Chapter 5

Real business cycles

5.1

Real business cycles

The most well known paper in the Real Business Cycles (RBC) literature is
Kydland and Prescott (1982). That paper introduces both a specific theory of
business cycles, and a methodology for testing competing theories of business
cycles.
The RBC theory of business cycles has two principles:
1. Money is of little importance in business cycles.
2. Business cycles are created by rational agents responding optimally to
real (not nominal) shocks - mostly fluctuations in productivity growth,
but also fluctuations in government purchases, import prices, or preferences.
The RBC methodology also comes down to two principles:
1. The economy should always be modeled using dynamic general equilibrium models (with rational expectations).
2. The quantitative implications of a proposed model should be taken seriously. In particular, a models suitability for describing reality should
be evaluated using a quantitative technique known as calibration. If
the model fits the data, its quantitative policy implications should be
taken seriously.
1

CHAPTER 5. REAL BUSINESS CYCLES

Romer, writing just a few years ago, treats these two meanings of the term as
essentially the same. But since then, the RBC methodology has taken hold in
a lot of places - researchers have analyzed RBC models with money, with all
sorts of market imperfections, etc. In order to reflect this change, researchers
are trying to change the name of the methodology to the more accurate (if
awkward) stochastic dynamic general equilibrium macroeconomics.

5.1.1

Some facts about business cycles

Business cycles are the reason why macroeconomics exists as a field of study,
and theyre the primary consideration of many macroeconomists. What characterizes business cycles? The two obvious characteristics are fluctuations in
unemployment and output. A few definitions:
Procyclical: a variable that usually increases in booms, decreases in
recessions. For example, productivity is procyclical.
Countercyclical: a variable that usually decreases in booms, increases
in recessions. For example, unemployment is countercyclical.
Acyclical: a variable that shows no systematic relationship to the business cycle.
Fiscal policy: the governments policy for taxes and spending.
Monetary policy: the governments policy for how much money to put
into the economy.
Before we go into the details of an RBC model, lets establish some stylized
facts about business cycles. Most of these are outlined in the beginning of
Chapter 4 in Romer.
1. Labor input varies considerably and procyclically (goes up in booms,
down in recessions). Most of this variation is variation in employment
rates, though some is in average weekly hours.
2. The capital stock varies little at business cycle frequencies (1-3 years).

5.1. REAL BUSINESS CYCLES

3. Productivity growth (as measured by the Solow residual) is procyclical,

though not nearly as much as labor input. In other words, most of the
output loss in recessions can be traced to unemployment.
4. Wages vary less than productivity, and have low correlation with output.
5. All major expenditure categories are procyclical. Investment in consumer and producer durables is quite volatile, while consumption of
nondurables and services varies much less than output. The most
volatile expenditure category is inventory investment.
One of the main research programs in macro has been to explain these facts
in a consistent manner (using a well-specified equilibrium model). A few
major puzzles:
Why do labor inputs vary? Specifically, if there is cyclical unemployment, what shock causes labor demand to go down? Once labor demand goes down, why is this reflected in unemployment rather than
wage cuts?
Decreasing returns to scale in labor implies countercyclical productivity, but productivity is procyclical. Why?
Why are recessions so persistent?
Returning to what we said earlier, one of the key puzzles in business cycle theory is procyclical productivity. The RBC theory explains procyclical
productivity quite directly - booms are good draws of technology growth
recessions are bad draws.
The second puzzle is employment. In the baseline RBC model, employment
fluctuations are just intertemporal substitution of leisure. In some time periods, labor is less productive than others. The optimal action for workers
is to work more in productive periods, less in unproductive periods. This
explains unemployment.
The third puzzle is persistence. In the baseline RBC mode, capital accumulatioon is the internal propagation mechanism - the thing that converts
shocks without persistence into highly persistent shocks to output. If the

CHAPTER 5. REAL BUSINESS CYCLES

technology level is below average, output is low, so investment is low, so the

next periods capital stock is also below average. So even if the technology
level returns to normal next period, output will be below normal.
A fourth observation (not so much a puzzle) is why investment spending is
more variable than consumption spending. This is not so hard to explain in
the baseline RBC model (or any other model): an agent with the preference
to smooth consumption over time will invest in productive periods and eat
capital in unproductive periods.

