Real Business Cycle Literature Research Articles

Using Micro Data to Estimate the Intertemporal Substitution Elasticity for Labor Supply in an Implicit Contract Model

Economists have devoted substantial resources to estimating the intertemporal substitution elasticity for labor supply because this elasticity plays a crucial role in the real business cycle literature. Generally, the estimates of the elasticity have been too low to explain business cycles. Economists have responded by trying to modify real business cycle models to allow for smaller elasticities, but they have experienced mixed success at best. However, the standard intertemporal substitution model has not done well when tested, and if this model is incorrect, so will be the estimated labor supply elasticities based upon it. An equilibrium alternative to the standard intertemporal labor supply model is the implicit contract model. In this latter model firms and workers bargain over state-contingent contracts denominated in terms of consumption and hours of work. Further, the price of leisure is the marginal product of labor or the shadow wage, which differs from the observed wage. A number of studies have found that the data are compatible with an implicit contract model; in particular in Ham and Reilly (2002) we found that we could reject a separable (within period) implicit contract model but not a non-separable one. If an implicit contract model is appropriate, this is the context in which we should try to estimate the intertemporal labor supply elasticity. However this estimation is potentially quite difficult with micro data since the shadow wage (marginal product of labor) is unobserved. In this paper we first develop a procedure that allows one to estimate the intertemporal substitution elasticity in an implicit contract model from micro data. We then implement this procedure using the Panel Study of Income Dynamics (PSID) and the Consumer Expenditure Survey (CES). We obtain statistically significant elasticities of 0.9 with the PSID and 1.0 with the CES. The consistency of the estimate across the data sets is impressive given that we use different estimation approaches (micro data versus synthetic cohorts) and different consumption measures (food consumption versus total nondurable consumption) in the two data sets. These results are three times larger than existing estimates based on the standard intertemporal supply elasticity from this data set and thus offer more hope that equilibrium perspectives on the labor market are capable of tracking the data. Given that the implicit contract model is less likely to be rejected than the standard model in our work and other research, we believe that our approach should prove to be quite useful.

Real Business Cycle Theory and the Great Depression: The Abandonment of the Abstentionist Viewpoint

Is the Great Depression amenable to real business cycle theory? In the 1970s and 1980s Lucas and Prescott took an abstentionist stance. They admitted that, because of its exceptional character, an explanation of the Great Depression was beyond the grasp of the equilibrium approach to the business cycle. However, while Lucas stuck to this view, we show that Prescott changed his mind at the end of the 1990s, breaking his earlier self-imposed restraint. In this paper we document this evolution of opinion and produce a first assessment of real business cycle models of the Great Depression. We claim that the fact of having constructed an equilibrium model of the Great Depression constitutes a methodological breakthrough. However, as far as substance is concerned, we argue that the contribution of real business cycle literature on the Great Depression is slim, and does not gain the upper hand over the works of economic historians. We conclude suggesting that historical episodes may exist for which the modelisation method of real business cycle theory is inferior to the thick sort of analysis that is proper to economic historians.

