Quantitative Macroeconomics

The Real Business Cycle Model

Andreas Tischbirek

Department of Economics
HEC Lausanne

2 November 2020
Introduction Micro-foundations Model Special Case

Introduction

Last two lectures: We confronted the Solow model with data

⇒ Analysis was concerned with the trend component of time series
⇒ Long-run perspective
Next lectures: How can one explain the business cycle?
⇒ Analysis concerned with the cyclical component of time series
(i.e. deviations from trend)
⇒ Short-run perspective
Today’s agenda
1 Micro-foundations of macroeconomic models
2 The RBC model and properties of its equilibrium
3 A tractable special case of the model

UNIL-HEC RBC Model

1. Why Micro-Foundations in Macroeconomics?
Introduction Micro-foundations Model Special Case

Micro-Foundations of Macroeconomic Models

Until the 1970’s, macroeconomic models were typically based on
assumptions about the relationships of macroeconomic aggregates
(Example: Savings are a constant fraction of income)
These assumptions were generally informed by past observations
Policy analysis performed using these models was implicitly based on
the assumption that the relationships between macroeconomic
aggregates were invariant to policy changes
In the early 1970’s, Robert Lucas pointed out that relationships
between macroeconomic variables are likely to be influenced by policy
(Example: Monetary policy in the form of interest rate targets has
effects on the savings rate)
⇒ Policy analysis based on historical relationships likely to be
erroneous
This criticism of then standard practices is sometimes referred to as
the “Lucas critique”
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Introduction Micro-foundations Model Special Case

Micro-Foundations of Macroeconomic Models

The main conclusion from this critique was that macroeconomic

models should be based on components that are invariant to policy
changes
As such building blocks are seen generally, for example
Consumer preferences
Production technologies
Market structures
Models based solely on these primitive components are called
“micro-founded”
⇒ Micro-founded models allow one to analyse how the decisions of
individual agents would change in hypothetical scenarios and therefore
to compare the effects of different counterfactual policies on
macroeconomic aggregates
We will now study a micro-founded model called the Real Business
Cycle (RBC) model
UNIL-HEC RBC Model
2. Model
Introduction Micro-foundations Model Special Case

Overview
Early example for a Dynamic Stochastic General Equilibrium
(DSGE) model
The model includes
a price-taking representative household
a price-taking representative firm
The productivity of the firm follows an exogenous stochastic process
⇒ Fluctuations have real origins (hence the name of the model)
Productivity shocks are the sole source of uncertainty in the model
(many extensions of the baseline model exist though in which this
assumption is relaxed)
In making optimal choices today, the household has to take into
account how productivity evolves in the future (also true for the firm?)
⇒ It has to form expectations about future productivity levels and all
other future variables that depend on productivity
⇒ An assumption has to be made about the way in which
expectations are formed
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Introduction Micro-foundations Model Special Case

Overview

Assumption—All agents in the model have rational expectations,

that is
Agents use all information available to them to forecast variables that
are unknown to them
Expected values can be represented by the mathematical expectations
operator Et , i.e. Et X ≡ E(X |Ωt ) denotes the expectation about some
variable X conditional on the information set at t, Ωt
In each period t, agents are furthermore assumed to know the
structure of the economy and the realised values of all model variables
in periods 0, 1, 2, . . . , t
Note that this implies that agents predict future values precisely in
the same way as we, the modellers, would if we had simulated the
model until period t

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Household
Maximises expected discounted utility from consumption (ct ) and
leisure (lt ) subject to its budget constraint
Labour (1 − lt ) earns a wage (wt )
Can invest in capital (kt+1 ) which it rents to the firm
Firm pays Rt to the household for each unit rented
Capital depreciates at rate δ
Since the household is a price taker, it takes Rt and wt as given
Formally, the problem is
∞
X
max E0 β t u(ct , lt ) subject to
{ct ,lt ,kt+1 }
t=0
ct + kt+1 = wt (1 − lt ) + Rt kt − δkt (1)
where β ∈ (0, 1) is the discount factor, k0 is given and Ponzi schemes
are ruled out
Let us look at three equivalent ways to solve this problem
UNIL-HEC RBC Model
Introduction Micro-foundations Model Special Case

Substitution Approach
By solving (1) for ct and substituting the resulting expression into the
objective, the problem can be re-written as
∞
X
max E0 β t u [wt (1 − lt ) + (Rt − δ)kt − kt+1 , lt ]
{lt ,kt+1 }
t=0

First-order condition with respect to kt+1

Et β t uc [wt (1 − lt ) + (Rt − δ)kt − kt+1 , lt ] (−1)
+ Et β t+1 uc [wt+1 (1 − lt+1 ) + (Rt+1 − δ)kt+1 − kt+2 , lt+1 ] (Rt+1 − δ) = 0
uc (ct+1 , lt+1 )
⇒ Et β (Rt+1 − δ) = 1 (2)
uc (ct , lt )
First-order condition with respect to lt (after simplifying)
ul (ct , lt )
wt = (3)
uc (ct , lt )