5.1.2

The model

Now lets put this into a model. Well take the equilibrium growth model
that weve already looked at, and add a labor-leisure choice, and a stochastic
technology. This produces whats commonly known as the baseline real
business cycle model. The version of the model Im outlining here is from
Chapter 1 in Thomas Cooleys Frontiers of Business Cycle Research. The
chapter is written by Cooley and Prescott. The model described in Romer
is basically the same.
Consumers
The consumers problem is the same as before, except that he values leisure.
He supplies labor ht 2 [0, 1] in period t, just like before, but now he receives
utility from leisure. The consumer also has uncertainty over future prices, so
he maximizes expected utility:
E0

1
X

u(ct , 1

ht )

t=0

subject to the constraints:

xt + ct + bt+1 wt ht + rt kt + Rt bt + t
kt+1 (1
)kt + xt
kt
0
k0
given
NPG

(5.1)

5.1. REAL BUSINESS CYCLES

We assume that the consumer is making all time-t choices (xt , ct , kt+1 , bt+1 , ht )
conditional on time t information (all variables subscripted t and below, plus
the interest rate on bonds Rt+1 ).
Notice that we will be modeling fluctuations in employment as a representative consumer varying his hours. Of course, employment fluctuations are a
lot lumpier than that - this may aect the outcomes we look at.
The firm
Weve talked about the consumer dealing with stochastic prices. We havent
discussed the source of uncertainty. That will be on the firm side. The firm
is the same as before. However, the production function is subject to random
productivity shocks: The firms problem is:
max ezt F (Kt , Ht )

wt Ht

Kt ,Ht

r t Kt

(5.2)

where F is a neoclassical production function and zt follows an AR(1) process:

zt = zt

+ t

(5.3)

where t is white noise.

Equilibrium
When variables are stochastic, equilibrium is defined slightly dierently.
An equilibrium in this economy is a joint distribution of prices and allocations
such that, etc.

5.1.3

Solving the model

The consumers Lagrangian is:

E0

1
X
t=0

u(ct , 1

ht ) +

t ((1

)kt + wt ht + rt kt + t

ct

kt+1 )

(5.4)

CHAPTER 5. REAL BUSINESS CYCLES

The first order conditions are:

ct : Et ( t uc (ct , 1 ht )
ht : Et ( t u` (ct , 1 ht ) +
kt+1 : Et ( t+1 (1
+ rt+1 )
bt+1 : Et ( t+1 (Rt+1 )

t)

=
t wt ) =
t) =
t) =

0
0
0
0

(5.5)
(5.6)
(5.7)
(5.8)

plus the capital accumulation equation and the transversality condition. The
appropriate expectations operator is Et because each of these variables is
chosen with the information available at time t. We can eliminate the expectations operator if the variables inside it are in the time t information set.
So we have:
t
uc (ct , ht )
(5.9)
t =
as in the basic equilibrium growth model, and:
u` (ct , 1

ht ) = uc (ct , 1

ht )wt

(5.10)

This equation shows that the worker equates the marginal utility from a little
more leisure to the utility from working an equal amount and getting more
consumption. In addition, we have:
uc (ct , 1

ht ) = Et [uc (ct+1 , 1

ht+1 )(rt+1 + 1

)]

(5.11)

which is just the same as Euler equation for the basic growth model, but
with the expectations operator.1 Finally, the bond price is given by:
Rt+1 = Et (rt+1 ) + 1

(5.13)

The solution to the firms problem implies:

wt = ezt FH (Kt , Ht )
rt = ezt FK (Kt , Ht )
1

Remember that

(5.14)
(5.15)

E(XY ) = Cov(X, Y ) + E(X)E(Y )

So we can rewrite () as:

uc (ct , ht ) = [Et (uc (ct+1 , ht+1 ))(Et (rt+1 ) + 1

) + Covt (uc (ct+1 , ht+1 ), rt+1 )]

(5.12)

We see that todays decision doesnt just depend on the expected value of future prices
but also their covariance with consumption.

5.1. REAL BUSINESS CYCLES

5.1.4

Calibration

Kydland and Prescott suggest a way to identify if this model can explain
business cycles. Their method is known as calibration. The procedure is:
Use microeconomic studies or theory to find values for all of the parameters.
Solve the model numerically, and simulate the economy.
Compare the moments (standard deviations, correlations, etc) of the
simulated economy with those in the actual economy.
If the moments are matched, success!
If not, the moments which dont match up suggest areas of potential
model improvement.
Were going to do this with the model. First, we need to put parametric
functional forms. First, utility:
u(c, 1

h) =

c1t

(1

ht )

(5.16)

