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Danny Anand Hamish Low

Aggregate data do not lend support to neoclassical business cycle models.


Discuss this statement paying particular attention to intertemporal decisions
about consumption, labour/leisure and investment.

Neoclassical business cycle models share the common view that the economy is
the best modelled as a floating Walrasian equilibrium, buffeted by productivity
shocks (Summers 1986). They assert that monetary policies have no effect on
real activity, that fiscal policies influence the economy only through their
incentive effects, and that economic fluctuations are caused entirely by supply
rather than demand shocks. This essay will first lay out the neoclassical model
used in Prescotts (1986) paper. This essay finds that although his model offers a
good fit to the aggregate data, his choice of some parameters are arbitrary.
Critique by Summers is significant in finding flaws in the model, and so this essay
concludes that the model cannot be universally used to understand business
cycle behaviour.

Prescotts theory and its variants build on the neoclassical growth economy of
Solow (1956) and Swan (1956). In the language of Lucas (1980), the model is
fully articulated, artificial economic system that can be used to generate
economic time series of a set of important economic aggregates. The model
assumes an aggregate production function with constant returns to scale, inputs
n and capital k, and an output which can be allocated either to current
consumption c or to investment x. The
production constraint is:

where xt. ct, kt, nt 0. The model further assumes that the services provided by a
unit of capital decrease geometrically at a rate 0 < < 1:

Solow completes the specification of his economy by hypothesizing that some


fraction 0 < < 1 of output is invested and the remaining fraction 1
consumed and that nt is a constant for all t.

This structure is inadequate though because neither employment nor the savings
rate vary, when in reality they do. This leads to the introduction of stand-in
household with some explicit preferences.

Where is the subjective time discount factor. Prescott (1971) shows that for a
class of economies that include this one, the social optimum is the unique
competitive equilibrium allocation.

Empirically, the model predicts a procyclical response of labour supply to


changes in productivity. Hansen and Wright (1992) observe that for the US the
number of hours fluctuates much more than productivity. Together with the small
variation in wages this implies a high intertemporal elasticity of substitution in
labour supply (near 1) to reconcile theory and aggregate data.
When looking at Prescotts assumption about the intertemporal elasticity
of substitution in labour supply, he cites no direct microeconomic evidence on
Danny Anand Hamish Low

this parameter, which is central to the model of cyclical fluctuations. Nor does he
refer to any aggregate evidence on it. Rather, he relies on a rather selective
reading of the evidence on the intertemporal elasticity of substitution in
consumption in evaluating the labour supply elasticity. Summer instead finds
there is only a minimal response of labour to transitory wage changes.
Eichenbaum, Hansen and Singleton (1986) suggest that the intertemporal
substitution model cannot account at either the micro or the macro level for
fluctuations in labour supply.
Alternatively, Hansen and Wright argue that the standard neoclassical
business cycle model can be augmented with the following features to produce a
better empirical fit: (i) indivisible labour, (ii) preferences that are non-separable
over time, (iii) home production and (iv) the importance of other shocks such as
government spending for business cycles.

A second fundamental objection Summer has to Presoctts model is the absence


of any independent corroborating evidence for the existence of what he calls
technological shocks. Prescott interprets all movements in measured total factor
productivity as being the result of technology shocks or to a small extent
measurement error. He provides no discussion of the source or nature of these
shocks, nor does he cite any microeconomic evidence for their importance.
Instead, these technology shocks could in fact be the observable concomitants
of labour hoarding and other behaviour which Prescott does not allow in his
model.

The model predicts a countercyclical response of real interest rates. For US data,
interest rates are weakly procyclical which can be reconciled with the model by
combining temporary and permanent productivity changes (Doppelhofer, 2009).
Real wages are procyclical which is in line with the stylised facts. Another
example highlighted by Summer is that Prescott takes the average real interest
rate to be 4 percent. Over the 30-year period he studies, it in fact averaged only
about 1 percent and is weakly procyclical.

In conclusion, this essay finds that although the formulation of the neoclassical
model is appealing in terms of its micro-foundations, it lacks explanatory power
when faced with the challenge of understanding aggregated behaviour involving
agents with diverse preferences.