Real Business Cycle Model Research Articles

International capital flows, external assets and output volatility

Cross-sectional evidence for 119 developing, emerging, and developed countries shows over the last three decades that countries with an on average higher volatility of output growth experience more procyclical capital outflows over the business cycle than those countries with the same growth rate but a more stable output path. This stylized pattern shows up in addition to the recently established fact that countries with higher macroeconomic uncertainty tend to accumulate higher external asset positions. To explain this finding we present an open-economy real business cycle model with stochastic growth rates in which higher uncertainty of the expected income stream increases the precautionary savings of households. We show that the combination of income risk and the precautionary savings motive leads to both more procyclical capital outflows in the shorter run and a higher long-run external asset position.

Sectoral composition of government spending, distortionary income taxation, and macroeconomic (in)stability

AbstractThis paper examines the interrelations between the sectoral composition of government spending and macroeconomic (in)stability in a two‐sector real business cycle model with positive productive externalities in investment and a balanced‐budget fiscal policy rule, whereby endogenous public expenditures are financed by the distortionary constant tax rate. Under the benchmark parameterization, our model always exhibits indeterminacy and sunspots provided the tax rate does not exceed a critical value. When the tax rate is raised to a higher level, a sufficiently high public‐consumption share can destabilize the macroeconomy by generating belief‐driven cyclical fluctuations. We also find that saddle‐path stability and equilibrium uniqueness will prevail when the household's labor supply elasticity is not higher than a threshold level. In addition, analytical proofs for each of the aforementioned quantitative results are provided.

Real business cycles, animal spirits, and stock market valuation

AbstractThis paper develops a real business cycle model with five types of fundamental shocks and one “equity sentiment shock” that captures fluctuations driven by animal spirits. The representative agent's perception that movements in equity value are partly driven by sentiment turns out to be close to self‐fulfilling. I solve for the sequences of shock realizations that allow the model to exactly replicate the observed time paths of US consumption, investment, hours worked, the stock of physical capital, capital's share of income, and the S&P 500 market value from 1960.Q1 onwards. The model‐identified sentiment shock is strongly correlated with survey‐based measures of US consumer sentiment. Counterfactual scenarios with the model suggest that the equity sentiment shock has an important influence on the paths of most US macroeconomic variables.

Intangible capital and the rise in wage and hours volatility

In a standard real business cycle model extended to include intangible capital (IC) I show that a rise in the income share of IC in the production function, in line with data can account for a significant share of the increase in real wage volatility (both absolute and relative to income) and labor input volatility (relative to income) observed in the U.S. since the mid 1980s even as volatility of output declined. Intangible capital accumulates stochastically and similar to final goods requires physical capital, intangible capital and labor to produce. Under these conditions an increase in the share of IC in production increases the propagation of the IC-specific shock which raises (absolute and relative) wage and labor input volatility. The higher propagation of the IC shock also accounts for the large decline in the pro-cyclicality of labor productivity (relative to both output and labor) observed during this period.

International Business Cycle and Financial Intermediation

AbstractThe paper extends a standard two‐country international real business cycle model to include financial intermediation by banks of loans and government bonds. The paper contributes an explanation for both the United States relative to the Euro‐area, and the United States relative to China, of cross‐country correlations of loan rates, deposit rates, and the loan premia. It shows a type of financial retrenchment for the United States relative to both Europe and China following a negative bank productivity shock, such as during the 2008 crisis. After 2008, results suggest that the Euro‐area has been more financially integrated with the United States, and China less financially integrated.

On the cyclicality of R&D activities

This paper develops a real business cycle model with endogenous innovation, in order to explore cyclical fluctuations in R&D activities. A calibrated version of the model is used to discriminate between different R&D production technologies on their ability to account for the observation that R&D in the U.S. is procyclical. The analysis finds that the knowledge-driven specification, commonly used in the growth literature, fails to account for important features of the business cycle, most notably the procycical movement of both R&D investment and R&D employment. An alternative specification that allows for multiple inputs including scientists, staff, and final goods can account for the business cycle phenomena of the U.S. economy, including the procyclicality of R&D activities. An implication of this particular specification of the R&D process is that productivity shocks amplify the business cycle by stimulating more ideas in good times.

