Snowdon & Vane Modern Macroeconomics

is already there! Of course the real business cycle view is that the government can do a great deal of harm if it creates various distortions through its taxing and spending policies. However, as we have already noted, in real business cycle models a temporary increase in government purchases will increase output and employment because the labour supply increases in response to the higher real interest rate brought about by higher (real) aggregate demand.

If technological change is the key factor in determining both growth and fluctuations, we certainly need to develop a better understanding of the factors which determine the rate of technological progress, including institutional structures and arrangements (see Chapter 11). To real business cycle theorists the emphasis given by Keynesian and monetarist economists to the issue of stabilization has been a costly mistake. In a dynamic world instability is as desirable as it is inevitable.

Finally, Chatterjee (1999) has pointed out that the emergence of REBCT is a legacy of successful countercyclical policies in the post-Second World War period. These policies, by successfully reducing the volatility of GDP due to aggregate demand disturbances compared to earlier periods, has allowed the impact of technological disturbances to emerge as a dominant source of modern business cycles.

6.16Criticisms of Real Business Cycle Theory

In this section we will review some of the more important criticisms of real business cycle theory. For critical surveys of the literature, the reader is referred to Summers (1986), Hoover (1988), Sheffrin (1989), Mankiw (1989), McCallum (1989), Phelps (1990), Eichenbaum (1991), Stadler (1994), and Hartley et al. (1997, 1998).

The conventional neoclassical analysis of labour supply highlights two opposing effects of an increase in the real wage. A higher real wage induces an increase in labour supply through the substitution effect, but at the same time a higher real wage also has an income effect that induces a worker to consume more leisure. In real business cycle models the substitution effect must be very powerful compared to the income effect if these models are to plausibly explain large variations of employment induced by technology shocks. But, as we have already noted, the available micro evidence relating to the intertemporal elasticity of substitution in labour supply indicates a weak response to transitory wage changes. If the wage elasticity of labour supply is low, then technological shocks that shift the labour demand curve (see Figure 6.3) will produce large variability of real wages and lower variability of employment. However, the variations in employment observed over the business cycle seem to be too large to be accounted for by intertemporal substitution. In addition, Mankiw (1989) has argued that the real interest rate

is not a significant consideration in labour supply decisions. How, for example, can agents be expected to accurately predict future interest rates and real wages in order to engage in intertemporal substitution?

A second major criticism of real business cycle theory relates to the reliance of these models on mainly unobservable technology shocks. Many economists doubt whether the technology shocks required in order to generate business cycle phenomena are either large enough or frequent enough. In these models large movements in output require significant aggregate disturbances to technology. Muellbauer (1997) argues that the kind of technological volatility implied by REBCT is ‘quite implausible’ for three reasons, namely:

(i) technological diffusion tends to be slow; (ii) aggregation of diffusion processes tends to produce a smooth outcome in aggregate; and (iii) the technical regress required to produce recessions cannot be given plausible microfoundations. In relation to this issue, Summers (1986) rejects Prescott’s use of variations in the Solow residual as evidence of significant shocks to technology. Large variations in the Solow residual can be explained as the outcome of ‘off the production function behaviour’ in the form of labour hoarding. Whereas real business cycle theorists interpret procyclical labour productivity as evidence of shifts in the production function, the traditional Keynesian explanation attributes this stylized fact to the quasi-fixity of the labour input. The reason why productivity falls in recessions is that firms retain more workers than they need, owing to short-run adjustment costs. In such circumstances it will pay firms to smooth the labour input over the cycle, which implies the hoarding of labour in a cyclical downturn. This explains why the percentage reduction in output typically exceeds the percentage reduction in the labour input during a recession. As the economy recovers, firms utilize their labour more intensively, so that output increases by a larger percentage than the labour input.

In general many economists explain the procyclical movement of the Solow residual by highlighting the underutilization of both capital and labour during periods of recession. Following Abel and Bernanke (2001), we can illustrate this idea by rewriting the production function given by (6.13) and (6.14) as (6.18):

where K represents the underutilization rate of the capital input, and L represents the underutilization rate of labour input. Substituting (6.18) for Y in (6.15) we obtain a new expression (6.19) for the Solow residual that recognizes that the capital and labour inputs may be underutilized.

Equation (6.19) shows that the Solow residual can vary even if technology remains constant. If the utilization rates of capital and labour inputs are procyclical, as the empirical evidence suggests is the case, then we will observe a procyclical Solow residual that reflects this influence (for discussions of this issue see Fay and Medoff, 1985; Rotemberg and Summers, 1990; Bernanke and Parkinson, 1991; Burnside et al., 1995; Braun and Evans, 1998; Millard et al., 1997).

