Technology Shocks and Aggregate Fluctuations: How Well Does the Real Business Cycle Model Fit Postwar U.S. Data?

WP/04/234

Jordi Galí and Pau Rabanal

IMF Working Paper

Western Hemisphere Department

Technology Shocks and Aggregate Fluctuations: How Well Does the Real Business Cycle Model Fit Postwar U.S. Data?

Prepared by Jordi Galí and Pau Rabanal1

Authorized for distribution by Tamim Bayoumi

December 2004

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Our answer: Not so well. We reached that conclusion after reviewing recent research on the role of technology as a source of economic fluctuations. The bulk of the evidence suggests a limited role for aggregate technology shocks, pointing instead to demand factors as the main force behind the strong positive comovement between output and labor input measures.

JEL Classification Numbers: E32

Keywords: Real Business Cycles, Technology Shocks, Nominal Rigidities, Real Frictions

Author(s) E-Mail Address: [email protected], [email protected]

1 Prepared for the 19th NBER Annual Conference on Macroeconomics. We are thankful to Susanto Basu, Olivier Blanchard, Yongsung Chang, John Fernald, Albert Marcet, Barbara Rossi, Julio Rotemberg, Juan Rubio-Ramirez, Robert Solow, Jaume Ventura, Lutz Weinke, as well as the editors, Mark Gertler and Ken Rogoff, and discussants, Ellen McGrattan and Valerie Ramey, for useful comments. We have also benefited from comments by participants in seminars at the CREI-UPF Macro Workshop, MIT Macro Faculty Lunch, and Duke University. Anton Nakov provided excellent research assistance. We are grateful to Craig Burnside, Ellen McGrattan, Harald Uhlig, Jonas Fisher, and Susanto Basu for help with the data. Galí acknowledges financial support from DURSI (Generalitat de Catalunya), Fundación Ramón Areces, and the Ministerio de Ciencia y Tecnología (SEC2002–03816). - 2 -

Contents Page

I. Introduction...... 4

II. Estimating the Effects of Technology Shocks...... 6 A. Revisiting the Basic Evidence on the Effects of Technology Shocks ...... 7 B. Related Empirical Work ...... 9 C. Implications...... 11

III. Possible Pitfalls in the Estimation of the Effects of Technology Shocks...... 12 A. Are Long-Run Restrictions Useful in Identifying Technology Shocks?...... 12 B. Robustness to Alternative VAR Specifications ...... 16 C. Investment-Specific Technology Shocks...... 20

IV. Explaining the Effects of Technology Shocks...... 21 A. The Role of Nominal Frictions ...... 22 B. A Simple Illustrative Model...... 23

V. Technology Shocks and the Business Cycle in an Estimated DSGE Model...... 30 A. Parameter Estimation...... 33 B. Main Findings...... 35

VI. Conclusions...... 38

VII. Addendum: A Response to Ellen McGrattan...... 39 A. Why Does the SVAR Evidence Fail to Match the McGrattan and CKM Models' Predictions?...... 40 B. Why Does the CKM Accounting Framework Predict a Rise in Hours?...... 42 C. Some Agreement...... 43

References...... 60

Tables 1. The Effects of Technology Shocks on Output and Hours in the Nonfarm Business Sector...... 45 2. The Effects of Technology Shocks on GDP and Employment...... 46 3. Investment-Specific Technology Shocks: The Fisher Model...... 47 4. Prior and Posterior Distributions ...... 48 5. Second Moments of Estimated DSGE Model ...... 49 6. Variance Decomposition from Estimated DSGE Model...... 50 7. Technology-Driven Fluctuations in Output and Hours: Correlations Implied by Alternative Model Specifications (BP-Filtered Data)...... 51

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Figures 1. Business Cycle Fluctuations in Output and Hours...... 52 2. The Estimated Effects of Technology Shocks (Difference specification, sample period 1948:01–2002:04)...... 53 3. Sources of Business Cycle Fluctuations, (Difference specification, sample period 1948:01–2002:04) ...... 54 4. Capital Income Tax Rates...... 55 5. Technology Shocks: VAR versus BFK ...... 56 6. Hours Worked (In natural logarithms, 1948–2002)...... 57 7. Posterior Impulse Responses to a Technology Shock, Estimated DSGE Model ...... 58 8. The Role of Technology Shocks in U.S. Postwar Fluctuations: Model-Based Estimates ...... 59