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Lagrangian Approach
We know that (under certain technical conditions) the solution to a
maximisation problem with equality constraints coincides with a
stationary point of the corresponding Lagrangian (i.e. a point where
all partial derivatives of the corresponding Lagrangian are zero)
⇒ Lagrange’s theorem
The Lagrangian for this problem is given by
X∞ ∞
X
L = E0 β t u(ct , lt ) + E0 λ̃t [wt (1 − lt ) + (Rt − δ)kt − ct − kt+1 ]
t=0 t=0
For expositional reasons it is convenient to work with the present
value formulation of the Lagrangian here
To do so, define λt ≡ λ̃t /β t and use the fact that λ̃t = β t λt to
re-write the expression above as
∞
X
L = E0 β t {u(ct , lt ) + λt [wt (1 − lt ) + (Rt − δ)kt − ct − kt+1 ]}
t=0
UNIL-HEC RBC Model
Introduction Micro-foundations Model Special Case

Lagrangian Approach

First order conditions

With respect to ct

uc (ct , lt ) − λt = 0

With respect to kt+1

−λt + βEt λt+1 (Rt+1 − δ) = 0

With respect to lt

ul (ct , lt ) + λt wt (−1) = 0

It is obvious now that combining the equations above yields

Equations (2) and (3) from before

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Dynamic Programming Approach

The idea behind dynamic programming is to collapse a potentially

difficult optimisation over many periods into a simpler two-period
problem
At the heart of the method is Bellman’s “Principle of Optimality”
Figuratively speaking, this principle says that if the optimal path from
A to C goes through B, then the optimal path from B to C must be
exactly the same as the corresponding segment from B to C in the
original optimal path.
Given that this is true for our problem here, one can show that the
objective can be re-written in recursive form as

V (kt ) = max [u(ct , lt ) + βEt V (kt+1 )]

kt+1 ,ct ,lt

The equation above is called the “Bellman equation” and the

function V the “value function”
UNIL-HEC RBC Model
Introduction Micro-foundations Model Special Case

Dynamic Programming Approach

Substituting for ct using the budget constraint yields
V (kt ) = max {u [wt (1 − lt ) + (Rt − δ)kt − kt+1 , lt ] + βEt V (kt+1 )}
kt+1 ,lt

First-order conditions
With respect to kt+1
uc (ct , lt )(−1) + βEt V 0 (kt+1 ) = 0
With respect to lt
uc (ct , lt )(−wt ) + ul (ct , lt ) = 0

In order to find V 0 (kt+1 ), one can make use of the fact that
V 0 (kt ) = uc (ct , lt )(Rt − δ)
Aside: The “indirect” effect of kt on V (kt ) through its effect on kt+1 is zero here by the
∂V (kt )
“envelope theorem”. We have therefore that V 0 (kt ) = ∂kt
.

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Introduction Micro-foundations Model Special Case

Dynamic Programming Approach

The equation above rolled forward by one period is
V 0 (kt+1 ) = uc (ct+1 , lt+1 )(Rt+1 − δ)
Combining this expression with the FOC for kt+1 yields
uc (ct+1 , lt+1 )
Et β (Rt+1 − δ) = 1
uc (ct , lt )
We also had
ul (ct , lt )
wt =
uc (ct , lt )
These are the same conditions as the ones derived using the first two
methods
The theory underlying this approach is particularly useful in deriving
numerical solutions for optimisation problems (this is beyond the
scope of this course though)
UNIL-HEC RBC Model 31 October, 2016
Introduction Micro-foundations Model Special Case

Household Optimality Conditions

Optimal household behaviour is described by the two conditions
derived in three different ways above (and the budget constraint)
Euler equation
uc (ct+1 , lt+1 )
Et β (Rt+1 − δ) = 1
uc (ct , lt )
⇒ Et βuc (ct+1 , lt+1 )(Rt+1 − δ) = uc (ct , lt )

Household must be just indifferent between consuming an additional

unit in t and investing this unit in capital to raise consumption in t + 1
Intertemporal condition
Labour supply optimality
ul (ct , lt )
wt =
uc (ct , lt )

The marginal rate of substitution between leisure and consumption

must equal the real wage
Intratemporal condition
UNIL-HEC RBC Model
Introduction Micro-foundations Model Special Case

Household Optimality Conditions

In order to be able to solve the model, the precise shape of the utility
function has to be specified
Therefore, assume from now on that period utility is given by

u(ct , lt ) = ln ct − χ(1 − lt )

The two optimality conditions then become

ct
Et β (Rt+1 − δ) = 1 (4)
ct+1
wt = χct (5)