Patents as a Measure of Technology Shocks and the Aggregate U.S. Labor Market

I. INTRODUCTION One of the dominant approaches to macroeconomic research in the past several decades has been the island paradigm of Friedman (1968) and Phelps (1970). In this framework, economic agents operate under incomplete information regarding relative and absolute prices when making economic decisions. This paradigm is used in the rational expectations literature (see McCallum 1980 and the references therein) in a market-clearing framework to study, among other things, the effects of fiscal and monetary policies in aggregate economic systems. This market-clearing model is sufficiently popular that it is rare to find a textbook treatment of macroeconomics that omits this classical model of the aggregate economy. One component of this aggregate economic model is a labor market where nominal wages are flexible. (1) This approach to the labor market was developed by Lucas and Rapping (1969); in their model, it is assumed that labor suppliers operate under incomplete information about the aggregate price level, thereby raising the possibility that output produced in the economy will vary with the level of price expectations. (2) Despite its central role in explaining economic fluctuations in a popular model of the economy, there is surprisingly little evidence available in previous research testing the implications of this model of the labor market. One objective of the present study is to provide some empirical evidence on this market-clearing model of the labor market. In carrying out such a test, it will be necessary to provide an explanation for the nonstationary nature of labor market series, such as real wages and employment. One possible explanation for this apparent nonstationarity would be the technology shocks frequently used in the real business cycle literature (e.g., Long and Plosser 1983), where it has often been assumed that these shocks are I(1) unobservable stochastic processes. Thus these shocks to the production function may be used as a way of explaining why macroeconomic time series are also I(1). A similar mechanism involves the possibly nonstochastic scalar preceding the aggregate production function. In the economic growth literature, this magnitude, called the Solow residual, measures the growth in aggregate output that cannot be explained by the growth of quality-adjusted factor inputs in production. This residual is sometimes thought to be measured by the stock of knowledge used by economic agents (Barro and Sala-i-Martin 1995, p. 351). Increases in the stock of knowledge enable the aggregate economy to produce more goods and/or new goods from quality-adjusted resource levels when knowledge increases. If the stock of knowledge is nonstationary, then so, too, would be output and other magnitudes in an aggregate economy. (4) Thus the nonstationary nature of aggregate data can be explained by a nonstationary element of the aggregate production function (whether stochastic or deterministic), however that variable is interpreted. If the sources of the apparent nonstationarity in macroeconomic data are assumed to be unobservable I(1) stochastic processes, an implication of this fact is that the inability to measure technology shocks renders it impossible to test the implications of economic models that would arise if these shocks could be measured. For example, if technology shocks are I(1), then optimizing behavior by households and firms will result in cointegrating relationships between technology shocks and choice variables set by the public. If it were possible to measure shocks to the production function, one could test for these long-run cointegrating relationships and the parameters of these cointegrating vectors could be estimated. (5) In addition, it is desirable to explicitly incorporate technical change into economic models, if it could indeed be measured, because doing so may result in more reliable estimates of structural parameters of economic interest, and it may permit improved tests of economic hypotheses. …

On the Cyclical Behavior of Employment, Unemployment and Labor Force Participation

In this paper I evaluate to what extent a real business cycle (RBC) model that incorporates search and leisure decisions can simultaneously account for the observed behavior of employment, unemployment and out-of-the-labor-force. This contrasts with the previous RBC literature, which analyzed employment or hours fluctuations by either lumping together unemployment and out-of-the-labor-force into a single non-employment state or assuming a fixed labor force participation. Once the three employment states are explicitly introduced I find that the RBC model generates highly counterfactual labor market dynamics.

Inverting the Hodrick–Prescott Filter

The Hodrick–Prescott (HP) filter is the most popular method of transforming data in the Real Business Cycle (RBC) literature. An algorithm to invert the Hodrick–Prescott (HP) filter is described. This algorithm is applied, using Markov chain Monte Carlo methods, to the problem of evaluating a simple RBC model. The problem of determining the optimal smoothing parameter for the HP filter is also studied.

Non-Walrasian Labor Markets and Real Business Cycles

The standard real business cycle literature mainly focuses on Walrasian models designed to fit the U.S. institutional framework. Differences between the United States and Europe, mostly evident in the labor market, suggest that a purely Walrasian model may be inappropriate for the study of European business cycles. I present a stochastic version of the dynamic general equilibrium model of Daveri and Maffezzoli (2000, “A Numerical Approach to Fiscal Policy, Unemployment and Growth in Europe,” Econometrics and Applied Economics Working Paper 2000-4, IEP, Università Bocconi), where unemployment is generated by monopolistic unions, and calibrate it to reproduce several long-run features of the Italian and U.S. economies. This framework is then compared with an indivisible labor model built on Hansen (1985, Journal of Monetary Economics16, 309–328) and Rogerson and Wright (1988, Journal of Monetary Economics22, 501–515). I focus on the impulse response functions, the standard business cycle statistics, and the ability to reproduce the cyclical components of the main macroeconomic variables. The main results are as follows: (i) the impulse response functions of the monopoly union (MU) model show a higher degree of overall persistence; (ii) the business cycle statistics are similar; (iii) the MU model enjoys a statistically significant advantage in reproducing the Italian business cycle, but not that of the United States. Journal of Economics Literature Classification Numbers: E32, E24, J23, J51.

