Nber Working Paper Series Do Equilibrium Real Business
Total Page：16
File Type：pdf, Size：1020Kb
NBER WORKING PAPER SERIES DO EQUILIBRIUM REAL BUSINESS CYCLE THEORIES EXPLAIN POST-WAR U.S. BUSINESS CYCLES? Martin Eichenbaum Kenneth J. Singleton Working Paper No. 1932 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 May 1986 We have benefited from helpful discussions with Lars Hansen, Bennett McCallum, Allan Meltzer, Dan Peled, Michael Woodford, and our discussants Robert Barro and Greg Mankiw. Research assistance was provided by Kun-hong Kim and David Marshall. The research reported here is part of the NBER's research program in Economic Fluctuations. Any opinions expressed are those of the authors and not those of the National Bureau of Economic Research. Working Paper #1932 May 1986 Do Equilibrium Real Business Cycle Theories Explain Post-War U.S. Business Cycles? ABSTRACT This paper presents and interprets some rw evidenceon the validity of the Real Business Cycle approach to businesscycle analysis. The analysis is conducted in the context of a nnetary businesscycle model which makes explicit one potential link between monetary policy and realallocations. This model is used to interpret Granger causal relationsbetween nominal and real aggregates. Perhaps the nost strikingempirical finding is that money growth does not Granger cause output growth in the context of several multivariate VARs and for various sample periodsduring the post war period in the U.S. Several possible reconciliations of thisfinding with both real and monetary business cycles models are discussed. We find that it is difficult to reconcile our npirical results with the view thatexogenous monetary shocks were an important independent source of variationin output growth. Martin Eichenbaum Kenneth J. Singleton Graduate School of Graduate School of Industrial Administration Industrial Administration Carnegie-Mellon University Carnegie-Mellon University Pittsburgh, PA 15213 Pittsburgh, PA 15213 (412)268-3683 (412) 268-8838 1. Introduction During the past decade there has been a resurgence of interest in equilibrium real business cycle theories. According to these theories, the recurrent fluctuation in outputs, consumptions, investments, and other real quantities- -what shall refer to as the business cycle phenomenon- -is precisely what one should expect to emerge from industrial market economies in which consumers and firms solve intertemporal optimum problems under uncertainty. Moreover, fluctuations in real quantities are attributed to exogenous technological and taste shocks combined with various sources of endogenous dynamics including adjustment costs, time-to-build capital goods, and the non-time-separability of preferences (e.g., Kydland and Prescott (1982), Long and Plosser (1983), Kydland (1984), and Prescott (1986)). Common characteristics of these models are that there is a complete set of contingent claims to future goods and services, agents have common information sets, and the only "frictions" in the economy are the to technological factors. In particular, real business cycle (RBC) uDdels abstract entirely from monetary considerations and the fact that exchange in modern economies occurs via the use of fiat money. There are two interpretations of this modeling strategy. The first interpretation is that monetary institutions and monetary policy are assumed to be inherently neutral in the sense that real allocations are invariant to innovations in financial arrangements and nDnetary policy. Money is a veil regardless of how much the veil flutters. The second interpretation is that the market organizations and the nature of monetary policy in the sample period being examined are such as that an RBC model provides an accurate characterization of the real economy. Under this interpretation RBC models 2 may be useful frameworks for examining the determination of real allocations for certain institutional environments and classes of monetary policies. Money may be a veil as long as the veil does not flutter too much. In our view, proponents of RBC theories are rt claiming that monetary policy cannot or has never had a significant impact on the fluctuation of real output, investment, or consumptions. Rather we subscribe to the second interpretation of RBC analyses as investigations of real allocations under the assumption that, to a good approximation, monetary policy shocks have played an insignificant role in determining the behavior of real variables. The assumption in equilibrium RBC models that monetary shocks have not been an important source of aggregate fluctuations is similar to the basic premise of certain early Keynesian ndels. According to these nodels, interest rates affected at most long-lived fixed investments, so the interest elasticity of aggregate