This is a variation on the CRRA form weve been using. Note that 1/ is
the intertemporal elasticity of substitution. When = 0, utility is linear,
when = 1, utility is Leontief, and when = 1, utility is Cobb-Douglas
(logarithmic).
Production is assumed to be Cobb-Douglas:
F (K, H) = K H 1

(5.17)

Now, we need plausible parameter values for this model. Ill use the values
from Cooley and Prescott (1995). Their model is identical to the one here,
except that they allow for population growth at rate and productivity
growth at a rate .
First, . At the non-stochastic steady state, we have R = 1 . The average
real interest rate in the U.S. is usually around 4% annually, which is about

CHAPTER 5. REAL BUSINESS CYCLES

1% quarterly. So R 1 = 1 1 = 0.01, or 0.99. Cooley and Prescott

follow a slightly more complex process and calibrate as 0.987.
Next, . If you remember, 1 will be labours share of output, a quantity that can be estimated from the national income accounts. Cooley and
Prescott set to 0.40.
is set to one. Estimates from micro studies of the typical workers intertemporal elasticity of substitution are in this range, and = 1 gives us a simple
Cobb-Douglas form of the utility function
u(c, h) = (1

) ln c + ln(1

h)

(5.18)

Now, solving for the steady state relationship between consumption, labour
supply, and output, we get the following:

=
=

w
(1

(5.19)
)

y
h

(5.20)

is set so that, in the non-stochastic steady state, 31% of available time is

spent working (h = 0.31)and the steady state output to consumption ratio is
about 1.33 (c/y = 1.33). Substituting into the equations above and solving
for , we get = 0.64.
Cooley and Prescott estimate that depreciation is 4.8% annually, so 1.2%
quarterly ( = 0.012).
The parameters of the stochastic process for technology is easy to estimate.
This model has perfect competition and constant returns to scale. So zt zt 1
is the Solow residual. The average value of the Solow residual gives us our
estimate for . Cooley and Prescott set = 0.0156, giving about 1.6% annual
TFP growth. Once we subtract out this average, we can estimate an AR(1)
model and get = 0.95 and = 0.007.
Finally the quarterly population growth rate is set at 0.012.
Numerical solution of the model
Once we have set up the model, and calibrated parameters, we next need to
find a numerical solution to the model.

5.1. REAL BUSINESS CYCLES

Demonstrate that the equilibrium of the model correspond to some

planners problem, that the solution to the planners problem corresponds to some Bellmans equation, and apply numerical dynamic programming methods.
Transform the problem itself using a linear-quadratic approximation
around the steady state. Basically, you take a quadratic approximation
of the objective function and a linear approximation of the constraints.
The result will be a model with linear Euler equations.
Log-linearization of the Euler equations around the steady state. This
has the advantage that it leads to closed-form approximate results, so
we can in the words of one researcher inspect the mechanism. As with
all linear approximations, this is a good approximation near the steady
state but may be a poor approximation to how the system responds to
large shocks.
Simulation
Under those assumptions we can simulate the model on a computer and
we get time series for output, employment, productivity, investment, consumption, and capital. We can look at the correlation between any of these
variables, the relative variance of dierent variables, etc.
There are many ways to do this simulation. The easiest is to take the Euler
equations, take logs of everything, and linearize them around the balanced
growth path. So the resulting variables are detrended - defined in terms
of percentage deviation from trend/BGP. Once you have these simulated
variables, you compare their properties to the properties of the corresponding
detrended variables from the economy in question.
US data
Std. Dev (%) x,GN P
GNP
1.72
1.0
Consumption (NDS) 0.86
0.77
Investment (GPDI) 8.24
0.91
Hours
1.59
0.86
Productivity
-

Baseline RBC
Std. Dev (%)
1.35
0.329
5.954
0.769
0.606

model
x,GN P
1.0
0.843
0.992
0.986
0.978

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CHAPTER 5. REAL BUSINESS CYCLES

As you can see, the variability in output is a little smaller, but the same order
of magnitude. As in reality, consumption is much less variable than output
and investment is much more variable. Just like in real life, the models
variables are closely correlated with output. Theyre actually a little too
closely correlated, which Cooley and Prescott note is due to the fact that
theres only one source of uncertainty in this model.
To an RBC theorist, these numbers represent success. Weve managed to
write down a very simple model that duplicates many of the properties (moments) of the actual data. There are a few failures though. This model seems
to understate the variability of both consumption and hours. The RBC approach to this failing is to investigate why the model doesnt match, and
adjust the model so that it does match.
The consumption variability is simple. Even with careful measurement, a
lot of consumption is actually purchase of consumer durables, which really
belongs in investment.

