Macroeconomics Theory 1

ECO – 221
Instructor – Piyali Banerjee
Monsoon, 2019
Chapter 16: Real Business Cycle and New Keynesian
Models

1
By the end of this chapter, we will learn the following:

 The Real Business Cycle (RBC) model, its properties, results, criticisms
and its implications in the field of economics.

 The New Keynesian (NK) model and its properties, e.g. the presence of
stabilization bias when monetary policy is discretionary.

 Most importantly, the comparisons between the NK DSGE (dynamic

stochastic general equilibrium) model, the RBC model and the 3-Eqn
model.

Overview:

 The 3-equation model used in this book is in some respects a radically

simplified version of the New Keynesian (NK) model.
 Both the 3-Eq & NK models share the 𝐼𝑆 − 𝑃𝐶 − 𝑀𝑅 equations and
include monopolistic firms with price-setting power which respond to
changes in 𝐴𝐷 by adjusting output (due to sticky prices).
 The difference: NK assumes forward-looking & REH behavior for all
actors, while 3-Eq assumes that only the CB & Forex market follow
REH.
 Criticism of NK/ DSGE modelling: 𝐴𝐷 relies on an intertemporal
substitution effect which is hard to detect in consumer data; 𝑁𝐾𝑃𝐶
implies purely forward-looking, REH behavior which is highly at odds
with data.
 RBC: Agents follow REH, and business cycles are due to exogenous
technological shocks, which are persistent and cause shifts in
working hours and intertemporal consumption as a result of agents
re-optimizing.

2
 ∴ Fluctuations in employment (𝑁, 𝑡ℎ𝑒𝑟𝑒𝑎𝑓𝑡𝑒𝑟) in the RBC are due to re-
optimizing behavior, and not due to firms hiring /retrenching in response to 𝐴𝐷
shocks (as in the 3-Eqn model).
 The NK model is descended from the RBC, with sticky prices
introduced.
 RBC: Business cycles are equilibrium phenomena → Cyclical
behavior is the result of agents optimally adjusting labor-leisure
choice. No intervention is welfare-improving since there are no
imperfections in the model.
 NK: Business cycles are equilibrium phenomena, but due to
imperfections (sticky prices), an inflation-targeting CB is welfare-
improving.
 3-Eqn model: Business cycles are disequilibrium phenomena, where
the economy is shifted away from equilibrium by a shock and the CB
gets the economy back to equilibrium.

RBC vs 3-eqn Model:

 In RBC households, choose savings optimally and follow REH (rational

expectation hypothesis).
 Agent behavior is captured by deep-parameters (of their utility and
production functions), and these are invariant to policy.
 Also, there are exogenous technological shocks (shifts in the production
function) which are believed to drive economic fluctuations in the
economy.
 Agents respond optimally to shocks; this leads to economic
fluctuations. E.g. –ve technological shock → real wages ↓ → employees
choose to supply less labor → economy is in business cycle trough.
 Unemployment is voluntary in a business cycle trough since this is due
to workers’ choices → No intervention can improve welfare since cycles
are equilibrium phenomena.
3
  3-Eqn model: Business cycles can result from shocks to 𝑦𝑒 or 𝐴𝐷 →
Sluggish adjustment of agents → Output is shifted away from
equilibrium → There is a role for policy to minimize the cost of the
shock.
 Cycles are modelled as a disequilibrium phenomenon in the 3-Eqn
model even if the source of the shock is on the supply side.
 E.g. –ve 𝐴𝐷 shock → Monopolistic firms cut production → The fall in
hours worked is due to fewer jobs available → 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 is
involuntary, unlike RBC.
 The RBC’s major propagation mechanism, which turns random shocks
into business cycle fluctuations is how households react to changes in
the real interest rate and the real wage.
Households maximize their utility over the planning horizon by making
optimal choices over savings, consumption, work and leisure.

Real Business Cycle (RBC) Model:

i) Consumption/ saving decision (as in PIH1): Households choose an

optimal consumption path subject to their intertemporal budget
constraint, savings are used to increase future consumption.
o 3 ingredients in the decision: permanent income, real interest rate
and subject discount rate.

