“Understanding Real Business Cycles”

by Charles I. Plosser

Presented by: Lizzie Dies Wade Letter Adam Vande Zande

Key Questions Addressed • Can current shocks have implications for future decisions

and/or outcomes?

• What different factors does RBC look at compared to other methods?

• How close does the model get to actual data?

Main Points• Focuses of Neoclassical vs. ISLM vs. Real Business Cycle

• Model can be accurate with some variables but off with others

• Difference – Real Business Cycles look at productivity shocks and other variables

• Neoclassical precursor for RBC

Outline of the Presentation• Background Information• Neoclassical Model• Robinson Crusoe• Productivity Disturbances• Economic Growth & Business Cycles• Real Business Cycles 1954-1985• Model Data• Productivity Shift Graphs• Real Business Cycle Research

Background Information

• 1960s & 1970s• Keynesian model vs. Business Cycles• “Idealized state of dynamic equilibrium”• Transform into more neoclassical

Neoclassical Model• Most basic model of economic dynamics• Benchmark model• Simple economic environment to consider• Households live forever• Utility of each agent is function of consumption & leisure• Maximize utility F(C,L)

• Labeled a “real business cycle model”

Robinson Crusoe• Crusoe’s choice problem is to maximize his lifetime utility • If there were no productivity disturbances…• Model imposes resource constraints • C + I ≤ Y• L + N ≤ 1• C, L, N, K, I are all positive

Robinson Crusoe (cont.)

• First Order Conditions

• Linearize (approximations)

• Constant Parameters α = .58; ᵦ = .95; ᵹ = .10

Productivity Disturbances• Observes a temporarily high value of productivity…• Consume more output in current period• Also value future consumption and leisure

• Temporary vs. Permanent• Temporary - substitution current for future work, and

current consumption for leisure, wealth higher, higher output, consumption and leisure in the future

• Permanent - raise wealth, less incentive to increase investment, more incentive for current consumption, less incentive to work harder today

• Output and consumption are likely to be correlated• Government actions?

Economic Growth & Business Cycles

• Neoclassical model of capital accumulation predicts that per capita values of output, capital and consumption will converge to constants.

• Solow – major factors• Nelson and Plosser argue that real per capita output behaves

as if they have random walk components. They also argue that Solow’s technology series behaves like a random walk.

• The fact that productivity grows over time raises additional complications

Productivity Shifts• Need to obtain some measure of the productivity shocks.• Figure 1 is the annual percentage rate of change in technology.

Real Business Cycles 1954-1985

• Simple neoclassical model described earlier is clearly an incomplete model of the U.S. Economy.

• Table 1 highlights some of the statistical properties of postwar business fluctuations.

Real Business Cycle Research• Multi-Sector Extension

• Labor Markets

• Endogenous Growth

• Money

• Strategies

Conclusions• Basic framework of RBC is the neoclassical model

• The model is accurate for some variables but not others

• Real technology shocks have occupied the central focus, but other shocks are being studied

• Real business cycle theory is still in its infancy

• Much work remains before economists have a full understanding of RBC