MSc Economics

Ec413 Macroeconomics
Real Business Cycles I

Christopher A Pissarides

November 2009

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What is a business cycle?

Business cycles are uctuations about the economys growth path

Business cycles are not alike - some are long, some short, some sharp,
some shallow
Dierent parts of the economy are aected dierently across dierent
cycles
Therefore we should not look for theories of regular dynamic
oscillations, like the ones used by engineers
We need models with stochastic shocks, i.e., ones that are not regular
and predictable

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 US GDP, logs

Hodrick-Prescott Filter (lambda=100)

11.0

10.5

10.0

9.5

.3 9.0

.2 8.5

.1

.0

-.1

-.2
1930 1940 1950 1960 1970 1980 1990 2000

LOGGDP Trend Cycle

 US hours of work over population 15+

Hodrick-Prescott Filter (lambda=100)

7.6

7.5

7.4

7.3
.2
7.2

.1 7.1

7.0
.0

-.1

-.2
00 10 20 30 40 50 60 70 80 90 00

LOGUS15 Trend Cycle

UK: hours of work over population of working age

Hodrick-Prescott Filter (lambda=100)

7.4

7.3

7.2

7.1
.06
7.0
.04
6.9
.02

.00

-.02

-.04

-.06
1960 1965 1970 1975 1980 1985 1990 1995 2000

LOGUK Trend Cycle

Business cycle facts I

Volatility
consumption is less volatile than output (US ratio of st. dev.
1.35/1.81)
investment is three times as volatile as output (st. dev. 5.30)
capital is much less volatile than output
total hours worked are about as volatile as output (st. dev. 1.79)
employment is as volatile as output but hours per worker much less
volatile
output per hour is less volatile than total output (st. dev. 1.02)
real wage is much less volatile than output (st. dev. 0.68, but beware
of composition eects)
government spending is less volatile than output

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Business cycle facts II

Comovement
consumption, investment, employment are pro-cyclical
real wages, capital stock, government spending are a-cyclical or mildly
pro-cyclical
Persistence
all aggregates exhibit large persistence: serial correlations of 0.9 or
above in annual time series are common

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A bit of history

Frisch, Slutsky and other early economists talked about shocks hitting
the economy
But early business cycle theory was dominated by Samuelson, Hicks
and others who looked for uctuations in non-linearities or arbitrary
lags in economic behaviour
For example, the multiplier-accelerator theory derives regular dynamic
patterns in output from the assumption that investment depends on
the change in output (the accelerator) and the level of output
increases by a multiple of investment (the multiplier).
This gives a second-order dierence equation in output which has
oscillating solution

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The equations of the multiplier-accelerator

Yt +1 Yt = m(It +1 It ) multiplier (1)

Kt = Yt constant capital-output ratio (2)

First-dierence (2) to get the accelerator:

It = Kt Kt 1 = (Yt Yt 1) (3)

Substitute the accelerator into the multiplier to get,

(1 + m)Yt +1 Yt + mYt 1 =0 (4)

a second-order equation that can exhibit regular oscillations.

But not all cycles are alike!

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A little more history

Lucas rst suggested in the 1970s that cycles should be represented

by log-linear models with stochastic shocks
The challenge then is to nd
the type of shock
the impulse mechanism
the propagation mechanism
Kydland and Prescott took up the challenge and created Real
Business Cycle Theory

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What are RBCs?

They are small equilibrium models of the economy

Their main distinguishing feature is that the shocks that drive the
cycles are real shocks
RBCs are the rst models that are Dynamic, Stochastic, General
Equilibrium models (DSGE for short)

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RBC Research methods

1 Take an equilibrium model, usually the Ramsey model without growth

2 Dene the stochastic variable, usually a real one (the driving forceof
the cycle). Usually this is the productivity parameter in the production
function (the cyclical component of the Solow residual) but it could
be government spending or a demand variable, such as consumption.
3 Solve the model, i.e. derive the time series aggregates in terms of the
driving force.
4 Give realistic values to the parameters, obtained from micro studies or
regularities in the data
5 Calibrate the model, i.e. construct articial time series of the
aggregates
6 Compute the statistical moments of the articial series and compare
them with actual data.

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Realistic?

Many criticized RBC for lack of realism: what are negative

productivity shocks?
This criticism is irrelevant: many real shocks are negative (oil price
hike, wars, government spending, export collapse etc.)
RBC is about uctuations from a growing path, so even slower
growth than usual can be interpreted as negative shock
Key issue is whether the model predicts well the behaviour of
economic aggregates
RBC models have been very inuential - even critics use their DSGE
techniques for their models

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The basic RBC model

The idea is to write a small Walrasian equilibrium model that can

predict the behaviour of economic aggregates.
The aggregates are output, investment, consumption, employment
Obvious candidate is the Ramsey model
Basic RBC model extends the Ramsey model in two directions
it introduces stochastic shocks to production
it introduces work-leisure choice

