Real Business Cycle Model Research Articles

How important are trend shocks? The role of the debt elasticity of interest rate

We study how financial frictions affect the importance of trend productivity shocks for macroeconomic fluctuations. Using long-run data from 17 small open economies (SOEs), we compare two variants of a workhorse SOE real business cycle model featuring a debt-elastic interest rate (DEIR), a measure of financial frictions. The first variant estimates the DEIR parameter, while the second fixes it to 0.001, effectively abstracting from financial frictions. On average, ignoring financial frictions doubles the contribution of trend shocks to output fluctuations. This suggests that a proper assessment of the quantitative effects of trend shocks requires reasonable DEIR values.

Replicating business cycles and asset returns with sentiment and low risk aversion

I solve for the sequences of shocks (or wedges) that allow a standard real business cycle model to exactly replicate the quarterly time paths of U.S. macroeconomic variables and asset returns since 1960. The resulting shock sequences can be grouped into three main categories: (1) shocks that affect household sentiment and preferences, (2) shocks that appear in the law of motion for capital, and (3) shocks that appear in the production function for output. For most variables including output, no single shock category is clearly dominant in explaining the observed movements in U.S. data. While some variables are driven by a single dominant shock category, the dominant category is different for each of those variables. The results imply that there is no “most important shock.” Rather, U.S. economic outcomes have been shaped by a complex and time-varying mixture of fundamental and non-fundamental disturbances.

Fiscal financing with labour markets frictions

AbstractIn this paper, we study the effect of search and matching frictions, i.e., equilibrium unemployment, on fiscal financing decisions in the United States. We build a Real Business Cycle model with labour market frictions and a rich set of fiscal tools and estimate the model using Bayesian methods on US data for various fiscal rule specifications. Most importantly, we find that the model with unemployment, output and debt in the fiscal rules fits the data best. Under the fiscal rule that best fits the data, the reaction of fiscal instruments to output and debt are significantly quantitatively different than a rule that ignores unemployment. Fiscal instruments react stronger to cyclical factors except transfers. These changes also affect model dynamics in response to fundamental non‐fiscal shocks.

Macroeconomic effect of NBFC default shock in India: a four-sector DSGE model

ABSTRACT In this study a four-sector dynamic stochastic general equilibrium model is developed by introducing banks and non-banking financial companies (NBFCs) in a general two-sector real business cycle model in context of Indian economy. Examining the impact of three shocks namely NBFC default shock, productivity shock and investment shock, default of NBFC on its loan does not have any significant impact on aggregate output, consumption and investment. The shock has localized impact on the NBFC sector itself because of its low asset size and weak interconnectedness with the Indian economy. Productivity and investment shock have significant impact on the macroeconomic variables.

The development planning of the Italian Mezzogiorno: a statistical-mathematical analysis by a Real Business Cycle model

Since the 1950s, the regions of the Italian South (Mezzogiorno) have benefited from large in-kind transfers (namely, the provision of goods and services financed by the richer Northern regions) with the aim of favouring their economic development. The research aim of this manuscript is to evaluate this planning strategy, namely, to understand whether the territorial transfers boost the Mezzogiorno’s development or, on the contrary, whether the crowding-out effect of the final government expenditure on private investment and household consumption is the reason for the longstanding low growth of this geographical area.To accomplish this goal, the authors write down and solve an appropriate Real Business Cycle model and carry out some stochastic simulations. Their findings demonstrate that the in-kind transfer strategy entails no benefits for the Southern regions. In addition, the authors, using an alternative specification of their baseline setting, document that an alternative approach based on infrastructural investment is effective in stimulating the long-term economic growth of the Italian South.

Zero-risk weights and capital misallocation

Financial institutions, especially in Europe, hold a disproportionate amount of domestic sovereign debt. We examine the extent to which this home bias leads to capital misallocation in a real business cycle model with imperfect information and fiscal stress. We assume banks can hold sovereign debt according to a zero-risk weight policy and contrast this scenario to one in which banks weight the sovereign debt according to default probabilities. Banks are assumed to miscalculate the probability of a disaster state due to moral hazard and imperfect monitoring. This distortion pushes the economy away from the first-best allocation. We show that the zero risk weight policy exacerbates these distortions while a non-zero risk-weight improves allocations. The welfare costs associated with zero-risk weight policies are large. Households are willing to give up 3.2 percent of their consumption to move to the first-best allocation, whereas in the economy with non-zero risk-weights households are willing to give up only 1.2 percent of their consumption to move to the first-best allocation.

