REAL BUSINESS CYCLE

The empirical data suggests that actual output is seldom at its potential level. Either it’s above the
potential level or below the potential level to which neo-classical growth theory has no answer as to the
reason why this phenomenon is taking place. Before we get into any of the explanations for these cycles
of disturbance we should first take a brief look at the business cycle facts.
When we take a look at the economic data we can readily see that there is no regular pattern to
fluctuations. An economy can stay in boom and then falls in recession then comes back to boom and
keeps repeating the process for uneven periods of time. Moreover the distribution of fluctuation among
components of a variable is uneven. If we take the example of output and say there is an increase of 20%
increase in output then it doesn’t mean that there is an equal 20% increase in consumption, investment
and government expenditures. Consumption may increase more than government expenditures and vice
versa.
There is a visible symmetry of fluctuations with respect to mean but not across time. If we consider the
overall output in the economy then we can readily see that booms and recessions in the economy are
symmetrically located around the mean potential output but if we take a look across time the results are
very different. The analysis across time would reveal how much time an economy spent in recession and
how much of the time it stayed in boom. So magnitude vs. time will be another focus of our discussion
here.
Another important business cycle fact is the movement of the variables with respect to fluctuation in the
economy. Basically, we divide the movements in two broad categories i.e. pro-cyclical and A-cyclical.
The pro-cyclical movements are when variables move in the same direction as the fluctuations e.g.
employment moves pro-cyclically with fluctuations in output. When the economy is in boom there will
be high employment too. On the other hand the inflation data shows us A-cyclical trends which stand for
no clear pattern to movements. In the same manner we can see that interest rate and real wages are pro-
cyclical whereas money stock is A-cyclical.
Real business cycle is a classical explanation of the business cycle phenomenon. The baseline model use
for this analysis is the Ramsey model. The significance of using Ramsey model as the baseline model is
that Ramsey model is built on the premise of a Walrasian economy with no information asymmetry and
perfect markets. The significance of using a Walrasian economy is that classicals don’t believe in the
government intervention approach which was founded by Keynes.
Now if we move ahead with a Walrasian setup and assume for a second that it succeeds in explaining
the business cycle fluctuations then every point along the path of fluctuations will be a Pareto optimal
point. This explanation of Pareto optimality comes from the first welfare theorem which explains that if
the setup is Walrasian and that there is no information asymmetry and markets are competitive then the
decentralized equilibrium will be Pareto efficient and hence in such setup the social planner
(Government) cannot increase the welfare of the individuals in the economy by his intervention. Thus
the government intervention is not justified. So in fact if we see the debate is more above about the setup
being Walrasian or non-Walrasian and effect of government intervention on the economy.
MODEL SETUP
To conclude RBC explains the fluctuations on the basis of Walrasian economy. All shocks originate
from real side of the economy like productivity shocks and government expenditure shocks. Before we
move on with our analysis we will make some changes to our baseline Ramsey model:
(i) Now population = labor force. The growth rate of population is an exogenous constant n. The
implication of this change suggests that the unemployment of labor is now by choice which
makes the labor supply decision endogenous.
(ii) Introduction of real shocks in the system i.e. Govt expenditure shocks and Technology
shocks.
We will also make the following assumptions:
(a) Time is discrete in our model.
(b) There are large numbers of infinitely lived identical households who are also price takers.
(c) There are large numbers of identical firms which are price takers and also assume a Cobb-
Douglas production function.

𝑌𝑡 = 𝐾𝑡𝛼 (𝐴𝑡 𝐿𝑡 )1−𝛼 0<𝛼<1 −1−

Capital in the next period is dependent upon the amount of capital already present plus new
investment less the depreciation on existing capital.

𝐾𝑡+1 = 𝐾𝑡 + 𝐼𝑡 − 𝛿𝐾𝑡 −2−

𝐾𝑡+1 = 𝐾𝑡 + 𝑌𝑡 − 𝐶𝑡 − 𝐺𝑡 − 𝛿𝐾𝑡

𝐾𝑡+1 = (1 − 𝛿)𝐾𝑡 + 𝑌𝑡 − 𝐶𝑡 − 𝐺𝑡
(d) Government expenditures are financed through lump-sum taxes.
(e) Markets are competitive so the returns to factors of production are equal to their marginal
products.