Analyzing Indeterminacies in a Real Business Cycle Model with Money

My purpose in wnting the paper Money in a Real Business Cycle Model was to explore the idea that the transmission may be explained in an equilibrium model in which preferences, endowments, and technology are, on their own, insufficient to pin down a unique equilibnum. By the monetary transmission mechanism I mean the time series properties of money, interest rates, pnces, and output in data from Europe and the United States. According to a common interpretation of these data, a change in the money supply has real effects on output in the short run but it is neutral in the long run. I had also hoped that an explanation of the transmission that relies on indeterminacy might rest solely on the idea that money is useful as a medium of exchange. I am indebted to Kirill Sossounov for pointing out a sign error in the computations in my 1997 article and for rescuing the message of the paper with minimal alterations to the basic framework. We have several examples of calibrated models of real economies in which the theoretical structure permits the existence of multiple stationary equilibria and I have argued elsewhere (Farmer 1993) that models of this class can be completed by specifying a rule by which agents form beliefs. These models suggest the possibility that animal spirits or ''self-fulEllling may have an independent role in propagating business cycles and that this possibility is fully consistent with the hypothesis of rational expectations and market clearing. We also have examples of models in which multiple equilibria may play a role in the transmission of shocks.l But to date, none of these models has been calibrated with the same degree of attention to the explanation of data as has become typical in the real business cycle literature. My 1997 paper, with Sossounov's amendments, goes some way toward filling this gap. From an argument onginally advanced by Negishi in 1960, it is known, if one imposes standard assumptions of convexity of preferences and technology, that infinite horizon economies with a finite number of agents typically contain a finite odd number of equilibna. From this fact, it follows that steady-state equilibna are locally determinate and that multiplicities that are exploited in models of self-fulfilling prophecies cannot occur.

On income tax functions: an application of robust, regression-based diagnostics to models of conditional means

This paper implements a variety of robust, regression-based diagnostics to nonlinear models of effective federal individual income tax. Estimates of effective marginal tax rates obtained from these tax models are frequently used in the empirical growth and real business cycle literature to quantify the macroeconomic effects of distortionary taxation. Based on a battery of conditional mean tests, the paper concludes that none of the tax models used in the empirical growth and real business cycle literature provides a good basis for obtaining reliable estimates of the effective marginal tax rates. Therefore, conclusions based on such tax estimates must be treated with caution.

The assessment: business cycles

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.

International and intranational business cycles

This paper surveys and analyzes the international real business cycle literature. We re-explore two international business cycle anomalies emphasized by Backus, Kehoe and Kydland (1995) as well as establishing the pattern of productivity growth between industries and countries. We then compare these findings for the international business cycle to those obtained for data between regions within a country--the so called business cycle. Importantly, the intranational business cycle is a natural environment for thinking about the interactions between economies when there are no trade frictions and when there are not multiple currencies. We summarize our findings with a comparison between the stylized facts for international and intranational business cycles and draw some policy conclusions. Copyright 1997 by Oxford University Press.

Indeterminacy and sector-specific externalities

We introduce mild increasing returns-to-scale into a version of the Real Business Cycle model. These increasing returns-to-scale occur as a consequence of sector-specific externalities, that is externalities where the output of the consumption and investment sectors have external effects on the output of firms within their own sector. Keeping the production technologies for both sectors identical for expositional simplicity, we show that indeterminacy can easily occur for parameter values typically used in the real business cycle literature, and in contrast to some earlier literature on indeterminacies, for externalities mild enough so that labor demand curves are downward-sloping.

Sectoral Solow residuals

This paper presents capital utilization corrected measures of technology shocks for aggregate and disaggregated (two-digit Standard Industrial Classification code) industries. We correct for variations in capital utilization by employing industrial electrical use as a measure of capital services. In contrast, the standard measures of technology shocks used in the Real Business Cycle literature are based on economy wide data and assume that capital services are proportional to the stock of measured capital. To assess the impact of these differences, we contrast selected properties of the competing technology shock measures. We argue that the properties of technology shocks for the manufacturing sector are quite different than those used in the RBC literature. We also find that correcting for capital utilization has important implications for the properties of the Solow residual.

Business cycles in open economies: A comment

a recent paper in this journal, P. Brandner and K. Neusser [1992] presented some astonishing empirical findings with regard to the characteristic properties of the business cycles in West Germany and Austria and their interrelatedness since the early 1960s. Following the real business cycle literature, they try to establish some kind of statistical relations among the fluctuation of those variables encountered in most macroeconomic models. They use the popular Hodrick-Prescott filter [Hodrick and Prescott, 1980] for extracting the 'cyclical dynamics' of the leading macroeconomic time series. Standard deviations and autocorrelations are used to capture some basic statistical properties of the business cycle fluctuations. Standard correlation tests are applied to evaluate the degree of cyclical comovements within and across the countries. This should help, they state, to shed some new light on the transmission of shocks. As for the general characteristics of the Austrian business cycle, two findings of this study are quite remarkable and do really stand out of the pack. First, quarterly real private consumption expenditure is estimated, for the period from 1964.1 to 1989.4, to be more volatile than the GDP. The standard deviation of the stationary component of private consumption is said to be 1.47 percent, that of GDP only 1.18 percent. Second, the Austrian output is supposed to lead the German one. A similar pattern is said to emerge with respect to investment and price level. The authors are quick to give an explanation for the latter. This result, they argue, may be mainly due to the dominance of basic industries in Austria. If these two findings could withstand the process of critical scrutiny they really deserved, from the viewpoint of Austria, to be called outstanding, because both run counter to mainstream views held in this country. Co-moving private consumption has been considered, by many economists in Austria, to be the chief cause for the low fluctuation of Austria's GDP since the late 1960s, and Austria has, at least in business cycle matters, always been considered to be a laggard rather than a forerunner. The latter was supposed to hold particularly with respect to Germany.