The Interaction between Credit Constraints and Uncertainty Shocks

AbstractThis paper proposes a novel link between credit markets and uncertainty shocks. We introduce a role for credit uncertainty via collateral constraints in an otherwise standard real business cycle (RBC) model and show that an increase in credit uncertainty triggers a precautionary response that interacts with the collateral constraint to generate a simultaneous decline in output, consumption, investment, real wages, and hours; a feature that previous work on uncertainty shocks without credit constraints is unable to produce in a flexible‐price environment. We also empirically test the theoretical predictions and show that an unforeseen increase in credit uncertainty generates a simultaneous decline in a broad measure of real activity in recessions.

Taking Heterogenous Production Times into Account: The Emergence of Stickiness in Real Business Cycle Model

Taking Heterogenous Production Times into Account: The Emergence of Stickiness in Real Business Cycle Model

Fossil energy use and carbon emissions: An easy-to-implement technical policy experiment

<p>Macroeconomic research on carbon policy mostly revolves around carbon pricing mechanisms such as carbon taxes, cap-and-trade-schemes, and a mix of them. Despite their relevance, however, carbon pricing is not the only policy available to mitigate carbon emissions. A richer and diversified arsenal of carbon policies may prove more effective in addressing carbon mitigation across different social, economic and geographic contexts. We proposed a policy experiment, which took the form of a <italic>technical tax</italic> on fossil energy use aiming at stabilizing carbon dioxide emissions. The <italic>technical tax</italic> responded to variations in all elements that are supposed to alter climatic phenomena, that is, domestic carbon emissions, domestic fossil energy use, and the industrial stock of atmospheric carbon dioxide, to which all world economies contribute. The macro-effects of the <italic>technical tax</italic> were simulated using an off-the-shelf Real Business Cycles (RBC) model targeting the economy of the United States and featuring a climatic block. The economy was perturbed by a technology shock and an energy-price shock. Special care was devoted to the processes of validation and calibration. The tax was responsive to the business cycle and showed positive aspects. When a technology shock hit the economy, it curbed carbon emissions with minor costs in terms of potential output losses. It also protected the economy from an increase in energy prices, mitigating the fall in output despite the drop in fossil energy use. Last but not least, the tax effectively stabilized carbon dioxide emissions by reducing their variance.</p>

Real Business Cycle: Stochastic driving force decomposition of output dynamics in East Java

This study aims to examine output dynamics in East Java using the Real Business Cycle (RBC) model. We constructed an RBC model with two stochastic shocks originating from the demand and supply sides. The RBC model in this study shows that output dynamics, as the driver of the business cycle in East Java, are mostly caused by exogenous shocks originating from the demand side. The model also shows that some variables such as wage levels, consumption, and capital accumulation exhibit inertia patterns in response to shocks. Therefore, after releasing the assumptions underlying the RBC model and accommodating fiscal and monetary policies, we argue that the response time lag shown by some of these variables can be advantageous for authorities to mitigate the impact of shocks and determine policies. Additionally, two main factors that determine policy effectiveness are understanding the sources of shocks and the timing of policy implementation.

Endogenous Uncertainty and Credit Crunches

Abstract We develop a theory of endogenous uncertainty in which the ability of investors to learn about firm-level fundamentals is impaired during financial crises. At the same time, higher uncertainty reinforces financial distress. Through this two-way feedback loop, a temporary financial shock can cause a persistent reduction in risky lending, output, and employment that coincides with increased uncertainty, default rates, credit spreads, and disagreement among forecasters. We embed our mechanism into standard real business cycle and New-Keynesian models and show how it generates endogenous and internally persistent processes for the efficiency and labour wedges.

