited to address policy issues, and that a quired standard deviation may be very further major challenge to RBC theory is small indeed. But this argument is coun- to develop more disaggregated models. tered by noting that generalizing RBC Models with heterogeneous agents are models by introducing imperfect compe- being developed (Jose-Victor Rios-Rull, tition or multiple sectors is likely to re- 1994, provides a survey), but the degree duce the importance of productivity of heterogeneity introduced is very lim- shocks sharply. ited—for example, in some formulations The empirical evidence of what causes workers differ only in the probability of business cycles does not give strong sup- being employed, or some are older, port to the proposition that real shocks skilled workers, others young, unskilled 1780 Journal of Economic Literature, Vol. XXXII (December 1994) workers. Generalizing such models fur- KYDLAND, FINN E. “Dynamics of the Trade Balance and the Terms of Trade: The J-Curve?” ther poses formidable technical prob- Amer. Econ. 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