demand was perceived as being low. Furthermore, the principal shocks impinging on the economy had their direct effects on aggregate demand. In particular, investment was thought to be influenced capriciously by "animal spirits." Thus, aggregate fluctuation was associated primarily with real shocks. Indeed, the economic environment was assumed to be such that changes in the money supply (both systematic and current updated shocks) had small impacts on real economic activity. The latter feature of these models led to the conclusion that fiscal policy was preferred to monetary policy for stabilizing output fluctuation. More recent Keynesian-style models share some common features with both early Keynesian and equilibrium RBC models, lxi.t they are also fundamentally different in several important respects. Proponents of modern Keynesian models often argue that monetary policy shocks have not been a significant 3 source of "instabilityt' in the U.S. economy. For cample Modigliani (1977, p.12) states that "..thereis ro basis for the nrnetarists' suggestion that our post war instability can be traced to nonetary instability.. .". Thuson this feature of the economy, proponents of modern Keynesian models and of equilibrium RBC theories are often in agreement. However, for at least two reasons, it would be misleading to argue that equilibrium RBC models and Keynesian models are simply different versions of business cycle models in which only (or primarily) real shocks matter for fluctuations in real quantities. First, the propogation mechanisms by which exogenous shocks impinge on the endogenous variables are typically very different in the tvo classes of nr,dels. As noted above, equilibrium RBC models focus on such technological frictions as gestation lags in building capital or intertemporal nonseparability of preferences in generating endogenous sources of dynamics. Contingent claims markets are assumed to be complete and goods and asset prices adjust freely in competitive markets. In contrast, Keynesian models typically emphasize various frictions that prevent perfectly flexible goods prices and wages (e.g., Modigliani 1958, Taylor 1980). The sources of these rigidities may be frictions associated with incomplete markets, contractual arrangements, or imperfect competition among firms. These differences in propogation mechanisms may imply very different reactions of the equilibrium RBC and Keynesian economies to the same type of shock. Second, and closely related to this first consideration, the potential roles for stabilization in these economic environments may be very different. The inflexible prices and incomplete markets in Keynesian models have been used to justify activist fiscal and nonetary policies designed to stabilize 4 output fluctuation. Of particular relevancefor our analysis is the important role often attributed to monetary policy in affecting the cyclicalbehavior of real variables in Keynesian nodels. While exogenous nonetary policyshocks may not be important sourcesof aggregate fluctuations, activist monetary policies are often deemed to have had significanteffects on the propogation of nonmonetary shocks. Hence, though the sources of uncertainty may be real, it seems clear that noney plays a central role in nodern KeynesiannDdels. This interpretation of modern Keynesian models was made explicitly by Modigliani (1977, p.1): "Milton Friedman was once quoted as saying'We are all Keynesians, now, and I am quite prepared to reciprocate that we are all monetarists if by nonetarism is nant assigning to the stock of noney a major role in determining output and prices". In contrast, equilibrium RBC models typically assume that there is a complete set of contingent claims markets and that prices are perfectly flexible. One implication of these assumptions in the models that have been examined to date is that real allocations are Pareto optimal. This, in turn, implies that there is rx role for a central policy authority. Thus, equilibrium RBC theories assume both that exogenous monetaryshocks have not been an important source of fluctuations, and that the policy rules followed by the monetary authorities have not had an importantrole in propogating nonmonetary shocks. For only under this joint hypothesisdoes it seem likely that an equilibrium RBC model would accurately characterize the economy. This paper presents and interprets some rw evidence on the validity of the RBC proach to business cycle analysis. Particular attention in given to: (1) the question of whether monetary policy shocks were an important determinant of real economic activity during the post war period, and (2) 5 several potentially important pitfalls in interpreting the available evidence as supporting or refuting the validity of RBC models. The analysis of the first question