A third line of criticism relates to the idea of recessions being periods of technological regress. As Mankiw (1989, p. 85) notes, ‘recessions are important events; they receive widespread attention from the policy-makers and the media. There is, however, no discussion of declines in the available technology. If society suffered some important adverse technological shock we would be aware of it.’ In response to this line of criticism, Hansen and Prescott (1993) have widened the interpretation of technological shocks so that any ‘changes in the production functions, or, more generally, the production possibility sets of the profit centres’ can be regarded as a potential source of disturbance. In their analysis of the 1990–91 recession in the USA, they suggest that changes to the legal and institutional framework can alter the incentives to adopt certain technologies; for example, a barrage of government regulations could act as a negative technology shock. However, as Muellbauer (1997) points out, the severe recession in the UK in the early 1990s is easily explained as the consequence of a ‘massive’ rise in interest rates in 1988–9, an associated collapse of property prices, and UK membership, at an overvalued exchange rate, of the ERM after October 1990. Few of these influences play a role in REBCT.

An important fourth criticism relates to the issue of unemployment. In real business cycle models unemployment is either entirely absent or is voluntary. Critics find this argument unconvincing and point to the experience of the Great Depression, where ‘it defies credulity to account for movements on this scale by pointing to intertemporal substitution and productivity shocks’ (Summers, 1986). Carlin and Soskice (1990) argue that a large proportion of the European unemployment throughout the 1980s was involuntary and this represents an important stylized fact which cannot be explained within a new classical framework. Tobin (1980b) also questioned the general approach of new classical economists to treat all unemployment as voluntary. The critics point out that the pattern of labour market flows is inconsistent with equilibrium theorizing. If we could explain unemployment as the result of voluntary choice of economic agents, then we would not observe the well-established procyclical movement of vacancy rates and voluntary quits. Recessions are not periods where we observe an increase in rate of voluntary quits! In Blinder’s view, the challenge posed by high unemployment during the 1980s was not met by either policy makers or economists. In a comment obviously

directed at real business cycle theorists, Blinder (1988b) notes that ‘we will not contribute much toward alleviating unemployment while we fiddle around with theories of Pareto optimal recessions – an avocation that might be called Nero-Classical Economics’. Although the intersectoral shifts model associated with Lilien (1982) introduces unemployment into a model where technology shocks motivate the need to reallocate resources across sectors, the critics regard the neglect of unemployment in real business cycle theory as a major weakness (see Hoover, 1988).

A fifth objection to real business cycle theory relates to the neutrality of money and the irrelevance of monetary policy for real outcomes. It is a matter of some irony that these models emerged in the early 1980s when in both the USA and the UK the monetary disinflations initiated by Volcker and Thatcher were followed by deep recessions in both countries. The 1990–92 economic downturn in the UK also appears to have been the direct consequence of another dose of monetary disinflation. In response to this line of criticism, real business cycle theorists point out that the recessions experienced in the early 1980s were preceded by a second major oil shock in 1979. However, the majority of economists remain unconvinced that money is neutral in the short run (see Romer and Romer, 1989, 1994a, 1994b; Blanchard, 1990a; Ball, 1994; and Chapter 7).

A sixth line of criticism relates to the important finding by Nelson and Plosser that it is hard to reject the view that real GNP is as persistent as a random walk with drift. This finding appeared to lend support to the idea that fluctuations are caused by supply-side shocks. The work of Nelson and Plosser (1982) showed that aggregate output does not appear to be trendreverting. If fluctuations were trend-reverting, then a temporary deviation of output from its natural rate would not change a forecaster’s estimate of output in ten years’ time. Campbell and Mankiw (1987, 1989), Stock and Watson (1988) and Durlauf (1989) have confirmed the findings of Nelson and Plosser. As a result, the persistence of shocks is now regarded as a ‘stylised fact’ (see Durlauf, 1989, p. 71). However, Campbell, Mankiw and Durlauf do not accept that the discovery of a near unit root in the GNP series is clear evidence of real shocks, or that explanations of fluctuations based on demand disturbances should be abandoned. Aggregate demand could have permanent effects if technological innovation is affected by the business cycle or if hysteresis effects are important (see Chapter 7). Durlauf has shown how, in the presence of coordination failures, substantial persistence in real activity can result from aggregate demand shocks. This implies that demand-side policies can have long-lasting effects on output. Stadler (1990) has also shown how the introduction of endogenous technological change fundamentally alters the properties of both real and monetary theories of the business cycle. REBCT does not provide any deep microeconomic foundations to explain technologi-

cal change and innovative activity. But the plausible dependence of technological progress on economic factors such as demand conditions, research and development expenditures and ‘learning by doing’ effects (Arrow, 1962) implies that changes on the supply side of the economy are not independent of changes on the demand side. Hence an unanticipated increase in nominal aggregate demand can induce technology changes on the supply side which permanently increase output. In such a model the natural rate of unemployment will depend on the history of aggregate demand as well as supply-side factors. A purely monetary model of the business cycle where technology is endogenous can also account for the Nelson and Plosser finding that output appears to follow a random walk.