Aggregation biases in empirical Euler consumption equations: evidence from Spanish data

This paper investigates the implications of aggregation in empirical analyses of Euler equations for consumption. We compare the results obtained after estimating the same model using total and non-durable microeconomic consumption data, from the maximum aggregation level (Spanish National Accounts) to household data from the Spanish Expenditure Survey (Encuesta Continua de Presupuestos Familiares). We use this survey to build cohort and aggregate data to test the model using different aggregate measures for consumption. The results we obtain confirm the theoretical predictions summarised in Blundell and Stoker (J Econ Lit 43:347–391, 2005. https://doi.org/10.1257/0022051054661486) as well as in previous empirical evidence, i.e. aggregation turns out to be crucial to empirically study Euler equations for consumption (Attanasio and Weber in Rev Econ Stud 60:631–649, 1993. https://doi.org/10.2307/229812) or when simulating real business cycle models (Guvenen in J Monet Econ 53:1451–1472, 2006. https://doi.org/10.1016/j.jmoneco.2005.06.001). The estimated elasticity of intertemporal substitution (EIS) with aggregated data is biased as compared with the corresponding estimate using microeconomic data. Further, we find that the size of the bias increases with the level of aggregation. Finally, our estimates confirm Hall (J Polit Econ 96:339–357, 1988. http://dx.doi.org/10.2139/ssrn.2704067) result that the EIS is not statistically different from zero, unless panel data are used.

Propagation Mechanisms for Government Spending Shocks: A Bayesian Comparison

AbstractThe inability of a simple real business cycle model to predict a rise in consumption in response to increased government expenditures, observed in many empirical studies, has stimulated the development of alternative theories of government spending shocks. Using the Bayesian approach, we evaluate the quantitative performance of five extant models, and find that neither of the considered transmission mechanisms for government spending helps improve the fit of the baseline model. Moreover, we find that consumption decreases in all estimated models in response to a rise in government spending.

Home production and small open economy business cycles

This paper incorporates home production into a real business cycle (RBC) model of small open economies to explain the different empirical patterns of international business cycles between developed economies and emerging markets. It is well known in the literature that in order for the RBC model to replicate quantitatively plausible empirical moments of small open economies, the model needs to feature counterfactually a small income effect on labor supply. This paper considers home production that introduces substitutability between market consumption and home consumption, which in turn generates a high volatility in market consumption in accordance with the data, even in the presence of a sizable income effect on labor supply. Furthermore, the model with estimated parameter values based on the simulated method of moments is able to match other empirical moments, such as the standard deviations of output, investment and the trade balance and the correlations between output and other macroeconomic variables. Given that home production is more prevalent in emerging markets than in developed economies, the model is able to replicate empirical differences between emerging markets and developed economies in the volatility of market consumption and the volatility/countercyclicality of the trade balance.

Predetermined interest rates in an analytical RBC model

We solve a version of the analytical Real Business Cycle (RBC) model with a predetermined rate of return on household saving. The solution differs from that of the benchmark RBC model along two dimensions: (i) Policy functions depend on the variance of the technology shock. (ii) There is a suboptimal pattern of excess saving. We discuss the economic intuition underlying these properties. We also demonstrate that unconditional welfare can be higher in the suboptimal model with predetermined interest rates, providing a clear illustration of the pitfall with unconditional welfare comparisons.

Reconciling endogenous job destruction with labor market stylized facts: The role of hiring costs

This note considers a Real Business Cycle model with search and matching frictions as well as purely endogenous separations in line with the model of Mortensen and Pissarides (1994) in order to solve the Shimer (2005) puzzle. This puzzle shows the inconsistency of such a model to capture the high volatility of labor market variables (unemployment, vacancies) and cyclical property (Beveridge curve, job creation and destruction). Using hiring costs rather than vacancy posting cost in this setup allows to solve this puzzle.

Real Business Cycles, Animal Spirits, and Stock Market Valuation

This paper develops a real business cycle model with five types of fundamental shocks and one "equity sentiment shock" that captures animal spirits-driven fluctuations. The representative agent's perception that movements in equity value are partly driven by sentiment turns out to be close to self-fulfilling. I solve for the sequences of shock realizations that allow the model to exactly replicate the observed time paths of U.S. consumption, investment, hours worked, the stock of physical capital, capital's share of income, and the S&P 500 market value from 1960.Q1 onwards. The model-identified sentiment shock is strongly correlated with survey-based measures of U.S. consumer sentiment. Counterfactual scenarios with the model suggest that the equity sentiment shock has an important influence on the paths of most U.S. macroeconomic variables. [The first version of this paper was July 4, 2018.]

Macroprudential policy and foreign interest rate shocks: A comparison of loan-to-value and capital requirements

This paper presents a generic small open economy real business cycle model with domestic and foreign borrowing. We incorporate capital requirements and loan-to-value regulation into this framework, and subject the model to a positive foreign interest rate shock that raises the country risk premium and reduces the supply of foreign funds. The results show that both these macroprudential instruments can attenuate the impact of such a shock and that their joint application is Pareto optimal. Loan-to-value regulation delivers the largest shock attenuation benefits but entail a welfare tradeoff between borrowers and savers. Capital requirements improve the welfare of both agents, but have smaller shock attenuation benefits. Lastly, we find that a macroprudential response to foreign interest rate shocks can benefit both financial and macroeconomic stability.