1 PIH (Permanent income hypothesis):

o PIH is an economic theory attempting to describe how agents spread consumption over
their lifetimes.
o it supposes that a person's consumption at a point in time is determined not just by their
current income but also by their expected income in future years—their "permanent
income". In its simplest form, the hypothesis states that changes in permanent income,
rather than changes in temporary income, are what drive the changes in a consumer's
consumption patterns.
o Assuming consumers experience diminishing marginal utility, they will want to smooth
out consumption over time, e.g. take on debt as a student and also ensure savings for
retirement.
o Coupled with the idea of average lifetime income, the consumption smoothing element of
the PIH predicts that transitory changes in income will have only a small effect on
consumption. Only longer-lasting changes in income will have a large effect on spending.

4
 ii) The RBC also adds in the consumption/ leisure choice: Households
choose freely between consumption (𝐶, henceforth) and leisure.
o The labor market is assumed to be perfectly competitive, so
workers can freely alter their hours of work in response to an
economic shock.
o Important ingredient: The (Frisch) intertemporal elasticity of labor
supply shows the % 𝛥 in hours that arises from a given % 𝛥 in
wages, ceteris paribus.
iii) The RBC methodology in characterizing business cycles: Using an H-
P2 filter to separate trend growth from business cycle fluctuations.
Analysis is then performed on the extracted cyclical component.

RBC: Cyclical components of Output, consumption & investment

2 H-P filter is Hodrick–Prescott filter (also known as Hodrick–Prescott decomposition) is a

mathematical tool used in macroeconomics, especially in real business cycle theory, to remove
the cyclical component of a time series from raw data.

5
 Business cycle facts / Findings:

- Consumption and output volatility are very similar

- Investment is much more volatile

Note: Shaded areas reflect recessions.

RBC: Cyclical components of Output, hours worked and employment.

Findings:
o Hours per worker are less responsive to changes in output than
employment.

6
o Data is not consistent with RBC propagation mechanism – that workers
adjust hours in response to shocks.

RBC model properties:

 RBC modelers did not work backwards from real world facts in making
their modelling decisions, instead they began with a simple model &
evaluated how well it matches facts about the business cycle (deductive
approach).

 On the other hand, the microfoundations of the 3-Eq model were

inductive – based on incomplete contracts & imperfect competition to
reflect the presence of involuntary 𝑈 at equ'm & the response of 𝑦, 𝑁 to
𝐴𝐷 shocks.

Assumptions of a simple RBC model:

1. Large number of identical, infinite-lived agents; Each agent is a

‘representative agent’.

2. When savings ↑, it is invested, so there is a larger capital stock

next period.

3. There is perfect competition and perfect information.

4. Expectations are formed rationally.

5. There is full flexibility of nominal wages & prices, so RBC looks

at real values.

6. There are random, persistent technological shocks which disturb

the economy via shifting the production function.

7
Long-run properties: Steady-state growth.
 At steady state, there is constant rate of population growth and
employment rate, thus the labor supply curve is vertical.

 In the RBC model, households are optimizing their consumption-

savings (or leisure) choice i.e. savings is endogenous.
 The economy is characterized by a production function which
includes exogenous technological progress. Technological progress
determines the constant rate of growth of output per capita & real
wages in the steady state.
 Fig 16.3: The labor demand curve shifts upward each period at the
rate of technological progress → Labor productivity & real wages rise
at this rate.
 RBC predictions are in line with rising productivity in advanced
countries and no long-run tendency for an increase in employment.

8
 The fact that rising real wages over long periods have not been
accompanied with rising 𝑁 (𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡) is interpreted as an inelastic
(vertical) labour supply curve. Thus, the model’s focus is on the
household’s optimal choices of hours worked, as opposed to 𝑁.

