Standard Real Business Cycle Model Research Articles

Comparing DSGE-VAR forecasting models: How big are the differences?

Abstract I generate priors for a vector autoregression (VAR) from a standard real business cycle (RBC) model, an RBC model with capital-adjustment costs and habit formation, and a sticky-price model with an unaccommodating monetary authority. The response of hours worked to a TFP shock differs sharply across these models. I compare the accuracy of forecasts made from each of the resulting dynamic stochastic general equilibrium vector autoregression (DSGE-VAR) models. Despite having different structural characteristics, the DSGE-VARs are comparable in terms of forecasting performance. As in previous work, DSGE-VARs compare favorably with atheoretical VARs.

Asset Pricing and the Role of Macroeconomic Volatility

Standard Real Business Cycle (RBC) models are well known to generate counter-factual asset pricing implications. This paper provides a simple extension to the prior literature where we study an economy that follows a regimes switching process both in the mean and the volatility, in conjunction with Epstein-Zin preferences for the consumers. We provide a detailed theoretical and numerical analysis of the model's predictions. We also show that a reasonable parameterization of our model conveys reasonable financial figures. Furthermore, we provide evidence in support of the necessity to model the decline of macroeconomic risk in this particular class of models.

Learning, Adaptive Expectations, and Technology Shocks

This study explores the macroeconomic implications of adaptive expectations in a standard real business cycle model. When rational expectations are replaced by adaptive expectations, we show that the self-confirming equilibrium is the same as the steady-state rational expectations equilibrium for all admissible parameters but that dynamics around the steady state are substantially different between the two equilibria. The differences are driven mainly by the dampened wealth effect and the strengthened intertemporal substitution effect, not by the escapes emphasized by Williams (2003). As a result, adaptive expectations can be an important source of frictions that amplify and propagate technology shocks and seem promising for generating plausible labor market dynamics.

Monetary Policy and Stock Market Boom-Bust Cycles

We explore the dynamic effects of news about a future technology improvement which turns out ex post to be overoptimistic. We find that it is difficult to generate a boom-bust cycle (a period in which stock prices, consumption, investment and employment all rise and then crash) in response to such a news shock, in a standard real business cycle model. However, a monetized version of the model which stresses sticky wages and a Taylorrule based monetary policy naturally generates a welfare-reducing boom-bust cycle in response to a news shock. We explore the possibility that integrating credit growth into monetary policy may result in improved performance. We discuss the robustness of our analysis to alternative specifications of the labor market, in which wage-setting frictions do not distort on going firm/worker relations. JEL Classification: C11, C51, E5, E13, E32

Cointegrated TFP Processes and International Business Cycles

A puzzle in international macroeconomics is that observed real exchange rates are highly volatile. Standard international real business cycle (IRBC) models cannot reproduce this fact. We show that total factor productivity processes for the United States and the rest of the world are characterized by a vector error correction model (VECM) and that adding cointegrated technology shocks to the standard IRBC model helps explaining the observed high real exchange rate volatility. Also, we show that the observed increase of the real exchange rate volatility with respect to output in the past twenty years can be explained by changes in the parameter of the VECM.

Global Liquidity Glut or Global Savings Glut? A Structural VAR Approach

Since the late-1990s, the global economy is characterised by historically low risk premia and an unprecedented widening of external imbalances. This paper explores to what extent these two global trends can be understood as a reaction to three structural shocks in different regions of the global economy: (i) monetary shocks (excess hypothesis), (ii) preference shocks (savings glut hypothesis), and (iii) investment shocks (investment drought hypothesis). In order to uniquely identify these shocks in an integrated framework, we estimate structural VARs for the two main regions with widening imbalances, the United States and emerging Asia, using sign restrictions that are compatible with standard New Keynesian and Real Business Cycle models. Our results show that monetary shocks potentially explain the largest part of the variation in imbalances and financial market prices. We find that shocks and investment shocks explain less of the variation. Hence, a liquidity glut may have been a more important driver of real and financial imbalances in the US and emerging Asia than a savings glut.

Business Cycle and Asset Prices: A Computable General Equilibrium Analysis with Agency Costs and Habit Formation

For the purpose of explaining both business cycles and asset returns, we examine a real business cycle (RBC) model with habit-augmented preferences and endogenous costs of adjusting the capital stock. Following the agency-cost model of Carlstrom and Fuerst (1997), capital adjustment costs are affected by the level of entrepreneur's net worth such that an increase in net worth (following a positive productivity shock) lowers agency costs associated with external financing, and hence makes it easier to expand the capital stock. Along with the restricted labor supply, the model resolves the asset pricing puzzles of the consumption-based model in the sense that the implied stochastic discount factor (or pricing kernel) reaches the Hansen-Jagannathan (1991) volatility bound. Further, this improvement in the asset pricing dimension is achieved without reducing its business cycle performance such as output and consumption volatility. This is in a sharp contrast to the standard RBC model with the reduced-form adjustment cost technology where sufficiently low supply elasticity of capital (or persistently high capital adjustment costs) is required to generate the equity premium at the expense of low output volatility. Here, the capital supply is highly elastic under the plausible calibrations of the structural parameters affecting endogenous capital adjustment costs. The slugghish behavior of net worth, as a shifter of the capital supply curve, is the key mechanism by which capital adjustment is delayed, hampering consumption smoothing desired by households with habit persistence preferences. The agency-costs model reveals that a small curvature in the capital adjustment cost function, viewed as crucial for understanding the fluctuations in Tobin's q, can be also consistent with both the historical equity premium and the key business cycle facts.