Application of Dsge Models for the Analysis of Latvian Economic Processes

Nowadays DSGE models are the mainstream of macroeconomic theory. DSGE stands for dynamic, stochastic, general equilibrium and the main purpose of these models is to perform the analysis of business cycle fluctuations and economic policy. The main advantage of DSGE models is related to their theoretical foundations – the dynamics of economic processes is described as interaction of rational optimizing agents, which react to "exogenous stochastic disturbances" (shocks). These advantage of DSGE models helps to analyse both economic processes on the aggregated level and individual markets under the circumstances of uncertainty. Historically, DSGE models have gone through several stages of development. The origins of DSGE models are related to Lucas critique – a series of papers, which presented a new approach of macroeconomic processes analysis. This approach was rather controversial with Keynesian theory. In the terms of R. Lucas, macroeconomic models must be based on microfoundations and consider expected variables, because the consideration of expectations in macroeconomic models best describes "the real economic situation" and makes these models suitable for economic policy development and analysis. The first DSGE models were basically RBC (Real Business Cycle) models, but their main drawback was assumption of neutrality of money, which made them not suitable for monetary policy analysis. Later DSGE models correct this drawback – contemporary DSGE models are used for various purposes, for instance, fiscal and monetary policy analysis. Keywords: macroeconomic modelling, DSGE, Latvian economy

Processing inflation news: A discussion of Binz, Ferracuti, and Joos (2023)

Binz, Ferracuti, and Joos (2023) examine whether better internal information systems can mitigate the association between inflation and investment. According to Real Business Cycle models, inflation should not impact real decisions like investment, yet empirically the two are positively related. Lucas (1972) theorizes that imperfect information can cause agents to rationally extrapolate from their local set of information to make conclusions about what is happening in aggregate. Motivated by this model, the authors argue that better internal information systems allow managers to disentangle firm-level real shocks from nominal shocks. My discussion evaluates the measurement of internal information quality and questions how distinct it is from external information quality. Next, I relate the findings to a growing literature that examines how individuals and firms form economic expectations. Finally, I consider whether and how these findings can inform policy.

The Effects of Government Expenditure on the Output: A Real Business Cycle Analysis for the Romanian Economy

Abstract One of the most researched topics in macroeconomics is the development and implementation of Real Business Cycle models. This article presents a small Real Business Cycle model, which is built for the Romanian economy, with data from the 2nd quarter of 1995 through the 3rd quarter of 2022. The main aim of this analysis is to assess the historical influence of exogenous and government spending shocks on economic growth. In order to obtain accurate results, we implemented a Bayesian estimation technique for calculating the parameters of the model. The main findings indicate the significant exogenous shocks effect on the Romanian economy, and the way in which government spending had a positive effect on increasing economic growth for the period between the 1st quarter 2000 and the 3rd quarter of 2022.

Macroeconomic impacts of COVID-19 pandemic first wave in the world

The paper seeks to identify the essential global-economic macro-shocks resulting from efforts by consumers, firms, or government policies to reduce social distancing, which caused a sharp temporary change in the world economy during the pandemic outbreak in the second quarter of 2020. The purpose is fulfilled using a simple two-period real-business cycle model. The observed reaction of the global economy in the second period of 2020 is measured by the deviation of the time series of GDP and its components, labor, labor income, and average labor product in the USA and EU from the log-quadratic trend. The model can replicate the observed economic response by reducing the total factor productivity, labor demand, and labor supply—no need to assume sticky prices. As a sudden drop in performance is supposed, followed by a modest recovery already in the following period, it is not assumed that the government would be able to avert it in time with fiscal or monetary policy. Moreover, the assumption of variable prices and supply-side shocks does not support such a policy.

Aggregate Properties of Open Economy Models with Expanding Varieties

Abstract We present a unified framework to study interconnections between business cycle and international trade models. This unified framework is built upon the standard competitive, representative-firm international real business cycle model and features production externalities in the intermediate and final goods sectors. Our main theoretical result is that this unified framework is equivalent in aggregate implications to dynamic international trade models featuring monopolistic competition, endogenous entry and exit, and heterogeneous firms. We show that a negative capital externality in the intermediate good sector is required to fit the data. This presents a puzzle for the literature because when viewed through the lens of our unified framework, we demonstrate that the standard assumptions used in dynamic trade models imply a positive capital externality.