Short-run properties:
 Business cycles are captured in the model as shocks to the process of
technological change. This produces equilibrium business cycles for 2
reasons:
i. The shocks are assumed to hit the economy, then die out
gradually. This in-built persistence makes shocks last, which
generates cycles (as opposed to jumps around long-run trends)
ii. Forward-looking, rational households respond to shocks as they
prefer a smooth consumption path. This response helps to sustain
the effects of the technological shock on 𝑌, 𝑁 and 𝐾.
 E.g. A +ve shock shifts the production function → Marginal
productivity of labor & capital ↑→ Perfect competition means real
wages & interest rate ↑ → Optimizing agents respond to the higher
𝑟 (int. rate)by increasing savings, and to the higher 𝑤 (𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒)
by increasing the hours worked.

In response to the technology shock, agents optimize on two margins:

1. Agents want to ensure that the subjective MRS between 𝐶𝑡 & 𝐶𝑡+1
equals the objective MRT between 𝐶𝑡 & 𝐶𝑡+1 .
The MRS shows how much 𝐶𝑡+1 is needed to keep utility constant, when
giving up 1 unit of 𝐶𝑡 ; The MRT reflects how much 𝐶𝑡+1 can be increased
when 1 unit of 𝐶𝑡 is saved.
Shock effect: MRT increases from the rise in 𝑟 (savings more attractive),
agents thus save more and consume less 𝐶𝑡 , thus the MRS rises as well
until it equals MRT.

9
 2. Agents want to ensure that the subjective MRS between 𝐶𝑡 & 𝐶𝑡+1
equals the objective MRT btw the return from working today &
working tomorrow.
This MRT reflects how much 𝐶𝑡+1 can be increased by sacrificing 1 unit
of leisure today (by working more & saving).
𝑤 ↑ → MRT ↑ (working more attractive), thus agents increase 𝐶𝑡+1 by
working more & saving. This increases the MRS until it equals the MRT.

RBC vs 3-Eqn model (continued):

 RBC: Higher savings are transformed into Investment (Households are
also the firms) → Capital stock ↑ → Labor demand ↑.
 3-Eqn & Keynesian model: No automatic mechanism to transform 𝑆
into 𝐼.
Steps 1- 5: – The effects of the +ve technological shock:
1. Output (𝑌) ↑ (Given the same inputs, output will be higher).
2. Real wage & interest rate ↑ due to the shock.
3. 𝐶 ↑ but not by as much as 𝑌 (due to 𝐶-smoothing across all future
periods)
4. Hours of work ↑ due to intertemporal substitution (𝐿 ↑)
5. Savings are automatically invested in new capital stock (𝐾 ↑) → 𝑀𝑃𝐿 ↑
→ Labour demand curve shifts up again (𝐿 ↑) → The initial shock is
amplified.
6. As the technological shock peters out, the economy gradually returns
to the steady state growth path.

Below: How a +ve shock to technology shifts the economy away from long-run
equilibrium growth path & produces an equilibrium real business cycle.

10
*Numbers correspond to the steps in the previous slide.
 Steps 1, 2, 3, 5 & their unwinding through time generate a cycle
for 𝑌, 𝐶 and 𝐼.
 Step 4 is necessary to get fluctuations in employment (hours).

Criticisms of the RBC model:

Criticism 1: The impulse & propagation mechanism
 Little evidence about the source & nature of technological shocks
(business cycle driver).
 The model also required technological regress to produce business
cycles. Later, the scope of what constitutes a tech. shock was widened
(e.g. to include changes to the regulatory system), but criticisms of
inconsistencies with l/run data remained.
 The propagation of the tech. shocks also requires a very persistent
initial impulse, but there is no economic justification or micro
foundation for this. Without high persistence, the RBC fits the data
poorly.

11
Criticism 2: The labour market
 The original RBC relies on the intertemporal substitution between
labor & leisure to drive business cycles. Following the model,
aggregate hours & productivity should vary closely with output. This
would imply that hours per worker vary closely with output and that
real wage is strongly procyclical.
 Aggregate hours worked is more variable than productivity in the
data, which is not supportive of the model. Fig 16.2 (slide 9) shows
that employment (not hours) varies more with 𝑦, suggesting that
change in employment is a key driver of changes in aggregate hours.
 Moreover, 𝑤 is shown to be acyclical/ mildly procyclical in the data,
which is more in line with the model in Ch. 2 where 𝐴𝐷 shocks shift 𝑤
around the equ'm.
 The RBC was better reconciled with data using some modifications,
e.g. using a model of indivisible labour & allowing 𝐺 to influence
labour mkt dynamics.
 Finally, micro estimations of the intertemporal elasticity of labour
supply also found that it was too small to account for the fluctuations
in actual hours.