𝜕𝑌𝑡 𝛼 −𝛼
𝐾𝑡 𝛼
𝑀𝑃𝑁 = 𝑤𝑡 = = (1 − 𝛼)𝐾𝑡 (𝐴𝑡 𝐿𝑡 ) 𝐴𝑡 = (1 − 𝛼) ( ) 𝐴𝑡 −3−
𝜕𝐿𝑡 𝐴𝑡 𝐿𝑡

𝜕𝑌𝑡 𝐾𝑡 1−𝛼
𝑀𝑃𝐾 = 𝑟𝑡 = = 𝛼𝐾𝑡𝛼−1 (𝐴𝑡 𝐿𝑡 )1−𝛼 = 𝛼 ( ) −4−
𝜕𝐾𝑡 𝐴𝑡 𝐿𝑡
(f) The utility function is same as that of Ramsey model with slight modification for the inclusion of
the choice of labor by an individual. The total labor hours are normalized to 1 for the sake of
simplicity where lt denotes the number of labor hours and 1 – lt denotes the number of leisure
hours.
∞
𝑁𝑡
𝑢 = ∑ 𝑒 −𝜌𝑡 𝑢(𝐶𝑡 , 1 − 𝑙𝑡 ) −5−
𝐻
𝑡=0

Nt is the population and H is the number of households; which makes Nt / H the size of
household.

𝑁𝑡 = 𝑒 𝑁̅+𝑛𝑡
 Population grows at an exogenous rate n and at any point in time the level of Nt is given by the
above expression. As all of the households are identical so the expressions of per-capital
consumption and labor is given by
𝐶𝑡 𝐿𝑡
𝑐𝑡 = , 𝑙𝑡 =
𝑁 𝑁
(g) For the purpose of simplicity we choose a logarithmic utility function which will transform the
function as follows.

𝑢 = 𝑙𝑛𝑐𝑡 + 𝑏𝑙𝑛(1 − 𝑙𝑡 ) 𝑤ℎ𝑒𝑟𝑒 𝑏 > 0

(h) Growth in technology in our system is a mixture of an exogenous rate of growth g and a
technology shock. The technology shock is random but follows an autoregressive procedure
which means it is serially correlated.

𝑙𝑛𝐴𝑡 = 𝐴̅ + 𝑔𝑡 + 𝐴̃ −6−

𝐴̃ = 𝜌𝐴 𝐴̃𝑡−1 + 𝜀𝐴,𝑡 𝑤ℎ𝑒𝑟𝑒 |𝜌𝐴 | < 1 −7−

(i) Government expenditures grow at a constant rate of (g + n) and an exogenous shock. The
exogenous shock is also both random and serially correlated.

𝑙𝑛𝐺𝑡 = 𝐺̅ + (𝑔 + 𝑛)𝑡 + 𝐺̃𝑡 −8−

𝐺̃𝑡 = 𝜌𝐺 𝐺̃𝑡−1 + 𝜀𝐺,𝑡 −9−

This completes the specification of our model. Now we can use this model to study the household
behavior and decision making procedure.

HOUSEHOLD BEHAVIOUR
To see what utility function implies for labor supply, we will consider a case where household has only
one member and lives for only one period and has no initial wealth. The constraint faced by the
individual is the one period labor income earned by him which is given by c = wl.

𝑀𝑎𝑥 𝑢 = 𝑙𝑛𝑐 + 𝑏𝑙𝑛(1 − 𝑙) 𝑆. 𝑇. 𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡 𝑐 = 𝑤𝑙

ℒ = 𝑙𝑛𝑐 + 𝑏𝑙𝑛(1 − 𝑙) + 𝜆(𝑤𝑙 − 𝑐)

