Can a real business cycle model pass the Watson test?

Abstract

Watson (1993) [Measures of fit for calibrated models. Journal of Political Economy 101 (6), 1011–1041] proposes a procedure for evaluating the fit of a dynamic equilibrium business cycle model. Under Watson's criterion, the standard real business cycle (RBC) model fails dramatically in reconciling the dynamics of the model with the data. This inability to account for the dynamics of US aggregate data remains a major challenge to RBC theory. This paper demonstrates that reasonable modifications can bring RBC theory into closer conformity with the data. The empirical results indicate that when habit formation on leisure choice and employment externality are incorporated into the analysis, the striking spectral density differentials documented by Watson virtually vanish at business cycle frequencies.