Causality and correlations of output and nominal variables in a real business cycle model

A dynamic general equilibrium economy in which output is exogenous with respect to money is calibrated and simulated following a procedure commonly used in the real business cycle literature. It is then confronted with key comovement patterns of output and nominal variables in post-war U.S. time series data. The model economy performs well in matching second-moment patterns involving output, money, and price. The model economy — with its embedded ‘reverse causation’ from output to money — also provides the means for carrying out a probabilistic appraisal of the observed money to output Granger causality in U.S. data. Repeated applications of the Granger causality test to simulated data lead to the rinding that money causes output more often than expected.

Money and the Business Cycle with One-Period Nominal Contracts

A modified version of the nominal contract developed by J. A. Gray (1976) and S. Fischer (1977) is introduced in a general equilibrium model with money which has been used in the real business-cycle literature. Money is introduced in the model through cash-in-advance constraint. Two kinds of contracts are examined, namely, a nominal wage contract and a nominal price contract. The nominal wage contract improves the fit of the model in many respects. The nominal price contract increases the output volatility enormously but it has some unrealistic features.

EQUILIBRIUM BUSINESS CYCLES: THEORY AND EVIDENCE

ABSTRACT. This paper surveys equilibrium business cycles (EBC) theory, which has dominated the business cycle literature since the mid 1970s. It focuses primarily on the real business cycle (RBC) literature the origin of which is traced to the monetary equilibrium business cycle (MBC) model developed by Lucas (1975). RBC and MBC models are themselves related to a wider class of linear stochastic business cycle models which, following Frisch (1933), view the cycle as the result of the propagation, by the economic system, of a series of random shocks. The MBC approach highlighted the importance of monetary shocks but its failure to adequately explain observed fluctuations provided the impetus to the development of the RBC approach, which emphasises the importance of real shocks. This paper also appraises the empirical support for the RBC approach and finds it less than compelling. Given the failure of Keynesian, and equilibrium linear stochastic business cycle models to fully explain economic fluctuations, the Frischian approach to business cycle modelling is called into question. Developments to existing models, which may help to clarify our understanding of business cycle behaviour, are discussed with a view to setting out a research agenda for the 1990s and beyond.

Risk sharing in the business cycle

Why do all developed economies experience fluctuations in their economic activity? The real business cycle (RBC) literature has provided an answer to this question by demonstrating that a well functioning decentralized model economy subject to exogeneous productivity shocks will behave in a way similar, in many respects, to the business fluctuations experienced by actual economies [Kyland and Prescott (1982)]. This is particularly true if one imposes restrictions on the choice set of the representative consumer-worker [Hansen (1985)]. Taking account of demand shocks in the form of variations in government spending further improves the performance of the model [Christian0 and Eichenbaum (1990)]. Should we be content with this answer? First, we must observe that the set of facts current RBC models are able to replicate is very limited and thus that claims of theoretical success should be proportionately modest [Danthine and Donaldson (1990)]. Second, at this level of explanation, it is quite likely that the same modest set of facts currently used to define the business cycle will be consistent with models of the economy which are significantly different from the pure Walrasian formulations which have predominated to date. It is this latter issue tihich we propose to address in this paper. Our starting point is the observation that all industrial economies have developed institutional and social arrangements designed to improve the distribution of income and risks over what would prevail in Walrasian equilibrium. Trade unions, minimum wage laws, and unemployment compensation mechanisms are examples of such arrangements, and they could be all interpreted as having the objective either of moving the economy away from

REAL BUSINESS CYCLES AND THE LUCAS PARADIGM

When the Lucas paradigm is generalized to include real effects, the effects of real factors and monetary factors on the business cycle are always interrelated. Furthermore, in such models monetary factors can affect the long‐run behavior of real output, contrary to the commonly held view that they cannot. Real business cycle models and Lucas‐type models are different paradigms, but not in the sense of real versus monetary. Rather, interrelationships between real and monetary factors are intrinsic to the Lucas paradigm, whereas the real business cycle literature implies a dichotomy between real and monetary factors.