𝜕ℒ 1
= −𝜆 =0
𝜕𝑐 𝑐
1
𝜆=
𝑐
𝜕ℒ 𝑏
=− + 𝜆𝑤 = 0
𝜕𝑙 1−𝑙
𝑏
𝜆=
𝑤(1 − 𝑙)
1 𝑏
=
𝑐 𝑤(1 − 𝑙)
 1−𝑙
=𝑏
𝑙
From above expression we deduce that in one period case of optimization the choice of labor supply is
not dependent upon wage i.e. labor supply is constant.
But this presumption changes quickly when we move from household living for two periods. Assume
that there is no initial wealth and there is no uncertainty about future wages and interest rates.
𝑐2 𝑤𝑙2
𝑀𝑎𝑥 𝑢 = 𝑙𝑛𝑐1 + 𝑏𝑙𝑛(1 − 𝑙1 ) + 𝑒 −𝜌 [𝑙𝑛𝐶2 + 𝑏𝑙𝑛(1 − 𝑙2 )] 𝑆. 𝑇. 𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡 𝑐1 + = 𝑤𝑙1 +
1+𝑟 1+𝑟
𝑤𝑙2 𝑐2
ℒ = 𝑙𝑛𝑐1 + 𝑏𝑙𝑛(1 − 𝑙1 ) + 𝑒 −𝜌 [𝑙𝑛𝑐2 + 𝑏𝑙𝑛(1 − 𝑙2 )] + 𝜆 [𝑤𝑙1 + − 𝑐1 − ]
1+𝑟 1+𝑟
𝜕ℒ −𝑏
= + 𝜆𝑤1 = 0
𝜕𝑙1 1 − 𝑙1
𝜕ℒ −𝑒 −𝜌 𝑏 𝜆𝑤1
= + =0
𝜕𝑙2 1 − 𝑙2 1 + 𝑟
Divide both equations
1 − 𝑙2 𝑤1 𝑒 −𝜌 (1 + 𝑟)
=
1 − 𝑙1 𝑤2
This expression implies that the relative labor supply decision is dependent upon real wage. If w1 rises
relative to w2 then household decreases first period leisure relative to second period leisure. Consider an
increase in interest rate r will raise the labor supply today and savings relative to working tomorrow.
This whole process of choice of relative labor supply dependent upon relative wage and interest rate is
called inter-temporal substitution in labor supply.
The household’s optimization problem in RBC differs from that of Ramsey model is that in former it
faces uncertainty with respect to wages and rates of return. Because of presence of this uncertainty the
consumers cannot choose a deterministic path for consumption and labor supply. The setup of the model
becomes complicated when we see that household’s decision about consumption and labor might also be
changed by the technology and government expenditure shocks. As it would be very difficult to
analytically solve this model we will take a similar intuitive way of solving the model.
Consider a household which reduces it consumption in period t by a small amount and then consumes a
greater wealth in the next period t+1. If the household is behaving optimally then this sort of marginal
change should leave the expected utility unchanged. The utility cost in shape of forgone consumption in
period t is given by the following expression.