SOVEREIGN DEBT IN THE UNITED STATES AND GROWTH EXPECTATIONS

This paper shows empirical evidence and theory consistent with the US government using debt optimally to adjust the federal budget to news about long-term growth. First, using historical forecasts from the Congressional Budget Office (CBO) since 1984, I find that government purchases and deficits are positively correlated with expectations about long-term productivity, real gross domestic product, and tax revenue growth, whereas tax receipts are negatively correlated. A structural vector autoregression estimated with US quarterly data in 1955–2015 identifies permanent and transitory productivity shocks and points to “trend” shocks as the source of these correlations. Second, I present an open economy real business-cycle model with stochastic productivity trend and optimal public purchases and taxes. Calibrating the model to the US economy, the Ramsey planners' allocation yields moments aligned with those observed in the data.

Progressive taxation as an automatic destabilizer under endogenous growth

It has been shown that in an otherwise standard one-sector real business cycle model with an indeterminate steady state under laissez faire, sufficiently progressive income taxation may stabilize the economy against aggregate fluctuations caused by agents’ animal spirits. We show that this previous finding can be overturned within an identical model which allows for sustained endogenous growth. Specifically, progressive taxation may operate like an automatic destabilizer that leads to equilibrium indeterminacy and sunspot-driven cyclical fluctuations in an endogenously growing macroeconomy. This instability result is obtained under two tractable progressive tax policy formulations that have been considered in the existing literature.

Evolution of Modern Business Cycle Models: Accounting for the Great Recession

Modern business cycle theory focuses on the study of dynamic stochastic general equilibrium (DSGE) models that generate aggregate fluctuations similar to those experienced by actual economies. We discuss how these modern business cycle models have evolved across three generations, from their roots in the early real business cycle models of the late 1970s through the turmoil of the Great Recession four decades later. The first generation models were real (that is, without a monetary sector) business cycle models that primarily explored whether a small number of shocks, often one or two, could generate fluctuations similar to those observed in aggregate variables such as output, consumption, investment, and hours. These basic models disciplined their key parameters with micro evidence and were remarkably successful in matching these aggregate variables. A second generation of these models incorporated frictions such as sticky prices and wages; these models were primarily developed to be used in central banks for short-term forecasting purposes and for performing counterfactual policy experiments. A third generation of business cycle models incorporate the rich heterogeneity of patterns from the micro data. A defining characteristic of these models is not the heterogeneity among model agents they accommodate nor the micro-level evidence they rely on (although both are common), but rather the insistence that any new parameters or feature included be explicitly disciplined by direct evidence. We show how two versions of this latest generation of modern business cycle models, which are real business cycle models with frictions in labor and financial markets, can account, respectively, for the aggregate and the cross-regional fluctuations observed in the United States during the Great Recession.

Eductive Stability in Real Business Cycle Models

We reexamine issues of coordination in the standard RBC model. Is the unique rational expectations equilibrium attainable by rational agents who contemplate the possibility of small deviations from equilibrium? Surprisingly, we …nd that coordination cannot be expected. Even with strong common knowledge assumptions, rational agents anticipating small but persistent deviations are led to take actions that eventually contradict the common knowledge assumption. This “impossibility”theorem for eductive learning is not fully overcome when adaptive learning is incorporated into the framework.

Flexible Labour, Income Effects, and Asset Prices

This paper studies how flexible labor decisions affect asset pricing in a Real Business Cycle model. It uses Jaimovich-Rebelo preferences with internal habits in consumption and distinguishes between two income effect channels: (i) the `habit income effect' channel and (ii) the `separability income effect' channel. I find that asset prices are superior when the first channel is strong and the second is weak, this is the case of using GHH preferences with internal habits in consumption.

An Estimated DSGE Model to Analyze Housing Market Policies in Hong Kong SAR

During the last decade, Hong Kong SAR has experienced a large increase in house prices and credit, prompting the authorities to respond with several rounds of tightening macroprudential rules and increasing stamp duty taxes. This paper provides a Dynamic Stochastic General Equilibrium (DSGE) model for Hong Kong SAR and analyzes the effectiveness of these measures, and finds that they have helped reduce house price appreciation and household leverage. A baseline small open economy real business cycle model is extended by including a housing sector, financial frictions, foreign demand for the domestic housing stock, and is estimated using Bayesian methods and data for Hong Kong SAR between 1996 and 2017. The paper finds that, without these policies, house prices would have been 10.5 percent higher, and the household credit-GDP ratio 14 percent higher.

Distortions in Macroeconomics

Distortions in Macroeconomics