A seventh criticism relates to the pervasive use of the representative agent construct in real business cycle theory. Real business cycle theorists sidestep the aggregation problems inherent in macroeconomic analysis by using a representative agent whose choices are assumed to coincide with the aggregate choices of millions of heterogeneous individuals. Such models therefore avoid the problems associated with asymmetric information, exchange and coordination. To many economists the most important questions in macroeconomic theory relate to problems associated with coordination and heterogeneity. If the coordination question and the associated possibility of exchange failures lie at the heart of economic fluctuations, then to by-pass the problem by assuming that an economy is populated only by Robinson Crusoe is an unacceptable research strategy for many economists (see Summers, 1986; Kirman, 1992; Leijonhufvud, 1992, 1998a; Akerlof, 2002; Snowdon, 2004a).

A final important criticism relates to the lack of robust empirical testing (see Fair, 1992; Laidler, 1992a; Hartley et al., 1998). As far as the stylized facts are concerned, both new Keynesian and real business cycle theories can account for a broad pattern of time series co-movements (see Greenwald and Stiglitz, 1988). In an assessment of the empirical plausibility of real business cycle theory, Eichenbaum (1991) finds the evidence put forward by its proponents as ‘too fragile to be believable’.

6.17Great Depressions: A Real Business Cycle View

As noted above, REBCT has been criticized for its lack of plausibility with respect to explaining the Great Depression. However, during recent years several economists have begun to investigate economic depressions using neoclassical growth theory.

Cole and Ohanian (1999) were the first economists to study the Great Depression from this perspective and they attempt to account not only for the downturn in GDP in the period 1929–33, but also seek to explain the recov-

ery of output between 1934 and 1939. In their analysis they do not deny the contribution of real and monetary aggregate demand shocks in initiating the Great Depression. However, conventional models predict a rapid recovery from such shocks after 1933 given the expansionary monetary policies adopted after abandoning the Gold Standard constraint, the elimination of bank failures and deflation, and the significant rise in total factor productivity. Given these changes, output should have returned to trend by 1936, but US output remained up to 30 per cent below trend throughout the 1930s. Cole and Ohanian argue that the weak recovery process was mainly due to the adverse consequences of New Deal policies, particularly policies related to the National Industrial Recovery Act (NIRA) of 1933. The NIRA, by suspending anti-trust laws in over 500 sectors of the US economy, encouraged cartelization and reductions in price competition. Firms were also encouraged to grant large pay increases for incumbent workers. Cole and Ohanian claim that it was the impact of NIRA that depressed employment and output during the recovery, thereby lengthening the Great Depression. Prescott (1999) provides a similar perspective for the US economy, arguing that the Great Depression was ‘largely the result of changes in economic institutions that lowered the normal steady-state market hours per person over 16’. Thus, for Prescott, the Keynesian explanation of the slump is upside down. A collapse of investment did not cause the decline in employment. Rather employment declined as a result of changes in industrial and labour market policies that lowered employment! (see also Chari et al., 2002). While arguing that a liquidity preference shock rather than technology shocks played an important role in the contraction phase of the Great Depression in the USA (providing support for the Friedman and Schwartz argument that a more accommodative monetary policy by the US Federal Reserve could have greatly reduced the severity of the Great Depression), Christiano et al. (2004) also agree with the Cole and Ohanian view that the recovery of employment in the USA during the 1930s was adversely affected by President Roosvelt’s ‘New Deal’ policies.

In a subsequent paper, Cole and Ohanian (2002b) focus on why both the US and UK Great Depressions lasted so long, with output and consumption in both economies some 25 per cent below trend for over ten years. Such a duration in both countries cannot be ‘plausibly explained by deflation or other financial shocks’. Instead, Cole and Ohanian focus on the negative impact of the NIRA (1933) and the NLRA (National Labour Relations Act, 1935) in the USA, both of which distorted the efficient working of markets by increasing monopoly power. In the case of the UK, their analysis follows the lead given in earlier research by Benjamin and Kochin (1979) that a generous increase in unemployment benefits lengthened the Great Depression.