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Specic example

General Ramsey model with the two additional features has no closed-form
solution. We work with a specic example
Production
Yt = Kt (At Lt )1 (5)
Capital accumulation

Kt +1 = Kt + It Kt (6)
= Kt + Yt Ct Gt Kt (7)

Note that output is divided between consumption, investment and

government purchases, nanced by lump sum taxes. I is gross investment
Exogenous variables are At and Gt . Kt is predetermined in t. Endogenous
are Yt , Ct , It , Kt +1 , Lt . RBC model solves for the endogenous in terms of
the exogenous, when At is stochastic

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Stochastic assumptions

TFP grows at mean rate g and there are stochastic rst-order

autoregressive deviations

ln At = A + gt + A t (8)
t
A = A A t 1 + A,t (9)

1 < A < 1 and A have zero mean and are uncorrelated over time
Similar assumptions about G

ln Gt = G + gt + G t (10)
G t = G G t 1 + G ,t (11)

I am assuming zero population growth to simplify the formulas

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Wages and interest rate

Marginal products equal factor prices

Kt
wt = (1 ) At (12)
At Lt
1
At Lt
rt = (13)
Kt

since Yt /Lt = At (Kt /At Lt ) this implies that the stochastic properties of
ln wt are exactly the same as the stochastic properties of ln (average
labour product) and for r they are dierent only because of depreciation.

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Utility function

Variable leisure.
u (Ct , 1 Lt )
U= . (14)
t =0 (1 + )t
We want to have variable leisure because we want the model to explain
employment uctuations. The canonical RBC model achieves this through
the intertemporal substitution of leisure.

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The structure of preferences: 2-period illustration

Key lesson here: how to use growth observations to restrict the models
functional forms

u (C1 , 1 L1 )
max u (C0 , 1 L0 ) + (15)
C ,L 1+
subject to budget constraint
C1 w1 L1
C0 + w0 L0 + . (16)
1+r 1+r
We note the following growth facts: Ct , wt are growing over time; Lt , rt
are stationary

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Utility of consumption
First-order condition I
uC0 (C0 , 1 L0 ) 1+r
= . (17)
uC1 (C1 , 1 L1 ) 1+
Growth fact I. Because L, r and are constant in the steady state, the
ratio of marginal utilities must be independent of the level of consumption.
This requires consumption to enter in ratio form and be independent of
leisure, i.e.,
Ct1
u = v (1 Lt ) 6= 1 (18)
1
u = ln Ct + v (1 Lt ) =1 (19)

In this case, and for constant L,

uC0 (C0 , 1 L0 ) C0 1+r
= = . (20)
uC1 (C1 , 1 L1 ) C1 1+

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Utility of leisure

First-order condition II
uL0 (C0 , 1 L0 ) ( 1 + r ) w0
= (21)
uL1 (C1 , 1 L1 ) ( 1 + ) w1
Growth fact II. Over long periods of time wage growth does not inuence
hours of work. This must be because income and substitution eects
cancel each other out. With our restricted utility function
1
uL0 (C0 , 1 L0 ) C0 v 0 (1 L0 ) ( 1 + r ) w0
= = , (22)
uL1 (C1 , 1 L1 ) C1 v 0 (1 L1 ) ( 1 + ) w1
consistent with steady consumption and wage growth and constant L0 and
L1 .

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Utility function

So the most general admissible utility function is

Ct1
u = v (1 Lt ) 6= 1 (23)
1
u = ln Ct + v (1 Lt ) =1 (24)

For most applications v (1 Lt ) is further simplied either to logarithmic

or to
(1 Lt )1
v (1 Lt ) = b (25)
1
is related to the Frisch elasticity of labour supply

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Intertemporal substitution of leisure
Intuition
Because income and substitution eects cancel each other out over
long periods of time, productivity shocks have an impact on
employment only if one of the two eects is weakened.
A permanent productivity shock increases the wage rate for ever,
implying a substitution eect because leisure becomes more expensive
and an income eect because of the permanent rise in the wage
stream.
A single period shock increases the wage rate for one period only.
The substitution eect in this period is the same as before but the
income eect is much weaker, because now future wages are
unaected by the shock.
So leisure in period 1 falls. This is the driving mechanism for
employment uctuations in the canonical RBC model. The question
is how strong is this?
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Maths

With our iso-elastic utility function, rst order condition is (ignore the
consumption component, for convenience. E.g., consider a zero-growth
economy)

1 L0 ( 1 + r ) w0
= , (26)
1 L1 ( 1 + ) w1
so
1/
1 L0 ( 1 + r ) w0
= . (27)
1 L1 ( 1 + ) w1
Leisure this period relative to next depends negatively on the interest rate
and on w0 /w1 , with elasticity 1/. So the supply of labour this period
depends positively on the interest rate and relative wage this period, with
elasticity related to 1/. Generally, the smaller the bigger the impact of
wage shocks on labour supply. In applications many people use = 1 or
slightly higher.

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