5.1.5

Other issues

Variation in labor
For an example of how the dynamic GE approach is supposed to work, lets
consider the low variation in hours. Gary Hansen, in a 1985 paper, developed
an explanation and a fix. All of the variation in hours worked in this model
take the form of changes in the hours worked by each worker. We know
that most of the variation in hours over the business cycle take the form of
variations in employment. Recall that the functional form of utility is:
u(c, h) =

c1t

ht )

(1
1

(5.21)

In order to generate higher variation in hours worked for each individual

worker, we need to make them more willing to substitute intertemporally work less when wages are low and more when they are high. For example,
if = 0, then their IES is infinity - they will work all day or not at all,
depending on wages. But micro studies show a low IES, so we cant justify
simply lowiering .

5.1. REAL BUSINESS CYCLES

11

Hansens solution is to note that much of the variation in hours takes the
form of variation in employment itself. He argues that it is not profitable
to vary hours, given the fixed costs of employment. Instead he sets up the
following model of the labor market. At the beginning of each period, a
worker signs a binding contract to work h (say 8) hours with probability t
and zero hours with probability (1t ). Whether the worker works or not is
decided by lottery. The worker gets paid wage wt t whether or not he works.
He doesnt get to choose the value of h, but does choose t .
Expected utility is:
E[1

ln c + ln(1

h)] = (1

) ln c + ln(1

h)

(5.22)

Now notice that this is linear in t . Per capita hours in this economy are
t h, so the aggregate IES is quite high. It turns out that once you make
this change, hours are much more variable, and the problem is fixed.
Internal propagation mechanism
One of the most difficult problems for RBC adherents to deal comes from
the results of Cogley and Nason (AER 1995). They analyze the baseline
RBC model from a dierent perspective. One of the selling points of the
RBC model is that fluctuations in the model are persistent. However, their
persistence really isnt much more than that of the Solow residual, which is
the exogenous source of shocks. Remember that the source of persistence in
the baseline RBC model is that investment is higher in booms, so capital is
higher in the near future. The problem is that new investment is very small
relative to the capital stock, so the capital stock itself varies little.
Many papers since Cogley and Nason aim to find a better internal persistence
mechanism. These include:
Financial markets - for example suppose that an unexpected negative shock causes solvent but illiquid companies to become cashflowconstrained or even go bankrupt. They could then become less efficient
as a result.
Labor market search - suppose that it takes time for workers to find
new jobs that they match well with.

12

CHAPTER 5. REAL BUSINESS CYCLES

Notice that these solutions tend to move the models away from the world of
perfectly functioning markets and no motivation for intervention.

5.1.6

Criticisms

The RBC school of thought has grown substantially since the early papers.
Part of the reason is that its compelling as science. We take the model
seriously, expect it to actually match observations quantitatively, and when
it doesnt, we adjust the model. Another reason its done so well is that the
methodology is a natural article generator. Find something that hasnt been
modeled yet, add it to the baseline model, and see what you get. The schools
that focus in this area have turned out vast quantities of grad students over
the last few years.
The main criticisms of the dynamic GE methodology are:
Why would you consider matching the moments in the data a desirable
property in a model that you know leaves out important features?
Statistical tests are meaningless except in the context of an alternative.
It may be the case that there are hundreds of dierent models that do
equally well.
Some key criticisms of the specific hypothesis that fluctuations in technical
progress explain business cycles are:
If we are to identify the Solow residual as the measure of short-term
technological progress, we must be prepared to interpret many deep recessions as exhibiting technical regress (especially the Great Depression
or the recent troubles in Japan).
Furthermore it is not clear what particular technological advances or
disasters can be associated with any of the major short-term swings in
the Solow residual.
If the Solow residual measures what RBC model says it does, then
it should be uncorrelated with the political party of the President,
millitary purchases, and oil price movements (once energy usage has
been accounted for). But it is correlated with all those things (Hall)

5.1. REAL BUSINESS CYCLES

13

One approach that some proponents of the RBC theory have suggested is
that the Solow residual is poorly measured. Capital (and labor) utilization
rates tend to vary significantly and procyclically. If you use the capital
stock to measure the flow of capital services, you will overstate the extent
of fluctuations in technical progress. Theres a paper by King and Rebelo in
the Handbook of Macroeconomics that adds variable utilization to an RBC
model and gets plausible fluctuations without negative Solow residuals.