International Financial Integration and the Real Economy

What are the consequences of financial integration for the real economy? This paper develops a set of theoretical benchmarks for the link between integration and macroeconomic volatility and welfare. The analysis is conducted in a standard two-sector international real business cycle model in which we introduce dynamic portfolio choice over equities and an international bond. The model predicts an increase in the volatility of output in response to integration, whereas the relationship between integration and consumption volatility is hump-shaped. We also find that financial integration is associated with significant improvement in risk-sharing across countries, although in aggregate the welfare benefits are very small. At the same time, the level of financial integration significantly affects how the welfare benefits of productivity shocks are distributed internationally.

Trade in Capital Goods and International Co-movements of Macroeconomic Variables

This paper contributes to the ongoing debate on the causes of international co-movements of macroeconomic variables. In particular, existing real business cycle models predict cross-country consumption correlations to be higher than in the actual data, cross-country output correlations to be lower than in the actual data, and cross-country consumption correlations to be relatively higher than the output correlations. We show that cross-country correlations of consumption, investment, employment and output predicted by a standard international real business cycle model are highly sensitive to the share of capital goods in total trade. Our calibrated model shows that when capital goods account for a share of total traded goods greater than 50%, the apparent discrepancy between the data and the simulations is resolved.

Modelling the central bank repo rate in a dynamic general equilibrium framework

This paper incorporates two components of a modern monetary system into a standard real business cycle model: a central bank which lends reserves to commercial banks and charges a repo interest rate; and banks which make loans under a fractional reserve system and thereby create money. We examine the response of our model to shocks in the monetary base, in the currency–deposits ratio and in the required reserve ratio. Our main finding is that all these monetary shocks lead to changes in the composition of total investment between the banking and the non-banking sectors.

Why have business cycle fluctuations become less volatile?

This paper shows that a standard Real Business Cycle model driven by productivity shocks can successfully account for the 50% decline in cyclical volatility of output, its components, and labor input that has occurred since 1983. The model is successful because the volatility of productivity shocks has also declined significantly over the same time period. We then investigate whether the decline in the volatility of the Solow Residual is due to changes in the volatility of some other shock operating through a channel that is absent in the standard model. We therefore develop a model with variable capacity and labor utilization. We investigate whether government spending shocks, shocks that affect the household’s first order condition for labor, and shocks that affect the household’s first order condition for saving can plausibly account for the change in TFP volatility and in the volatility of output, its components, and labor. We find that none of these shocks are able to do this. This suggests that successfully accounting for the post-1983 decline in business cycle volatility requires a change in the volatility of a productivity-like shock operating within a standard growth model.

Staggered wages, financial frictions, and the international comovement problem

Standard international real business cycle models often generate negative cross-country correlations in labor and investment. The data, however, display positive correlations. This paper studies the effect of real wage rigidity and financial frictions on international comovement. We find that staggered wages mainly improve the cross-country correlation of labor, while financial frictions improve investment comovement. However, each friction alone cannot account for the magnitude of international correlations of either variable. When the two imperfections are introduced together, the effect of each friction endogenously reinforces the other and the model generates realistic correlations in both variables.

The impact of technology shocks on the Japanese business cycle—An empirical analysis based on Japanese industry data

In order to investigate the impacts of technology shocks on the recent Japanese business cycles, we construct an aggregate technological measure from industry-based data. Our approach is to estimate production function by industry, by controlling for the returns to scale factor and unobserved factor utilization. We find that positive technology shocks result in a contraction of labor input on impact. This result implies that the standard real business cycle (RBC) model is not supported and the new Keynesian model or the labor reallocation model is a candidate to explain the Japanese business cycles. From further empirical studies, we find that the labor reallocation model is plausible for explaining the Japanese business cycles.

Reconciling conflicting evidence on the elasticity of intertemporal substitution: A macroeconomic perspective

In this paper we reconcile two opposing views about the elasticity of intertemporal substitution (EIS). Empirical studies using aggregate consumption data typically find the EIS to be close to zero, whereas calibrated models designed to match growth and fluctuations facts typically require it to be close to one. This contradiction is resolved when two kinds of heterogeneity are acknowledged: one, the majority of households do not participate in stock markets; and two, the EIS increases with wealth. We introduce these two features into a standard real business cycle model. First, limited participation creates substantial wealth inequality as in the U.S. data. Consequently, the properties of aggregates directly linked to wealth (e.g., investment and output) are mainly determined by the (high-EIS) stockholders. Since consumption is much more evenly distributed than is wealth, estimation from aggregate consumption uncovers the low EIS of the majority (i.e., the poor).

