Intermediate Macroeconomics: The Real Business Cycle Model

Having developed an operational model of the economy, we want to ask ourselves the following two questions. First, can the model explain actual business cycle data? Second, to the extent to which it can fit the data, what are the implications for economic policy? To proceed we first have make clear what is meant by “business cycle” data. This requires briefly looking at some US macroeconomic data. It is typical to summarize business cycle data by looking at “second moments” of de-trended natural logs of aggregate data. Second moments refer to variances (measures of volatility) and correlations (measures of co-movement). We will focus on correlations. Characterizing the qualitative co-movements in the data, we will then ask how well the equilibrium business cycle model we have developed can account for these co-movements. We will argue that the model can qualitatively match these co-movements if it is predominantly driven by exogenous changes in At, which are sometimes labeled productivity shocks. The model we have developed predominantly driven by changes in At is often referred to as the “real business cycle model.” It is “real” in the sense that there are no frictions which would give rise to monetary non-neutrality – the only source of movements in output and its components are “real shocks” like productivity and government spending. The model has the implication that fluctuations in output driven by these real shocks are “efficient” in the sense that there is no room for welfare improvement due to activist economic policies. Therefore, to the extent to which one believes the model, economic policies should not attempt to try to smooth out business cycle fluctuations. We will conclude with a critique of real business cycle theory, and will then move on to models with frictions that give rise to more interesting policy implications.