This new approach to explaining depressions has not convinced the majority of economists, who mainly continue to highlight the importance of

aggregate demand shocks and monetary and financial factors in their explanations of the Great Depression (see Chapter 2). Nevertheless, Prescott’s (2002) Ely Lecture focused on using supply-side explanations of ‘Prosperity and Depression’ for the interwar experience of the USA, UK and Germany, the recent depression in France and the post-war record of Japan. In each case the most important factor causing output to be below trend is supplyside, rather than demand-side in origin (see also Kehoe and Prescott, 2002). Crucial to the maintenance of prosperity are policies that focus on enhancing total factor productivity. Given this perspective, Prescott recommends sup- ply-side policies that will:

1.promote the establishment of an efficient financial sector to allocate scarce investment funds;

2.enhance competition, both domestic and international; and

3.promote international integration, including the establishment of trading clubs such as the EU.

6.18An Assessment

In his Yrjo Jahnsson lectures, given in 1978, James Tobin noted that ‘there is no economic business cycle theory, new or old, involved in assuming that waves of economic activity simply mirror waves in underlying technology and taste’ (Tobin, 1980a, p. 37). This state of affairs was to change dramatically during the 1980s when, following the widespread rejection of the monetary misperception version of equilibrium theory, real business cycle models proliferated. The research initiated by Nelson and Plosser provided substantial support for the view that shocks to aggregate output tend to have long-lasting effects. Output does not appear to revert to a deterministic trend. This finding has had a profound influence on business cycle research, in that it suggests that much of the disturbance to aggregate output that we witness is caused by supply-side influences. By demonstrating that equilibrium models are not inconsistent with aggregate instability, real business cycle theorists have challenged the conventional wisdom and forced theorists on all sides to recognize just how deficient our knowledge is of business cycle phenomena. The real business cycle approach has therefore performed a useful function in raising profound questions relating to the meaning, significance and characteristics of economic fluctuations. We have seen in this chapter how REBCT is a continuation of the research programme, stimulated in the modern era by Lucas, that aims to explore the general equilibrium intertemporal characteristics of macroeconomics (Wickens, 1995). In doing so, REBCT has integrated the theory of growth and fluctuations and irreversibly changed the direction of business cycle research. New insights have been gained, along with innovative modelling techniques.

More than 30 years ago, Harry Johnson (1971), in his lecture to the 1970 meeting of the American Economic Association, attempted to provide reasons for the rapid propagation of the Keynesian revolution in order to better understand the monetarist counter-revolution which during the late 1960s and early 1970s had begun to fill the intellectual vacuum created by the retreat of the Keynesian orthodoxy in the face of accelerating inflation. In Johnson’s highly perceptive article, attention was drawn to the shared characteristics of both the Keynesian revolution and the monetarist counter-revolution which appear important in explaining the success of these developments. According to Johnson, there are two types of factor which can help explain the rapid acceptance and propagation of new ideas among professional economists. The first factor relates to the ‘objective social situation in which the new theory was produced’. The second important factor encompasses the ‘internal scientific characteristics of the new theory’. We would argue that these factors can help in understanding the rapid propagation of new classical ideas, both the MEBCT and the REBCT (see Snowdon and Vane, 1996).

Although an established orthodoxy, such as trend-reverting cycles, which is in apparent contradiction to the ‘most salient facts of reality’ is the ‘most helpful circumstance for the rapid propagation of a new and revolutionary theory’, Johnson also identified five internal scientific characteristics which in his view were crucial because it was these aspects of the new theory which appealed to the younger generation of economists. In summary, the five main characteristics Johnson identified involved:

1.‘a central attack, on theoretically persuasive grounds, on the central proposition of the orthodoxy of the time’;

2.‘the production of an apparently new theory that nevertheless absorbed all that was valid in the existing theory’;

3.a new theory having an ‘appropriate degree of difficulty to understand’ that would ‘challenge the intellectual interest of younger colleagues and students’;

4.‘a new more appealing methodology’ than that prevailing;

5.‘the advancement of a new and important empirical relationship suitable for determined estimation’ by econometricians.

To what extent have these five internal scientific characteristics played an important role in explaining the success of new classical macroeconomics, in particular the REBCT?

