Real Business Cycle Model Research Articles

Can International Macroeconomic Models Explain Low-Frequency Movements of Real Exchange Rates?

Real exchange rates exhibit important low-frequency fluctuations. This makes the analysis of real exchange rates at all frequencies a more sound exercise than the typical business cycle one, which compares actual and simulated data after the Hodrick- Prescott Olter is applied to both. A simple two-country, two-good, international real business cycle model can explain the volatility of the real exchange rate when all frequencies are studied. The puzzle is that the model generates too much persistence of the real exchange rate instead of too little, as the business cycle analysis asserts. We show that the introduction of input adjustment costs in production, cointegrated productivity shocks across countries, and lower home bias allows us to reconcile theory and this feature of the data.

Macroeconomic Implications of Time-Varying Risk Premia

A large empirical literature suggests that risk premia on stocks or corporate bonds are large and countercyclical. This paper studies a simple real business cycle model with a small, exogenously time-varying risk of disaster, and shows that it can replicate several important facts documented in the literature. In the model, an increase in disaster risk leads to a decline of output, investment, stock prices, and interest rates, and an increase in the expected return on risky assets. The model matches well business cycle data and asset price data, and the countercyclicality of risk premia. I present an extension of the model with endogenous choice of leverage and endogenous default, and show that the model accounts well for the level and cyclicality of credit spreads, and in particular the relation between investment and credit spreads.

What (Really) Accounts for the Fall in Hours after a Technology Shock?

The paper asks how state of the art DSGE models that account for the conditional response of hours following a positive neutral technology shock compare in a marginal likelihood race. To that end we construct and estimate several competing small-scale DSGE models that extend the standard real business cycle model. In particular, we identify from the literature six different hypotheses that generate the empirically observed decline in worked hours after a positive technology shock. These models alternatively exhibit (i) sticky prices; (ii) firm entry and exit with time to build; (iii) habit in consumption and costly adjustment of investment; (iv) persistence in the permanent technology shocks; (v) labor market friction with procyclical hiring costs; and (vi) Leontief production function with labor-saving technology shocks. In terms of model posterior probabilities, impulse responses, and autocorrelations, the model favored is the one that exhibits habit formation in consumption and investment adjustment costs. A robustness test shows that the sticky price model becomes as competitive as the habit formation and costly adjustment of investment model when sticky wages are included.

Exogenous oil shocks, fiscal policies and sector reallocations in oil producing countries

Previous literature has suggested that different mechanisms of transmission of exogenous oil shocks are responsible for the negative effects on the economic performances of oil exporting countries. This paper aims at providing further evidence on the role of sectoral reallocation between private and public sectors in explaining the impact of shocks to oil revenues on the economic growth rates of major oil producing countries (namely the GCC – Gulf Corporation Council – countries). The effects of oil shocks and expansionary fiscal policy on the business cycle of oil producing countries are examined. The possibility to distinguish between various components of public sector spending policy (that is, purchases of consumption goods, investments in productive activities and compensation for public employees) is, in particular, allowed for. A real business cycle (RBC) model is calibrated to fit the data on an “average” oil producing country. Results from the simulation of the theoretical model suggest that the possibility that the expansion of the size of the government (due, in particular, to the increase in the number of employees) can explain a large fraction of the negative effects of shocks to oil revenues on the private sector of the economy. However, since the growth in size of the public sector more than compensate for the reduction in size of the private sector, an increase in oil revenues has the effect to boost total output.

ACCOUNTING FOR THE SIZE OF THE INFORMAL SECTOR IN NIGERIA

AbstractThis paper uses a Real Business Cycle (RBC) model to analyse and simulate the effect of a negative oil‐price shock on the informal sector in Nigeria. Secondly, the paper shows that RBC theory can account for the size of the informal sector as produced by the Multiple Indicator Multiple Cause (MIMIC) model. The MIMIC model has been criticised for generating estimates of the informal sector without an underlying theory. This paper shows that the model's estimates of the informal sector can be supported by theory.

The effect of fiscal policy on the size of the informal sector in Nigeria

This paper adapts a dynamic real business cycle model to examine the effect of fiscal policy on the relative size of the informal sector in Nigeria. The motivation for this paper is to provide an economic intuition on how fiscal policy has contributed to the growth of the informal sector. The results of the model show the presence of an inverted U-shaped relationship between the tax rate and the size of the informal sector. It also predicts that for a given tax rate below a threshold of 30%, public capital stock contributes to an increase in the size of the informal sector and vice versa. The theoretical predictions of the model are supported empirically using data from Nigeria between 1980 and 2000. The model finally shows that there is a proportional relationship between the agent’s welfare and the size of the informal sector.

International risk cycles

Recent work in international finance suggests that exchange rate puzzles can be accounted for if (1) aggregate uncertainty is time-varying, and (2) countries have heterogeneous exposures to a world aggregate shock. We embed these features in a standard two-country real business cycle framework, and calibrate the model to equity risk premia in low and high interest rates countries. Unlike traditional real business cycle models, our model generates volatile exchange rates, a large currency forward premium, “excess comovement” of asset prices relative to quantities, and an imperfect correlation between relative consumption growth and exchange rates. Our model implies, however, that high interest rate countries have smoother quantities, equity returns and interest rates than low interest rate countries, contrary to the data.