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Firm

The representative firm produces output (yt ) using capital and labour
as inputs
Its production function is given by

yt = At ktα (1 − lt )1−α

where At is the level of technology used in production

Technology evolves according to

ln At = ρ ln At−1 + εt (6)

with εt ∼ N(0, σ 2 )
Note that since the realisation of εt+1 is not known in t, the same is
true for At+1 (and all other model variables that depend on εt+1 )

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Firm

The profit maximisation problem of the representative firm is given by

max At ktα (1 − lt )1−α − (Rt − 1)kt − wt (1 − lt )

kt ,1−lt

Observe that the problem of the firm is static

⇒ Expectations about future periods play no role on the firm side
The corresponding first-order conditions can be written as

αAt ktα−1 (1 − lt )1−α = Rt − 1 (7)

−α
(1 − α)At ktα (1 − lt ) = wt (8)

The price-taking firm equates the marginal product of capital to the

net interest rate and the marginal product of labour to the wage

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Equilibrium
In an equilibrium of the model, both the representative household
and the representative firm behave optimally (and markets clear)
⇒ Their respective first-order conditions must be satisfied
To summarise, in an equilibrium the following must hold
From the household side
ct + kt+1 = wt (1 − lt ) + (Rt − δ)kt (9)
ct
Et β (Rt+1 − δ) = 1 (10)
ct+1
wt = χct (11)
From the firm side
ln At = ρ ln At−1 + εt (12)
αAt ktα−1 (1 − lt )1−α = Rt − 1 (13)
(1 − α)At ktα (1 − lt )−α = wt (14)

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Equilibrium

Rt and wt can be eliminated from the equation system above

Doing so yields

At ktα (1 − lt )1−α = ct + kt+1 − kt + δkt (15)

ln At = ρ ln At−1 + εt (16)
ct  α−1
(1 − lt+1 )1−α + 1 − δ = 1

Et β αAt+1 kt+1 (17)
ct+1
1
(1 − α)At ktα (1 − lt )−α = χ (18)
ct
Note that Equation (15) is the resource constraint for this economy
(output=consumption+investment+depreciation)
Is the allocation implied by these equilibrium conditions socially
optimal?

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Welfare

To find the social optimum, we can search for the allocation that a
beneficent social planner would choose who is not tied to markets as
an allocation mechanism
The beneficent social planner would maximise household utility
subject to
the resource constraint (15)
the law of motion of TFP (16)
It turns out that the first-order conditions of the social planner’s
problem (i.e. the conditions describing the socially optimal allocation)
are identical with (17) and (18)
⇒ In the RBC model, the market outcome is socially optimal
This fact should not surprise us, given the fundamental welfare
theorems

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Welfare

The fundamental welfare theorems state that if the economy is

described by complete markets, no externalities or non-convexities
(such as increasing returns to scale) then
1 every equilibrium of the competitive market is Pareto optimal
2 every Pareto optimal allocation can be achieved by a competitive
economy subject to appropriate lump-sum transfers of wealth
Many times solving for the market outcome is more complicated than
solving the problem of the beneficent social planner
⇒ Fundamental welfare theorems imply that these coincide if certain
conditions are met
Note that since the market outcome is socially optimal, there is no
policy intervention that is welfare improving

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Solving the Model

How can one find the value that each model variable takes on in
equilibrium in period t = 0, 1, 2, . . .?
Recall that the solution is described by

At ktα (1 − lt )1−α = ct + kt+1 − kt + δkt

ln At = ρ ln At−1 + εt
ct  α−1
(1 − lt+1 )1−α + 1 − δ = 1

Et β αAt+1 kt+1
ct+1
1
(1 − α)At ktα (1 − lt )−α = χ
ct
Thus, solving for the equilibrium allocation amounts to solving a
non-linear system of expectational difference equations
⇒ Generally no closed form solution exists

UNIL-HEC RBC Model

3. Solving the model in a special case - full capital depreciation
Introduction Micro-foundations Model Special Case

Model with Full Capital Depreciation

Let us begin by solving the model for the special case that capital
fully depreciates every period, i.e. δ = 1
This case is clearly not very realistic, but it is instructive because it
allows us to solve the model “by hand”
With δ = 1, the model equations become

At ktα (1 − lt )1−α = ct + kt+1 (19)

ln At = ρ ln At−1 + εt (20)
ct α−1
Et β αAt+1 kt+1 (1 − lt+1 )1−α = 1 (21)
ct+1
1
(1 − α)At ktα (1 − lt )−α = χ (22)
ct

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Solving the Model with Full Capital Depreciation