𝑈𝑡𝑖𝑙𝑖𝑡𝑦 𝐶𝑜𝑠𝑡 = 𝑢′ (𝑐𝑡 )Δ𝑐

From equation 5 we can find out
1 𝑁𝑡
𝑢′ (𝑐𝑡 ) = 𝑒 −𝜌𝑡 ( )
𝑐𝑡 𝐻
 1 𝑁𝑡
𝑈. 𝐶 = 𝑒 −𝜌𝑡 ( ) Δ𝑐 − 10 −
𝑐𝑡 𝐻
The marginal utility consumption of each member of household in t+1 is given by
1 𝑁𝑡+1
𝑢′ (𝑐𝑡+1 ) = 𝑒 −𝜌(𝑡+1) ( )
𝑐𝑡+1 𝐻
Since there will by en times more member in period t+1 the total expected utility as of period t will
become
1 𝑁𝑡+1 −𝑛
𝐸. 𝑈. 𝐺 = 𝐸𝑡 [𝑒 −𝜌(𝑡+1) ( ) 𝑒 (1 + 𝑟𝑡+1 )Δ𝑐]
𝑐𝑡+1 𝐻
For optimality equation 10 and 11 should be equal
1 𝑁𝑡 1 𝑁𝑡+1 −𝑛
𝑒 −𝜌𝑡 ( ) Δ𝑐 = 𝐸𝑡 [𝑒 −𝜌(𝑡+1) ( ) 𝑒 (1 + 𝑟𝑡+1 )Δ𝑐]
𝑐𝑡 𝐻 𝑐𝑡+1 𝐻
1 𝑁𝑡 1 𝑁𝑡+1
𝑒 −𝜌𝑡 ( ) Δ𝑐 = 𝐸𝑡 [𝑒 −𝜌𝑡 𝑒 −(𝜌+𝑛) ( ) (1 + 𝑟𝑡+1 )Δ𝑐] − 11 −
𝑐𝑡 𝐻 𝑐𝑡+1 𝐻
Variables as of period t+1 are uncertain and that of period t are certain so expectations will be as follows
1 𝑁𝑡 𝑁𝑡 1 + 𝑟𝑡+1
𝑒 −𝜌𝑡 ( ) Δ𝑐 = 𝑒 −𝜌𝑡 𝑒 −𝜌 Δ𝑐𝐸𝑡 [ ]
𝑐𝑡 𝐻 𝐻 𝑐𝑡+1
1 1
= 𝑒 −𝜌 𝐸𝑡 [ (1 + 𝑟𝑡+1 )] − 12 −
𝑐𝑡 𝑐𝑡+1
The expression on the right hand side of this equation is the tradeoff between present and future
consumption which depends not just on the expectations of future marginal utility and of the rate of
return but also on their interaction. The expectation of the product of two variables is equal to the
product of their expectations plus their covariance.
1 1 1
= 𝑒 −𝜌 [𝐸𝑡 (1 + 𝑟𝑡+1 )𝐸𝑡 ( ) + 𝑐𝑜𝑣 (1 + 𝑟𝑡+1 , )]
𝑐𝑡 𝑐𝑡+1 𝑐𝑡+1
The covariance term in the above expression tells us about the relationship among the rate of interest
and marginal utility of consumption. Suppose if the rate of interest rises then so will consumption which
means that covariance between rate of interest and marginal utility of consumption is negative. The
returns to savings are high in the times when the marginal utility of consumption is low, this makes
saving less attractive than it is if both of them are uncorrelated.
A household doesn’t only choose consumption at each period abut also to supply labor. So the second
optimization condition relates his current consumption to current labor supply. Suppose a household
increases his labor by a small amount in period t and uses the resulting higher income to raise
consumption of the same period. Again we say that if household is acting optimally then this sort of
marginal change should leave the expected utility unchanged. Utility cost of the individual in terms of
forgone leisure will be

𝑈. 𝐶 = 𝑢′ (𝑙𝑡 )Δ𝑙
 𝑏 𝑁𝑡
𝑢′ (𝑙𝑡 ) = −𝑒 −𝜌𝑡 ( )
1 − 𝑙𝑡 𝐻
𝑏 𝑁𝑡
𝑈. 𝐶 = −𝑒 −𝜌𝑡 ( ) Δ𝑙 − 13 −
1 − 𝑙𝑡 𝐻
And the utility benefit in terms of increased consumption will be given by
1 𝑁𝑡
𝑈. 𝐺 = 𝑒 −𝜌𝑡 ( ) Δ𝑙𝑤𝑡 − 14 −
𝑐𝑡 𝐻
For optimality equations 13 and 14 should be equal
𝑏 𝑁𝑡 1 𝑁𝑡
−𝑒 −𝜌𝑡 ( ) Δ𝑙 = 𝑒 −𝜌𝑡 ( ) Δ𝑙𝑤𝑡
1 − 𝑙𝑡 𝐻 𝑐𝑡 𝐻
𝑏 𝑤𝑡
=
1 − 𝑙𝑡 𝑐𝑡
𝑐𝑡 𝑤𝑡
= − 15 −
1 − 𝑙𝑡 𝑏
This expression relates current consumption with current leisure which is dependent upon wage rate.
Uncertainty doesn’t enter the expression because all the variables involved are related to current period.

SOLUTION WITH SIMPLIFYING ASSUMPTIONS

The expression for the capital stock in the economy is as follows

𝐾𝑡+1 = 𝐾𝑡 + 𝐼𝑡 − 𝛿𝐾𝑡
Now we will take the simplifying assumptions. There is no government expenditure shock and the rate
of depreciation is 100%, S = I and G = 0.