Criticism 3: The Modelling Approach

 Earlier models only used identical representative agents. Absence of
heterogeneity or aggregation limited the quantitative accuracy of the
model’s predictions.

The Impacts of RBC Modelling:

1. Increased the focus of models on microfoundations. (Models now more
robust, but choice of microfoundations remains open to dispute).

12
2. Since RBCs are microfounded, they are better able to analyze the
causal effects of policy (assuming the specified agent behavior in the
model is a good representation of the economy).
3. It refocused macroeconomics on the real causes of business cycles.
4. The device of building a model economy is a potentially valuable
methodology – e.g. the NK DSGE models utilize more realistic
microfoundations, and they are useful to quantify the welfare
implications of economic policy.

13
 REAL BUSINESS CYCLE THEORY

Rational expectations provided a theoretical basis for the notion that monetary policy
should not have important effects on output. The work of Nelson and Plosser cast doubt
on the empirical importance of aggregate demand shocks. These ideas supported the
development of equilibrium real business cycle theory (RBC).26 RBC theory asserts that
fluctuations in output and employment are the result of a variety of real shocks that hit
the economy, with markets adjusting rapidly and remaining always in equilibrium.
RBC theorists also differ from more traditional macroeconomists on how to
measure the economic parameters that govern a model’s behavior. RBC theorists gen-
erally prefer using calibration or quantitative theory techniques. In practice, this
means choosing a small number of parameters that are crucial to the behavior of a
model and estimating the value of each parameter from microeconomic studies, rather
than from the macroeconomic data itself. We explore here a very simple RBC model
that focuses attention on a single parameter, the intertemporal elasticity of substitu-
tion of labor.

A SIMPLE REAL BUSINESS CYCLE MODEL

Real business cycle theorists create models in which firms choose optimal investment
and hiring plans and individuals make optimal consumption and labor supply choices—
all choices being made in a dynamic, uncertain environment. The resulting models are
technically complex. In fact, they can be solved only by use of relatively sophisticated
mathematics combined with computer simulation. We present here a simple model that
gives the flavor of real business cycle models and focuses on the question of the inter-
temporal substitution of labor. In this simple model, the firm buys labor and produces
output in each of the many periods. A representative worker sells her labor and buys
consumption goods each period. If she wishes, the worker can save her
consumption goods for another period.
Each period, the representative firm buys labor Lt and uses it to produce output Yt
according to the production function
Yt  at Lt (1)
where at is the marginal product of labor in period t. (Looking ahead, we know the real
wage rate will end up equaling at because in a competitive market the real wage rate
equals the marginal product of labor.) Changes in the marginal product of labor are the
source of real shocks in this simple model.

dor75926_ch21_557-588.indd 579 03/11/10 3:28 PM

 −
The representative −worker has up to L hours available to sell in each − period. The
worker’s
period theleisure is L hours
representative lessreceives
worker the timeutility
she sells,
fromsoleisure
leisureand
equals  L t . Each
fromLconsumption,
C t . We assume that the worker’s utility function in a given period can be expressed as
2 − −
U(Ct, L  Lt)  Ct (L  Lt) (2)
The worker’s lifetime budget constraint states that the sum of lifetime
consumption must equal the sum of lifetime earnings:
Ct  Ct1  Ct2  · · ·  wt Lt  wt1Lt1  wt2 Lt2  · · · (3)

where wt is the real wage rate in period t. The worker chooses consumption and leisure
each period in amounts that will maximize the sum of lifetime utility subject to the bud-
get constraint in equation (3).
It will prove helpful to note that the marginal utilities of consumption and
leisure are
Ut
MUconsumption  Ct 1 ( L  Lt )  _
−
(4)
Ct
Ut
MUleisure  Ct ( L  Lt )1  _
−
− (5)
L  Lt
The optimal tradeoff between leisure and consumption requires
MUleisure  wt  MUconsumption,
or
Ct
L  Lt  _
−
w (6)
t