One can show that in the version of the RBC model outlined above
with
log utility
full capital depreciation
the ratio of consumption to output ct /yt remains constant at all times
To solve the model, we therefore use this information, i.e. we guess
that ct /yt = Cy in all t and verify our guess later
(where Cy is some constant that we have to find still)
If the initial guess ct /yt = Cy is wrong, we will find a contradiction
when we solve the model

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Solving the Model with Full Capital Depreciation

The model equations (19) to (22) can be re-written as follows
Resource constraint
At ktα (1 − lt )1−α = ct + kt+1
kt+1 = yt − ct (23)
Consumption Euler equation
ct  α−1
(1 − lt+1 )1−α = 1

Et β αAt+1 kt+1
ct+1
 
1 α−1 kt+1 1
Et β αAt+1 kt+1 (1 − lt+1 )1−α =
ct+1 kt+1 ct
1 yt+1 1
Et αβ =
ct+1 kt+1 ct
1 yt+1 1
Et αβ =
ct+1 yt − ct ct
yt+1 yt − c t
Et αβ =
ct+1 ct

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Solving the Model with Full Capital Depreciation

Re-writing (19) to (22)
Consumption Euler equation (continued)
yt+1 yt
Et αβ = −1
ct+1 ct
1 1
αβ = −1
Cy Cy
αβ = 1 − Cy
Cy = 1 − αβ
Intratemporal labour supply condition
1
(1 − α)At ktα (1 − lt )−α = χ
ct
1 1 − lt
(1 − α)At ktα (1 − lt )−α =χ
ct 1 − lt
1 yt
(1 − α) =χ
ct 1 − lt

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Solving the Model with Full Capital Depreciation

Re-writing (19) to (22)

Intratemporal labour supply condition (continued)

1 − α yt
1 − lt =
χ ct
1−α 1
1 − lt =
χ Cy
1−α
1 − lt = (24)
χ(1 − αβ)

UNIL-HEC RBC Model

Introduction Micro-foundations Model Special Case

Solving the Model with Full Capital Depreciation

To summarise, we have found
1−α
1 − lt = (25)
χ(1 − αβ)
yt = At ktα (1 − lt )1−α (26)
ct = (1 − αβ)yt (27)
kt+1 = yt − ct (28)
ln At+1 = ρ ln At + εt+1 (29)
Together with initial values for At and kt in t = 0 this yields a
complete model solution
⇒ With A0 and k0 given
(25) determines labour in t = 0
(26) determines output in t = 0
(27) determines consumption in t = 0
(28) and (29) determine technology and capital in t = 1, i.e. A1 and k1
...
UNIL-HEC RBC Model
Introduction Micro-foundations Model Special Case

Solving the Model with Full Capital Depreciation

What are appropriate starting values A0 and k0 ?
If one is purely interested in short-run fluctuations and wants to
eliminate the effects of an initial adjustment to the long-run
equilibrium, one can choose the values that At and kt take on in the
steady state
A long-run equilibrium or steady state is an equilibrium of the model
in which all endogenous and exogenous variables remain constant at all
times
(We can therefore drop the subscript t to describe the steady state)
Here the steady-state values for technology and capital are

Ā = 1
1 1−α
k̄ = (αβ) 1−α
χ(1 − αβ)
(Can you show this?)
We will use these values for our simulation
UNIL-HEC RBC Model
Introduction Micro-foundations Model Special Case

Model Simulation
Technology (A) Output (y)
1.06 0.31

1.04 0.3
1.02
0.29
1
0.28
0.98
0.27
0.96

0.94 0.26

0.92 0.25
0 20 40 60 80 100 0 20 40 60 80 100

Consumption (c) Capital (k)

0.22 0.11

0.105
0.21

0.1
0.2
0.095
0.19
0.09

0.18
0.085

0.17 0.08
0 20 40 60 80 100 0 20 40 60 80 100

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Introduction Micro-foundations Model Special Case

Impulse Responses to a Technology Shock

Technology (A) Output (y)
1.014 0.292

1.012 0.291

1.01
0.29
1.008
0.289
1.006
0.288
1.004

1.002 0.287

1 0.286
0 20 40 60 80 100 0 20 40 60 80 100

Consumption (c) Capital (k)

0.1965 0.095

0.196 0.0948

0.1955 0.0946

0.195 0.0944

0.1945 0.0942

0.194 0.094

0.1935 0.0938

0.193 0.0936
0 20 40 60 80 100 0 20 40 60 80 100

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Introduction Micro-foundations Model Special Case

References

Mandatory Reading
Romer, David (2012): Advanced Macroeconomics, McGraw-Hill, New
York, NY, 4th edition, Chapters 5.2-5.5
Further Reading
King, Robert G. and Sergio T. Rebelo (1999): “Resuscitating real
business cycles” in J.B. Taylor and M. Woodford (eds.): “Handbook
of Macroeconomics,” Vol. 1, Elsevier

UNIL-HEC RBC Model