𝐾𝑡+1 = 𝐼𝑡 = 𝑌𝑡 − 𝐶𝑡 = 𝑆𝑡

𝐴𝑡 𝐿𝑡 1−𝛼
𝑟𝑡 = 𝛼 ( )
𝐾𝑡

𝐴𝑡+1 𝐿𝑡+1 1−𝛼

1 + 𝑟𝑡 = 𝛼 ( )
𝐾𝑡+1
𝐾𝑡+1 = 𝑠𝑡 𝑌𝑡
𝑌𝑡
𝑐𝑡 = (1 − 𝑠𝑡 )
𝑁𝑡
Substituting the definition and modifying equation 12

1 𝛼(𝐴𝑡+1 𝐿𝑡+1 ⁄𝐾𝑡+1 )1−𝛼

= 𝑒 −𝜌 𝐸𝑡 [ ]
(1 − 𝑠𝑡 ) 𝑌𝑡 ⁄𝑁𝑡 (1 − 𝑠𝑡+1 ) 𝑌𝑡+1 ⁄𝑁𝑡+1
𝛼 (𝐴 1−𝛼
𝑌𝑡+1 = 𝐾𝑡+1 𝑡+1 𝐿𝑡+1 )
 𝛼
(𝐴𝑡+1 𝐿𝑡+1 )1−𝛼 = 𝑌𝑡+1 ⁄𝐾𝑡+1
𝛼 )(1⁄
1 −𝜌
𝛼(𝑌𝑡+1 ⁄𝐾𝑡+1 𝐾𝑡+1 )1−𝛼
= 𝑒 𝐸𝑡 [ ]
(1 − 𝑠𝑡 ) 𝑌𝑡 ⁄𝑁𝑡 (1 − 𝑠𝑡+1 ) 𝑌𝑡+1 ⁄𝑁𝑡+1

1 𝛼 𝑌𝑡+1 ⁄𝐾𝑡+1
= 𝑒 −𝜌 𝐸𝑡 [ ]
(1 − 𝑠𝑡 ) 𝑌𝑡 ⁄𝑁𝑡 (1 − 𝑠𝑡+1 ) 𝑌𝑡+1 ⁄𝑁𝑡+1

1 𝛼 𝑌𝑡+1 ⁄𝐾𝑡+1
= 𝑒 −𝜌 𝐸𝑡 [ ]
(1 − 𝑠𝑡 ) 𝑌𝑡 ⁄𝑁𝑡 (1 − 𝑠𝑡+1 ) 𝑌𝑡+1 ⁄𝑁𝑡+1

1 𝛼 𝑌𝑡+1 ⁄𝑠𝑡 𝑌𝑡
= 𝑒 −𝜌 𝐸𝑡 [ ]
(1 − 𝑠𝑡 ) 𝑌𝑡 ⁄𝑁𝑡 (1 − 𝑠𝑡+1 ) 𝑌𝑡+1 ⁄𝑁𝑡+1

1 𝛼𝑁𝑡+1
= 𝑒 −𝜌 𝐸𝑡 [ ]
(1 − 𝑠𝑡 ) 𝑌𝑡 ⁄𝑁𝑡 (1 − 𝑠𝑡+1 )𝑠𝑡 𝑌𝑡
1 𝛼𝑒 𝑛 𝑁𝑡
= 𝑒 −𝜌 𝐸𝑡 [ ]
(1 − 𝑠𝑡 ) 𝑌𝑡 ⁄𝑁𝑡 (1 − 𝑠𝑡+1 )𝑠𝑡 𝑌𝑡

Taking Natural log

𝛼𝑒 𝑛 𝑁𝑡
− ln(1 − 𝑠𝑡 ) − 𝑙𝑛𝑌𝑡 − 𝑙𝑛𝑁𝑡 = −𝜌 + 𝑙𝑛𝐸𝑡 [ ]
(1 − 𝑠𝑡+1 )𝑠𝑡 𝑌𝑡
𝛼𝑒 𝑛 𝑁𝑡 1
− ln(1 − 𝑠𝑡 ) − 𝑙𝑛𝑌𝑡 − 𝑙𝑛𝑁𝑡 = −𝜌 + ln [ 𝐸𝑡 ]
𝑠𝑡 𝑌𝑡 (1 − 𝑠𝑡+1 )
1
− ln(1 − 𝑠𝑡 ) − 𝑙𝑛𝑌𝑡 + 𝑙𝑛𝑁𝑡 = −𝜌 + ln 𝛼 + 𝑛 + 𝑙𝑛𝑁𝑡 − 𝑙𝑛𝑠𝑡 − 𝑙𝑛𝑌𝑡 + 𝑙𝑛𝐸𝑡
(1 − 𝑠𝑡+1 )
1
− ln(1 − 𝑠𝑡 ) = −𝜌 + ln 𝛼 + 𝑛 − 𝑙𝑛𝑠𝑡 + 𝑙𝑛𝐸𝑡
(1 − 𝑠𝑡+1 )
The two state variables of the model i.e. A and K don’t enter this expression so it implies that there is a
constant value of s that satisfies the condition. If s constant at some value then st+1 is not uncertain.