How do we find the worker’s optimal tradeoff defining her intertemporal substitu-
tion of leisure? If the worker reduces leisure 1 hour this period, she earns wt more,
which permits her to add wt wt1 hours of leisure the following period. It follows that
the marginal utility of leisure this period must equal wt wt1 times the marginal utility
of leisure next period:

MUleisuret  (wt兾wt1)  MUleisure t+1 (7)

Equating the values of the marginal utilities of present and future leisure—
using equations (4)–(6) in equation (7)—gives us the worker’s intertemporal
substitution of leisure:
−
L  Lt wt1 1
_
_−
L  Lt1
 _ w t
1 
( ) (8)

We assume that and  are both positive.

Note again that we are implicitly assuming a zero interest rate.

dor75926_ch21_557-588.indd 580 03/11/10 3:28 PM

 Equation (8) tells us that if the wage in period t  1 increases 1 percent while the
wage in other periods remains constant, leisure in period t  1 will fall by (1  )
(1   ). Depending on the values of  and , leisure might be very responsive or
quite unresponsive to temporary changes in the wage rate.
Our model needs to be consistent with the empirical observation that permanent
wage changes have little effect on labor supply. We can check this by computing the
long-run response of leisure to a permanent wage change. Suppose the wage were con-
stant over time, say, w*. In this case, consumption and labor supply would also be con-
stant over time, say, C * and L *. From the budget constraint [equation (3)], it must be
true that C*  w*L*. Combine this with the worker’s consumption-leisure tradeoff,
from equation (6) to derive the long-run labor supply, and we find

(兾 ) (w*L*) −
L  L*  __ L*  _ L
−
or (9)
w* 
Equation (9) shows that the long-run response of labor to the wage rate is zero,
since w* drops out of equation (9) entirely. So in this aspect our model is in accord
with the facts.
Consider now the effect of intertemporal substitution of labor as a propagation
mechanism . Suppose there is a transitory technology shock in period t and thus the mar-
ginal product of labor rises by %a. We know that the wage rate equals the marginal
product of labor, so the wage rate will increase along with the increase in a. The total
change in output will be

% Y  % a  % L (10)
The propagation mechanism is the “extra kick” to output % L. We know
from equation (8) that leisure will decrease by [(1  )(1   )]  % a. Since
leisure hours are roughly three times labor hours, 31 the percentage increase in labor
should be approximately %  L  3  [(1  )(1   )]  % a. The total
change in output will be
1
%Y  a 1  3  _ b  %a (11)
1 

The parameters  and are examples of what are called deep parameters in the
real business cycle literature. RBC theorists argue that our models should depend on the
parameters that describe the preferences of consumer-workers and the parameters that
describe the production function of firms. These parameters can be identified from mi-
croeconomic studies. In our very simple model, if   is close to 1, the intertemporal
substitution of leisure will be very strong and the propagation mechanism in
equation (11) will translate relatively small technology shocks into much larger
output

Empirically, the long-run supply of labor is slightly backward-bending. In the long run, higher wages reduce
labor supply somewhat as people prefer to spend some of their higher income on increased leisure.
Suppose one works 2,000 out of 8,760  24  365 hours.

dor75926_ch21_557-588.indd 581 03/11/10 3:28 PM

 shocks. In contrast, if the intertemporal substitution of leisure is weak, this propagation
mechanism will be relatively unimportant. The empirical evidence, based on
microeco-nomic data, favors the view that intertemporal substitution is relatively
weak.

RECAP

• Real business cycle theory models the macroeconomy through the optimizing deci-
sions about work and consumption made by individuals and the optimizing decisions
about production made by firms. The model presented above is a simple version of
the dynamic models deployed by RBC theorists.
• Real business cycle theory minimizes the role of nominal fluctuations and money.
• RBC theorists try to identify deep parameters that can be measured in microeco-
nomic studies. The elasticity of the intertemporal substitution of leisure is a key ex-
ample. The conclusions from the measurement of such parameters are not always
favorable to the RBC models.

dor75926_ch21_557-588.indd 582 03/11/10 3:28 PM