Organizational capital and the international co-movement of investment

A recent literature explores the macroeconomic implications of organizational capital (OC) and especially its ability to resolve discrepancies between existing models and data. This paper contributes to the OC literature by studying the effect of OC on international investment flows in the context of a two-country real business cycle model. The presence of OC introduces novel considerations into agents’ investment decisions since current investment and future productivity levels are positively linked. These new considerations help bring the model closer to the data. In response to a productivity shock in one country, investment increases in both countries, producing positive international co-movement in investment, a feature of the data that several IRBC models fail to produce.

The consumption-real exchange rate anomaly: nontraded goods and distribution services

In the data, Real Exchange Rates (RERs) tend to move in opposite directions with respect to the relative consumption across countries. Chari et al. (2002) refer to the inability of models to replicate the previous stylized fact as the consumption-RER anomaly. In this article, it is shown that an International Real Business Cycle (IRBC) model, similar to the one proposed by Chari et al. but extended by considering nontraded goods and an incomplete asset market structure, can solve the anomaly. Nontradable goods amplify wealth effects arising from the incomplete assets market structure, generating a negative co-movement between the RER and relative consumption. Adding Distribution Services (DS) improves the performance of the model in some other dimensions. In particular, DS help to generate countercyclical net exports.

Asset Pricing Implications in a Production Economy with an Investment Specific Technology Shock

The focus of this paper is to examine the asset pricing implications of a real business cycle model with recursive preferences and an investment specific technology shock. Particularly, in this model, the relative price of capital is subject to a shock and thereby it first increases the efficiency of investment and then improves the expected marginal product of next period's capital. Introduction of investment specific technology shock along with Epstein-Zin-Weil preferences in a dynamic stochastic general equilibrium model is able to generate equity premium and risk free rate, its volatility as well as key macroeconomic facts that are consistent with U.S. data. The model successfully achieves the desired results with reasonable values of intertemporal elasticity of substitution (IES) and relative risk aversion (RRA) parameters that are consistent with empirical evidence.

Inexact Newton methods for model simulation

Robust and efficient solution techniques for solving macroeconometric models are increasingly becoming a key factor in developing models employed by policy-making institutions for policy simulations and forecasting. Traditionally, when solved in the presence of forward-looking variables, these models are nonlinear, large-scale and sparse and give rise to large and highly structured nonlinear systems. This paper proposes a Newton-GMRES method obtained tuning up the basic algorithm by properly choosing the forcing terms sequence and the preconditioning strategy. In addition, the Newton–GMRES method is wrapped into a globalization strategy based on a nonmonotone linesearch technique in order to enlarge its convergence basin and to enhance its robustness. The combination of these ingredients yields a reliable method with low memory requirements. Numerical experiments using the MULTIMOD model and a basic real business cycle model are presented. A Matlab code based on this approach is provided.

HABIT PERSISTENCE AND INTERNATIONAL COMOVEMENTS

Theoretically, two-country real business cycle models with time-separable preferences and complete markets predict that cross-country investment correlations will be negative. The opposite is true in the data. This phenomenon has been described by Backus et al. [in Cooley (ed.),Frontiers of Business Cycle Research, pp. 331–356 (Princeton, NJ: Princeton University Press, 1995)] as a quantity anomaly. This paper proposes to address this discrepancy by allowing the nonseparability of preferences over time. Here, we incorporate internal habit formation into consumption. Our model predicts the empirically plausible value of cross-country investment correlation without sacrificing other business cycle statistics. The results are robust to the degree of spillovers and persistence in the specification of the productivity shocks.

WELFARE COST OF INFALTION IN A NEW KEYNESIAN MODEL

AbstractWe study the welfare cost of inflation in a new Keynesian dynamic stochastic general equilibrium model. Nominal prices and wages are subjected to Taylor‐style adjustments in the benchmark model. We find that the welfare cost of inflation in a new Keynesian dynamic stochastic general equilibrium model is much higher than its counterpart in a real business cycle model. We also find that the welfare cost of inflation increases linearly with the inflation rate with the introduction of monopolistic competition but rises faster as the inflation rate increases with the introduction of nominal rigidity. Alternative price and wage setting schemes, such as Rotemberg and Calvo‐style adjustments would yield welfare costs of moderate inflation that are 2–10 times higher.