𝑙𝑛𝑠𝑡 − ln(1 − 𝑠̂ ) = −𝜌 + ln 𝛼 + 𝑛 − 𝑙𝑛(1 − 𝑠̂ )

𝑙𝑛𝑠̂ = −𝜌 + ln 𝛼 + 𝑛
Taking antilog

𝑠̂ = 𝛼𝑒 𝑛−𝜌
Thus the model has a solution for a constant saving rate.
Now consider equation 15
𝑐𝑡 𝑤𝑡
=
1 − 𝑙𝑡 𝑏
Using the definitions we can write
𝑌𝑡
(1 − 𝑠̂ ) 𝑤𝑡
𝑁𝑡
=
1 − 𝑙𝑡 𝑏
𝜕𝑌𝑡
𝑤𝑡 = = (1 − 𝛼)𝐾𝑡𝛼 (𝐴𝑡 𝐿𝑡 )−𝛼 𝐴𝑡
𝜕𝑙𝑡
𝑌𝑡 𝑌𝑡 𝑌𝑡
𝑤𝑡 = (1 − 𝛼) 𝐴𝑡 = (1 − 𝛼) = (1 − 𝛼)
𝐴𝑡 𝐿𝑡 𝐿𝑡 𝑙𝑡 𝑁𝑡
𝑌𝑡 𝑌𝑡
(1 − 𝑠̂ ) (1 − 𝛼)
𝑁𝑡 𝑙𝑡 𝑁𝑡
=
1 − 𝑙𝑡 𝑏
Taking natural log

ln(1 − 𝑠̂ ) + 𝑙𝑛𝑌𝑡 − 𝑙𝑛𝑁𝑡 − ln(1 − 𝑙𝑡 ) = ln(1 − 𝛼) + 𝑙𝑛𝑌𝑡 − 𝑙𝑛𝑙𝑡 − 𝑙𝑛𝑁𝑡 − 𝑙𝑛𝑏

𝑙𝑛𝑙𝑡 − ln(1 − 𝑙𝑡 ) = ln(1 − 𝛼) − ln(1 − 𝑠̂ ) − 𝑙𝑛𝑏

Antilog of the above expression will yield
𝑙𝑡 1−𝛼
=
1 − 𝑙𝑡 𝑏(1 − 𝑠̂ )
This expression tells us that the labor supply is also constant. Despite the household’s willingness to
substitute their labor supply inter-temporally the labor supply stays constant because the movements in
either technology or capital have offsetting impacts on the relative wage and interest rate effects on labor
supply. For example an improvement in technology raises current wages relative to expected future
wages, and raises labor supply. But by raising the amount saved, it also lowers the expected interest rate,
which acts to reduce labor supply.
FLUCTUATIONS
This model provides an example of an economy where real shocks drive output movements. Because the
economy is Walrasian, the movements are the optimal responses to the shocks. Thus, contrary to the
conventional wisdom about macroeconomic fluctuations, here fluctuations do not reflect any market
failures, and government interventions to mitigate them can only reduce welfare. In short, the
implication of real-business-cycle models, in their strongest form, is that observed aggregate output
movements represent the time-varying Pareto optimum. The specific form of the output fluctuations
implied by the model is determined by the dynamics of technology and the behavior of the capital stock.
In particularly the production function

𝑌𝑡 = 𝐾𝑡𝛼 (𝐴𝑡 𝐿𝑡 )1−𝛼

Taking natural log

𝑙𝑛𝑌𝑡 = 𝛼𝑙𝑛𝐾𝑡 + (1 − 𝛼)[𝑙𝑛𝐴𝑡 + 𝑙𝑛𝐿𝑡 ]