The first characteristic (that is, an attack on a central proposition of the established orthodoxy) can be straightforwardly identified in REBCT. Before 1980 the established consensus regarded business cycles as socially undesirable. In sharp contrast, the main policy implication of real business cycle

theory is that because the existence of fluctuations in aggregate output does not imply the failure of markets to clear, the government should refrain from any attempt to reduce such fluctuations not only because such policies are unlikely to achieve their desired objective, but also because reducing instability would reduce welfare!

The application of Johnson’s second internal characteristic (that is, the ability of a new theory to absorb as much as possible of the valid components of the existing orthodox theory) can also be applied to REBCT, which has pioneered the use of the orthodox neoclassical growth model as a framework for the quantitative analysis of aggregate fluctuations as well as absorbing much of the methodology advocated by Lucas in the 1970s.

Johnson’s third characteristic (that is, an intellectually challenging new theory with appeal to the younger generation of economists) is one that again can be readily applied to REBCT. There is no question that the new classical revolution pushed macroeconomic theory into new, more abstract directions involving the introduction of techniques not found in the ‘kit bags of the older economists’ (Blinder, 1988b). Being better trained mathematically, the younger generation has been able to absorb the new techniques, such as calibration, giving them a ‘heavy competitive edge’ over the ‘older’ economists.

Turning to the fourth characteristic (that is, a new methodology), the REBCT programme has wholeheartedly embraced a methodological framework involving a formal general equilibrium approach. Responding to the ‘Lucas critique’ has fostered an emphasis on a return to first principles in the quest to establish sound microfoundations for general equilibrium macroeconomic models. Since real business cycle methodology is in principle ideologically neutral, it has the capability of fostering models with enormous diversity.

The fifth characteristic (concerning a ‘new and important empirical relationship’ for estimation) is more difficult to apply to REBCT developments. Rather than attempting to provide models capable of conventional econometric testing, real business cycle theorists have instead developed the ‘calibration method’ in which the simulated results of their specific models (when hit by random shocks) in terms of key macroeconomic variables are compared with the actual behaviour of the economy. Unfortunately calibration does not provide a method that allows one to judge between the performance of real and other (for example Keynesian) business cycle models.

From the above discussion it should be evident that while Johnson put forward five main ‘internal’ characteristics to help explain the success of the Keynesian revolution and monetarist counter-revolution, the first four of these same characteristics also help in understanding why REBCT has made such an important impact on the development of macroeconomics since the early

1980s. In assessing whether or not REBCT has constituted a ‘fashion’ or a ‘revolution’ in macroeconomics, Kirschner and Rhee (1996) conclude from their statistical analysis of the spread of scientific research that data on publications and researchers in the REBCT field exhibit ‘mini-revolution’ characteristics.

A distinguishing feature of the early REBCT is the downplaying of monetary influences as a major cause of business cycles. Instead random shocks to technology play the major role in creating disturbances, and the desire of economic agents for consumption smoothing and ‘time to build’ constraints acts as a major propagation mechanism leading to persistence. While the early REBCT models had too narrow a focus, more recent work has also begun to add monetary and financial variables into the model, as well as to extend this line of research to include government and open economy influences (see Mendoza, 1991; Backus et al., 1992; Hess and Shin, 1997). Going further and adding market imperfections to REBCT will provide a bridge between new classical and new Keynesian approaches to business cycle research (Wickens, 1995). We should also note that the real business cycle approach has furthered the cause of those economists who insist that macro models need to be based on a firmer microeconomic base. This in turn has strengthened the general move to improve our understanding of the supply side. If anyone seriously questioned it before, no one now doubts that macroeconomics is about demand and supply and their interaction. As Blinder (1987b) notes, ‘events in the 1970s and 1980s demonstrated to Keynesian and new classical economists alike that Marshall’s celebrated scissors also come in a giant economy size’.

While recognizing the achievements of the real business research programme, the critics remain convinced that this approach has serious deficiencies. A majority of economists believe that the short-run aggregate demand disturbances that arise from monetary policy can have significant real effects because of the nominal price and wage rigidities which characterize actual economies (see Chapter 7). This important line of criticism challenges the new classical assumption that markets continuously clear, even in a recession. If markets do not clear quickly and the world is characterized by both aggregate demand and aggregate supply disturbances, the actual fluctuations that we observe will consist of a stochastic trend around which output deviates as the result of demand shocks. This view is well represented by Blanchard and Quah (1989) where they ‘interpret fluctuations in GNP and unemployment as due to two types of disturbances: disturbances that have a permanent effect on output and disturbances that do not. We interpret the first as supply disturbances, the second as demand disturbances.’ Clearly the role of stabilization policy in such a world is immensely complicated, even if we accept that demand disturbances are important. How, for