Real Business Cycle Theory
Real Business Cycle Theory
Real Business Cycle Theory
To Accompany Chapter 19
CHAPTER 19
slide 1
Learning objectives
This chapter presents an overview
of recent work in two areas:
CHAPTER 19
slide 2
CHAPTER 19
slide 3
slide 4
CHAPTER 19
slide 5
Economic fluctuations as
optimal responses to shocks
In Real Business Cycle theory,
fluctuations in our economy are similar
to those in Crusoes economy.
CHAPTER 19
slide 6
slide 7
(1+r)W1 / W2
where W1 is the wage in period 1
(the present) and W2 is the wage in
period 2 (the future).
CHAPTER 19
slide 8
slide 9
Technology shocks
In RBC theory, economic fluctuations
are caused by productivity shocks.
slide 10
Percent
10
per year
8
Output growth
6
4
2
0
-2
Solow residual
-4
1945
1950
1955
CHAPTER 19
1960
1965
1970
1975
1980
1985
1990
1995
2000
Year
slide 11
Technology shocks
Proponents of RBC theory argue that
the strong correlation between
output growth and Solow residuals
is evidence that productivity
shocks are an important source of
economic fluctuations.
CHAPTER 19
slide 12
Productivity shocks
Procyclical bias may be due to:
Labor Hoarding - Labor input is
overestimated in a recession.
Workers are kept on payroll even
though they are not working as hard.
Just sitting around waiting for
recession to end.
Output Mismeasurement - In a
recession, workers may produce things
that are hard to measure. They might
clean the factory, organize
inventory, get some training.
CHAPTER 19
slide 13
CHAPTER 19
slide 14
slide 15
CHAPTER 19
slide 16
CHAPTER 19
slide 17
slide 18
slide 19
CHAPTER 19
slide 20
slide 21
CHAPTER 19
slide 22
CHAPTER 19
slide 23
CHAPTER 19
slide 24
Inflation Inertia
Staggered price setting leads to slow
CHAPTER 19
slide 25
Inflation Inertia
The evidence contradicts this
implication and shows inflation
to be highly persistent (e.g.,
NAIRU theory).
slide 26
Inflation Inertia
Perhaps the model is incorrect.
Instead of sticky prices, we have
sticky information (Mankiw and Reis,
QJE 2002)
slide 27
Inflation Inertia
Problems with Sticky Information:
Evidence of fixed prices in the
economy
Most firms do not seem to set
predetermined paths for prices
Fixed prices also appear essential for
explaining why shifts in aggregate
demand have smaller and short-lasting
effects in high inflation economies
Fixed prices help explain why
announcing disinflation policy in
advance doesnt have big effect on
ultimate cost
CHAPTER 19
slide 28
CHAPTER 19
slide 29
Chapter summary
1. Real Business Cycle theory
assumes perfect flexibility of wages
and prices
shows how fluctuations arise in
response to productivity shocks
the fluctuations are optimal given
the shocks
2. Points of controversy in RBC theory
intertemporal substitution of labor
slide 30
Chapter summary
3.New Keynesian economics
accepts the traditional model of
aggregate demand and supply
attempts to explain the
stickiness of wages and prices
with microeconomic analysis,
including
menu costs
coordination failures
staggering of wages and prices
CHAPTER 19
slide 31
CHAPTER 19
slide 32