𝐾𝑡 = 𝑠̂ 𝑌𝑡−1 , 𝐿𝑡 = 𝑙̂𝑡 𝑁𝑡
 𝑙𝑛𝑌𝑡 = 𝛼𝑙𝑛𝑠̂ + 𝛼𝑙𝑛𝑌𝑡−1 + (1 − 𝛼)[𝑙𝑛𝐴𝑡 + 𝑙𝑛𝑙̂𝑡 + 𝑙𝑛𝑁𝑡 ]

𝑙𝑛𝐴𝑡 = 𝐴̅ + 𝑔𝑡 + 𝐴̃𝑡 , 𝑙𝑛𝑁𝑡 = 𝑁

̅ + 𝑛𝑡

𝑙𝑛𝑌𝑡 = 𝛼𝑙𝑛𝑠̂ + 𝛼𝑙𝑛𝑌𝑡−1 + (1 − 𝛼)[𝐴̅ + 𝑔𝑡 + 𝐴̃𝑡 ] + (1 − 𝛼)𝑙𝑛𝑙̂𝑡 + (1 − 𝛼)[𝑁

̅ + 𝑛𝑡]

On the right hand side of the above expression αlnYt – 1 and (1 - α) 𝐴̃𝑡 doesn’t follow the deterministic
part so we can write the above expression as follows. Suppose 𝐴̃𝑡 = 0 for all t
∗
𝑙𝑛𝑌𝑡∗ = 𝛼𝑙𝑛𝑠̂ + 𝛼𝑙𝑛𝑌𝑡−1 + (1 − 𝛼)[𝐴̅ + 𝑔𝑡] + (1 − 𝛼)𝑙𝑛𝑙̂𝑡 + (1 − 𝛼)[𝑁
̅ + 𝑛𝑡]

Subtract both expressions

∗ )
𝑙𝑛𝑌𝑡 − 𝑙𝑛𝑌𝑡∗ = 𝛼(𝑙𝑛𝑌𝑡−1 − 𝑙𝑛𝑌𝑡−1 + (1 − 𝛼)𝐴̃𝑡
′
𝑌𝑡′ = 𝛼𝑌𝑡−1 + (1 − 𝛼)𝐴̃𝑡
Recursive Solution
′
𝑌𝑡−1 ′
= 𝛼𝑌𝑡−2 + (1 − 𝛼)𝐴̃𝑡−1
1
𝐴̃𝑡−1 = [𝑌 ′ − 𝛼𝑌𝑡−2
′ ]
1 − 𝛼 𝑡−1
′
𝑌𝑡′ = 𝛼𝑌𝑡−1 + (1 − 𝛼)[𝜌𝐴 𝐴̃𝑡−1 + 𝜀𝐴,𝑡 ]
′ ′ ′ ]
𝑌𝑡′ = 𝛼𝑌𝑡−1 + 𝜌𝐴 [𝑌𝑡−1 − 𝛼𝑌𝑡−2 + (1 − 𝛼)𝜀𝐴,𝑡
′ ′
𝑌𝑡′ = (𝛼 + 𝜌𝐴 )𝑌𝑡−1 − 𝛼𝜌𝐴 𝑌𝑡−2 + (1 − 𝛼)𝜀𝐴,𝑡

Thus, departures of log output from its normal path follow a second-order autoregressive process; that
is, 𝑌̂ can be written as a linear combination of its two previous values plus a white-noise disturbance.

The combination of a positive coefficient on the first lag of 𝑌̃𝑡 and a negative coefficient on the second
lag can cause output to have a “humped-shaped” response to disturbances. Suppose, for example, that α
= 1/3 and ρA = 0.9. Consider a one-time shock of 1/(1 – α) to εA. Iterations show that the shock raises
log output relative to the path it would have otherwise followed by 1 in the period of the shock (1 – α
times the shock), 1.23 in the next period (α + ρA times 1), 1.22 in the following period (α + ρA times
1.23, minus α times ρA times 1) then 1.14, 1.03, 0.94, 0.84, 0.76, 0.68… in subsequent periods.