Pollution and labor market search externalities over the business cycle

We study the relationship between unemployment, environmental policy, and business cycles. We develop a dynamic stochastic general equilibrium real business cycle model that includes both a pollution externality and congestion externalities from labor market search frictions. These frictions generate unemployment on the extensive margin and affect hours worked on the intensive margin. We consider two policies to address the market failures: an emissions tax and a tax or subsidy on job creation. With both policies present, the efficient outcome can be achieved. When one policy is constrained or absent, we solve for the second best. The absence of a vacancy policy to address the congestion externalities substantially affects the value of the emissions tax, both in steady state and over the business cycle.

Confronting increases to labour and capital taxes to finance the pension deficit in the Dominican Republic: a real business cycle approach

Ageing demographics have prompted widespread pension reforms across Latin America. This has left several countries with a significant financial burden related to the transition from one system to another. In this article, we evaluate two alternative methods of financing the recent pension reform in the Dominican Republic. We build on a simple real business cycle model with perfect competition and add a fiscal block that allows us to simulate shocks to the tax rates on capital and labour, based on the present value of the pension reform cost. We find that increasing the tax rate on returns to capital would not only fill the pension deficit, but also have a significantly smaller adverse effect on the macroeconomy, when compared with an increase to the tax on labour.

Optimal Environmental Policy for Heterogeneous Governments in China

The purpose of the article is to study how the shift in the developing philosophy of China's central leadership has impacted the management style of China's local governments and, in turn, the country's economic and environmental equilibrium. We use a real business cycle model with environmental variables and divide governments into those with/without environmental concerns and into those with long- and short-term policy horizons. We find that forcing local governments to plan in the long run is effective only when those governments are simultaneously mandated to consider the environment to be as important as the economy. Theoretical results show that both output and pollution levels are highest under governments without environmental obligations, intermediate under long-term governments with environmental obligations, and lowest under short-term governments with such obligations.

A Small Open Economy DSGE Model for Pakistan

In recent years there has been a growing interest in academics, international policy institutions and central banks1 in developing small-to-medium, even large-scale, open economy macroeconomic models called Dynamic Stochastic General Equilibrium (DSGE) models based on new-Keynesian framework.2 The term DSGE was originally used by Kydland and Prescott (1982) in their seminal contribution on Real Business Cycle (RBC) model. The RBC model is based on neoclassical framework with micro-founded optimisation behaviour of economic agents with flexible prices. One of the critical assumptions of this model is that fluctuations of real quantities are caused by real shock only; that is, only stochastic technology or government spending shocks play their role. Later research in DSGE models however included Keynesian short-run macroeconomic features (called nominal rigidities), such as Calvo (1983) type staggered pricing behaviour and Taylor (1980) type wage contracts. Hence this new DSGE modeling framework labeled as new-neoclassical synthesis or new-Keynesian modeling paradigm. 3 This new approach combines micro-foundations of both households and firms optimisation problems and with a large collection of both nominal and real (price/wage) rigidities that provide plausible short-run dynamic macroeconomic fluctuations with a fully articulated description of the monetary policy transmission mechanism; see, for instance, Christiano, et al. (2005) and Smets and Wouters (2003). The key advantage of modern DSGE models, over traditional reduce form macroeconomic models, is that the structural interpretation of their parameters allows to overcome the famous Lucas critique (1976).4 Traditional models contained equations linking variables of interest of explanatory factors such as economic policy variables. One of the uses of these models was therefore to examine how a change in economic policy affected these variables of interest, other things being equal. In using DSGE models for practical purposes and to recommend how central banks and policy institutions should react to the short-run fluctuations, it is necessary to first examine the possible sources,5 as well as to evaluate the degree of nominal and real rigidities present in the economy. In advanced economies, like US and EURO area, it is easy to determine the degree of nominal and real rigidities as these economies are fully documented. In developing economies like Pakistan, where most of economic activities are un-documented (also labeled as informal economy, black economy, or underground economy), it is very difficult to determine the exact degree of nominal and real rigidities present in the economy. However, one can approximate results using own judgments and through well defined survey based methods