Learning-by-doing or habit formation?

In a recent paper, Chang et al. [2002. Learning-by-doing as a propagation mechanism. American Economic Review 92 (5) 1498–1520] extend the standard real business cycle (RBC) model to allow for a learning-by-doing (LBD) mechanism whereby current labor supply affects future productivity. They show that this feature magnifies the propagation of shocks and improves the matching performance of the standard RBC model. In this paper, we show that the LBD model is nearly observationally equivalent to an RBC model with habit formation in labor (or, equivalently, in leisure). Under the same calibration of the parameters, the two models share the same equilibrium paths of output, consumption, and investment, but have different implications for hours worked. Using Bayesian techniques, we investigate which of the LBD and Habit models fits the US data better. Our results suggest that the Habit specification is more strongly supported by the data.

Capacity constraints, asymmetries, and the business cycle

We study how an occasionally binding capacity constraint affects the properties of business cycles. A real business cycle model is constructed where production takes place at individual plants and the number of plants operated varies over the cycle. The capacity constraint binds in states where all plants are operated. We derive the aggregate production function for this economy, which turns out to differ from the standard Cobb–Douglas function while retaining its desirable properties. The business cycle features of this one-sector growth model are similar to those of a standard real business cycle model in most respects. Our model does, however, display some properties of actual economies that standard models do not. In particular, business cycles in our model are asymmetric—troughs are deeper on average than peaks are tall. Also, labor's share of income is counter-cyclical, as it is in US data.

Is Schumpeterian ‘creative destruction’ a plausible source of endogenous real business cycle shocks?

This paper examines the link between growth and business cycles by incorporating Schumpeterian growth into an otherwise standard real business cycle (RBC) model. We ask whether Schumpeter's creative destruction process can generate realistic business cycles. We solve the model, generate artificial time series, and compare statistical properties of these series with their historical counterparts. In our approach, the trend component is included in our artificial series just as it is in the data. Hence, we are not tied to any particular filtering method for our comparisons. We find that Schumpeterian fluctuations alone can generate time series that match key moments from U.S. data. We also find, however, that a model with both Schumpeterian and standard RBC shocks performs better.

Stock Return Predictability in a Production Economy

This paper demonstrates that the standard real business cycle model, augmented by capital adjustment costs and variable capital utilization, yields countercyclical consumption growth volatility and equity risk premia predictability. In the model, as in the data, the investment to capital ratio and the fraction of investment in output are procyclical due to consumption smoothing. These two results imply that as productivity declines due to adverse productivity shocks, output falls at increasing rates (since in high productivity states the growth of the economy's stock of capital offsets the effect on output of productivity declines) and investment must be reduced by increasing rates if consumption were to fall at a constant rate. Convex capital adjustment costs and time to build (note that even in the standard RBC model capital takes one period to build) imply a desire for investment smoothing and a trade-off between investment smoothing and consumption smoothing. Since high productivity states are more likely in the data (as well as in the model) than low productivity states, much of the economy's consumption smoothing (i.e. investment fluctuations) occurs when productivity fluctuates between two relatively high states. The desire for investment smoothing implies that in the less frequent cases of transition into lower productivity states, more of the decline in output is absorbed by consumption. Consequently, in the model consumption growth is countercyclical (which is consistent with the empirical findings in Kandel and Stambaugh (1990) and Bekaert and Liu (2004)) as is the equity risk premium. Our model incorporates variable capital utilization rates which give rise to a countercyclical output gap. Model simulations show that the output gap serves as a measure for recessions and is positively correlated with future excess stock returns. In the data we find that the output gap is a strong predictor of future excess returns over both short and long horizons, and does a better job, both in-sample and out-of-sample, than other variables known to predict excess returns.

Long-Run Productivity Shifts and Cyclical Fluctuations: Evidence for Italy

Using unobserved stochastic components and Kalman filter techniques, the paper assesses the relative importance of transitory and permanent shifts in Italian real GDP within a production function framework. Evidence suggests that the increase in hours worked that has accompanied pension and labor market reforms accounts for the bulk of low-frequency variation in growth, but points to factor utilization as the main driver of business cycle fluctuations. In contrast with the predictions of standard Real Business Cycle models, a positive shock to the underlying rate of total factor productivity growth generates a slight decline in hours, whereas the response of output to the same shock is found to be positive.

Long-Run Productivity Shifts and Cyclical Fluctuations: Evidence for Italy

Using unobserved stochastic components and Kalman filter techniques, the paper assesses the relative importance of transitory and permanent shifts in Italian real GDP within a production function framework. Evidence suggests that the increase in hours worked that has accompanied pension and labor market reforms accounts for the bulk of low-frequency variation in growth, but points to factor utilization as the main driver of business cycle fluctuations. In contrast with the predictions of standard Real Business Cycle models, a positive shock to the underlying rate of total factor productivity growth generates a slight decline in hours, whereas the response of output to the same shock is found to be positive.