RATIONAL EXPECTATIONS BUSINESS CYCLE MODELS: A SURVEY Michael Dotsq and G. King’ Development of rational expectations models of of the business cycle. One could take the view that the business cycle has been the central issue on the an ultimate explanation of economic fluctuations will macroeconomic research agenda since the influen- require a return to “psychological influences.” We tial analyses of Robert Lucas (1972a, 197Zb). In this prefer to believe that existing individual models essay, we review these developments, focusing on highlight specific features that are important and that the extent to which the rational expectations perspec- the gradual accumulation of knowledge about shocks tive has generated a new understanding of economic and propagation mechanisms will ultimately yield fluctuations. rational expectations models consistent with ob- Economists have long suspected that expectations served business cycles. play a central role in the business cycle, particularly The organization of our discussion is as follows. in determining the relationship between money and First, we briefly consider a set of “stylized facts” that economic activity. For example, Haberler’s (1937) any successful model must minimally produce. Then, classic interwar survey of business cycle theory we turn to four categories of rational expectations stresses the role of expectations, in a variety of models of the business cycle, considering in turn how theories that explain the business cycle as a Frischian each has been developed to account for some specific (1933) interaction of external shocks and internal pro- set of stylized facts. We then review the empirical pagation mechanisms. Expectations also constitute evidence regarding the overall performance of each an independent source of shocks in “psychological” class of models. theories of the business cycle. However, as Haberler’s We begin by exploring the role of expectations in survey makes clear, there has long been substantial the basic real business cycle models of Kydland and disagreement among economists about the relative Prescott (1982) and Long and Plosser (1983), in importance of various economic factors-sources of which dynamics of business cycles reflect the inter- shocks and propagation mechanisms-in determin- action of temporary real shocks and intertemporal ing the observed character of business fluctuations. (capitalistic) production. We then consider the With the development of formal econometric analyses monetary business cycle models of Lucas (1972a, of business cycles-beginning with Tinbergen’s work 1973) and Barro (1976, 1980) which utilize in- (1939) and proceeding through Sargent (1981)-it complete information as a rationale for temporary real has become clear that unrestricted models of expec- effects of monetary disturbances. Although agents have rational expectations in these models, lack of tations preclude a systematic inquiry into business timely information on monetary shocks implies that fluctuations. agents erroneously perceive price level movements The postulate that expectations are rational in the as representing changes in relative prices. After con- sense of Muth (1961), i.e., that economic agents ac- sidering equilibrium models of the business cycle-in cumulate information and utilize information effi- which prices are flexible-we turn to Keynesian ciently, imposes considerable discipline on business models of business fluctuation constructed under the cycle analysis. At present, no single rational expec- rational expectations postulate. Our discussion begins tations model has captured all of the central elements with the analyses of Fischer (1977) and Gray (1976), who model temporary wage stickiness arising from nominal wage contracts. Subsequently, we consider l Michael Dotsey is Economist and Research Officer, Federal Reserve Bank of Richmond. Robert G. King is Professor of the emerging class of theories that focus on com- Economics, University of Rochester, and Research Advisor, modity price stickiness, beginning with a parable told Federal Reserve Bank of Richmond. by McCallum (1982) and then considering some Reprinted from TXeNm PaZgrave:A Dictionaryof Economics, edited by John Eatwell, Murray Milgate, and Peter Newman, alternative formal developments by Rotemberg and published by the McMillan Press Limited, London and the (1982), Mankiw (1985) and Blanchard and Kiyotaki Stockton Press, New York, 1987. (1987). FEDERAL RESERVE BANK OF RICHMOND 3 Throughout our discussion, we follow the tradi- time. In Mitchell’s (195 1) consideration of interwar tional macroeconomic practice of considering data for the United States, the price level and short- business cycles-defined as the stochastic com- term nominal interest rate were strongly procyclical. ponents of macroeconomic time series-as stationary More recent investigations by Hodrick and Prescott stochastic processes. This practice is foll,owed in our (1980) into post-war U.S. cycles, document a chang- description of stylized facts, but is also implicit in ing relation, price levels are countercyclical during the theoretical economies that we consider, since the the latter half of their sample and short-term rates time series generated by these economies are sta- are not systematically related to economic activity. tionary. If, in fact, economic time series exhibit However, most investigations do document a positive nonstationarity, as argued by Nelson and Plosser relation between income velocity and real activity that (1982), then these classes of models are called into mirrors the financial transactions data. question. In a concluding section we briefly discuss When many sectors are included in this analysis, the ongoing development of rational expectations as in Mitchell (1951), there is a tendency for co- business cycles that are capable of producing model movement across sectors and considerable stability economies that have nonstationary components. in lead-lag relations relative to aggregate output. There do appear to be different degrees of sectoral Stylized Facts co-movement and amplitude. For example, agri- Much of our survey deals with the ability of various culture does not covary closely with the rest of the business cycle models to generate time series whose economy. The producer and consumer durable goods properties are consistent with commonly discussed manufacturing sectors exhibit greater volatility than summary statistics, i.e., the stylized facts of business the services sector. cycles (see e.g., Lucas, 1977). Presentations of these Expectations and Real Business Cycles stylized facts typically proceed as follows. First, cer- tain smooth curves are removed from the data, fre- In recent years, macroeconomists have begun the quently after a logarithmic transformation; these long-postponed task of developing basic equilibrium eliminate deterministic growth and seasonal com- models of economic fluctuations. That this is an ponents. Summary statistics are then calculated on essential first step was cogently argued by Hicks the transformed data. (1933) over fifty years ago, who stressed that one At a minimum the list of real quantity variables to could not measure the extent of disequilibrium be considered consists of the major national accounts without first determining the content of equilibrium aggregates-consumption, investment and output- theory and that, in a dynamic stochastic system, there along with measures of labor input (manhours, is rich content to equilibrium theory. employment). In addition, real wages, real money The analyses of Kydland and Prescott (1982) and balances and certain financial activity variables are Long and Plosser (1983) explain the dynamics of frequently considered, as in the growth rate of some business cycles as reflecting the interaction of real nominal variables such as the money stock, nominal shocks-to total factor productivity-and intertem- interest rates and prices. All of the quantity series- poral (capitalistic) production possibilities. The Long including real balances -exhibit significant positive and Plosser (1983) analysis develops some general serial correlation at the annual or quarterly interval. economic principles-mentioned by Haberler They all also display positive covariation, both with ( 1937) -by studying the decisions of a representative output and with each other. They differ somewhat consumer (Robinson Crusoe) who directly operates in relative volatilities, notably investment is more the production technology of the economy. In this volatile than output, which in turn is more volatile context the business cycles that arise are Pareto than consumption. Evidence concerning the cyclical efficient. Thus, the mechanisms that generate cyclical behavior of the real wage is inconclusive; in part, this activity are quite general and should carry over to reflects a variety of constructs used. In general, richer macroeconomic models that possess incom- however, there does not appear to be a pronounced plete information and nominal rigidities, including cyclical relation. Measures of financial activity- those that we consider below. such as deposit turnover and bank clearings-are For example, the analysis of Long and Plosser strongly procyclical (Mitchell (195 1)). As Lucas shows that even if disturbances to production (1977) observes, there is little reason to qualify the possibilities are temporally independent, real observations by reference to specific time periods. quantities-output, consumption and capital-display However, the