Exogenous Oil Shocks, Fiscal Policy and Sector Reallocations in Oil Producing Countries

Previous literature has suggested that different mechanisms of transmission of exogenous oil shocks are responsible for the negative effects on the economic performances of oil exporting countries. This paper aims at providing further evidence on the role of sectoral reallocation between private and public sectors in explaining the impact of shocks to oil revenues on the economic growth rates of major oil producing countries (namely the GCC - Gulf Corporation Council - countries). The effects of oil shocks and expansionary fiscal policy on the business cycle of oil producing countries are examined. The possibility to distinguish between various components of public sector spending policy (that is, purchases of consumption goods, investments in productive activities and compensation for public employees) is, in particular, allowed for. A real business cycle (RBC) model is calibrated to fit the data on an “average” oil producing country. Results from the simulation of the theoretical model suggest that the possibility that crowding-out effects of public over private investments can explain a large fraction of the negative effects of shocks to oil revenues on the private sector of the economy. In addition, since the growth in size of the public sector is unable to compensate for the reduction in size of the private sector, an increase in oil revenues has the effect to decrease total output. An expansionary fiscal policy is argued to have significant positive effects on private investments, employment and overall production. On the contrary, a shock to government consumption expenditure impacts negatively the level of public investment. As employment in the public sector increases significantly, public output responds positively to a shock in government consumption expenditure. Finally, an instantaneous negative effect on total investments and on the stock of capital in the economy is predicted. However, driven by the increase of the number of employees in the economy, total output expands.

International real business cycles with endogenous markup variability

The aggregate impact of decisions made at the level of the individual firm has recently attracted a lot of attention in both the macro and trade literatures. We adapt the benchmark international real business cycle model to a game-theoretic environment to add a channel for the strategic interaction among domestic and foreign firms. We show how the sum of strategic pricing decisions made at the level of the individual firm can have significant effects on the volatility and cross country co-movement of GDP and its components. Specifically we show that the addition of this one channel for strategic interaction leads to a significant increase in the cross-country co-movement of production and investment, as well as a significant decrease in the volatility of investment and the trade balance over the benchmark IRBC model.

Emissions targets and the real business cycle: Intensity targets versus caps or taxes

For reducing greenhouse gas emissions, intensity targets are attracting interest as a flexible mechanism that would better allow for economic growth than emissions caps. For the same expected emissions, however, the economic responses to unexpected productivity shocks differ. Using a real business cycle model, we find that a cap dampens the effects of productivity shocks in the economy on all variables except for the shadow value of the emissions constraint. An emissions tax leads to the same expected outcomes as a cap but with greater volatility. Certainty-equivalent intensity targets maintain higher levels of labor, capital, and output than other policies, with lower expected costs and no more volatility than with no policy.

On the cyclicality of unemployment: Resurrecting the participation margin

This paper considers a real business cycle model with search frictions in the labor market and labor supply which is elastic along the participation margin. Previous authors have found that such models generate counterfactually procyclical unemployment and a positively sloped Beveridge curve. This paper presents a calibrated model which succeeds at generating countercyclical unemployment and a negatively sloped Beveridge curve, despite the presence of a participation margin.

The (un)importance of unemployment fluctuations for the welfare cost of business cycles

This paper studies the cost of business cycles within a real business cycle model with search and matching frictions in the labor market. We endogenously link both the cyclical fluctuations and the mean level of unemployment to the aggregate business cycle risk. The key result of the paper is that business cycles are costly: fluctuations over the cycle induce a higher average unemployment rate since employment is nonlinear in the job-finding rate and the past unemployment rate. We show this analytically for a special case of the model. We then calibrate the model to U.S. data. For the calibrated model, too, business cycles cause higher average unemployment; the welfare cost of business cycles can easily be an order of magnitude larger than Lucas's (1987) estimate. The cost of business cycles is the higher the lower the value of nonemployment is, or, equivalently, the lower is the disutility of work. The ensuing cost of business cycles rises further when workers' skills depreciate during unemployment.

Wpływ sposobu finansowania wydatków rządowych na oddziaływanie polityki fiskalnej. Ujęcie modelowe

The impact of a government spending financing is analysed in the article. The analysis is based on Baxter and King real business cycle model. It occurred that the choice of the financing method of a government spending is crucial for the impact of the fiscal policy on the economy. The increase in a government spending financed by budget deficit decreases consumption and leisure time and increases the level of labour and production. On the contrary the increase in a government spending financed by higher taxes depended on production has a significant negative impact on GDP.

How should environmental policy respond to business cycles? Optimal policy under persistent productivity shocks

How should environmental policy respond to economic fluctuations caused by persistent productivity shocks? This paper answers that question using a dynamic stochastic general equilibrium real business cycle model that includes a pollution externality. I first estimate the relationship between the cyclical components of carbon dioxide emissions and US GDP and find it to be inelastic. Using this result to calibrate the model, I find that optimal policy allows carbon emissions to be procyclical: increasing during expansions and decreasing during recessions. However, optimal policy dampens the procyclicality of emissions compared to the unregulated case. A price effect from costlier abatement during booms outweighs an income effect of greater demand for clean air. I also model a decentralized economy, where government chooses an emissions tax or quantity restriction and firms and consumers respond. The optimal emissions tax rate and the optimal emissions quota are both procyclical: during recessions, the tax rate and the emissions quota both decrease.