A Response to Stockman’s “Real Business Cycle Theory: A Guide, an Evaluation, and New Directions”

Alan Stockman comes right out and states the purpose of real business cycle (RBC) models–that is, these models are used to “explain aggregate fluctuations in business cycles without reference to monetary policy.”  In fact, he goes on to make four assertions as to why the real business cycle model is important.  From evidence gathered, monetary policy does not affect the real output as much as economists once believed.  Second, even if it does affect the real output of the economy, it isn’t the driving force behind the business cycle, supply shocks and non-monetary occurrences usually influence the aggregate fluctuations to a greater degree than monetary policy, and lastly, real business cycle models can be used to determine how disturbances affect different sectors of the economy.  These real business cycle models incorporate the following: GDP, consumption, fixed assets (i.e. investment, nonresidential, structures, equipment), average nonfarm employment, and capital stocks.  Stockman notes that others have used variations of the real business cycle model to include cross-sector analyses to track output and production across the aggregate economy in order to trace the disturbances from one sector to another.

Stockman starts the discussion on real business cycle (RBC) models with two assumptions–people maximize their utility with different combinations of leisure and consumption and there’s a technology coefficient that allows for the transformation of capital and labor into output that can be either consumed by households or reinvested back into capital stocks for period t+1.  Stockman traces some early, prototype models that had their roots with RBCs.  One of the first was Kydland and Prescott, who used backwards induction to come up with an abstract model that looked at utilization of capital, lagged effects of leisure on utility, and imperfect information about productivity.  Hansen furthered the Kydland-Prescott 1982 model by adding a “lottery on employment,” in which people are assumed to either work full time or not at all, without looking at part-time work.  This lottery of employment assumes that people that choose to work and those who choose not to work are randomly selected.  The Greenwood et al. model looks at current and future investment.  It is noted that the model shows increases in consumption, labor supply, output, and investment are due to current economic conditions.  The model discusses technology shocks as one factor, but that would only increase future output resulting from increases in future capital.  Current output, however, is affected by current economic conditions.  Kydland-Prescott’s 1988 model incorporates that the cost of a greater utilization of capital is a greater utilization of labor.  This variable work week (a longer work week) predicts the variability in the U.S. inventories.  Parkin (1988) tried to calculate the parameters in the Cobb-Douglas production function using labor data from the GDP.  He determined that these parameters varied over time and as a result, was able to calculate the technology shock.  Because his model showed the share of leisure s(preference shock) relatively stable over time, this implied that preference shocks can be viewed as unimportant to RBC models.  The last model mentioned is that of Christiano and Eichenbaum (1988), which looked at government shocks as affecting shifts in the labor supply curve.  Coupled with technology shifts, these two movements could induce changes to the real wage.

Stockman starts his discussion on RBC models by listing parameters often included in these models.  They include the fraction of total time spent working and the time spent in leisure, the psychological factor, the rate of capital depreciation, the marginal rate of substitution in consumption, the marginal rate of substitution in leisure, labor as a percentage of GDP, and the variance of productivity shocks.  However, the one common criticism is how to use the RBC models to explain periods in which real output falls using the logic that negative technology shocks exist.  (This is most commonly observed in smaller sectors of the economy.)  What Robert Hall (1988) deems the most important is the ability to differentiate between temporary reductions (aggregate output) from permanent reductions (measured output).  However, I don’t understand the difference bewteen the above logic dealing with negative technological shocks and the difference between measured output and total output (page 32).

An interesting note when discussing the criticisms, Stockman observes that econometric tests may reject the RBC model.  This is because the models may be wrong due to large influences in measurement errors.  Even if they prove to be wrong, RBC models have been shown to give better advice for policymakers than other incorrect theories.  Another criticism is that involuntary unemployment isn’t explained by RBC models.  The example looks at two individuals–both of whom have the same tastes and preferences and characteristics, but the only difference is that one is employed and one is unemployed.  However, the model will not differentiate between the two; the only explanation is that unemployment is the result of a random fluctuation in productivity within the economy.  Going back to the technology criticism, Stockman proposes the question that technology shocks may be more influential to a group of industries rather than the nation as a whole.  Thus, this brings into question that though technology shocks are important, nation-specific disturbances play at least as large of a role in output fluctuations as these technology shocks.

To see if the RBC model explains the random fluctuations of the international economies, there are two “tests.”  One is to see if the goodness of fit improves with the addition of more variables, but this requires the addition of more equations and more parameters.  The other is to test the RBC model with the same criteria and parameters to a different set of macroeconomic facts.  These RBC models should work fairly well because exchange rates look at the relationship between currencies (relative and nominal) due to “real shocks,” which are what RBCs are trying to model and explain.  However, the one obstacle that will be encountered is that various economies have different parameters and disturbances.

The ultimate question is whether these real business cycle models should be used for optimal policy decisions.  If the assumptions of RBC models are true, then monetary policy will have no effects on the real output of the economy.  To achieve optimal policy responses, as was suggested in our reading of Kydland and Prescott, there can be no fiscal and monetary interventions because policies are made based on expectations and conditions in time t.  The policy is implemented assuming the status quo, but once the policy is implemented, in time t+1, t+2, … , t+n, expectations will change and the policy will not achieve the optimal response.  Another thing to consider, which goes along with the Kydland-Prescott model is that the responses of the economy (to changes in regimes/administrations) bring about these suboptimal conditions because of market failures.  Stockman ends the discussion by stating that fluctuations in the economy are most likely optimal resopnses to uncertainty, rather than the failure of markets to clear, which was the general thinking of Keynesian economists and monetarists.  Essentially, the RBC should be concerned with long-run rates of technological change and low inflation instead of large fluctuations in GDP because those fluctuations are random and shouldn’t be “massaged” by either monetary or fiscal intervention.

Source: Stockman, Alan C.  1988.  Real business cycle: A guide, an evaluation, and new directions.  Economic Review 24 no. 4 (Quarter 4): 24-43.

One Response to “A Response to Stockman’s “Real Business Cycle Theory: A Guide, an Evaluation, and New Directions””

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