The assessment: business cycles

Abstract

This overview paper places in context eight papers covering a wide spectrum of views on modern business cycle modelling. Inter alia, these address some gaps in the real business cycle (RBC) literature (e.g. the extremely limited treatment of credit and asset markets) and various other anomalies (e.g. the failure to explain volatility and persistence of employment and unemployment, and the non-cyclicality of real wages). The paper then focuses further on two issues central to RBC models. Such models are driven by large and persistent technology shocks. However, empirical evidence from UK manufacturing shows that correcting for cyclical utilization results in shocks which are small and non-persistent. The second issue is one of empirical methodology. Though the RBC approach was intended as a response to the Lucas critique, by largely assuming away government policy feedback rules, these models are far from policy-relevant. The alternative vector autoregression (VAR) approach implicitly incorporates these rules, but ignores shifts in rules. A constructive response to the Lucas critique needs to incorporate policy rule shifts and private-sector reactions directly, which looks hard to achieve outside the context of structural econometric modelling.