Real business cycles: cycles interpreted as random walk
Real business cycles models are usually considered the second generation of models within the New Classical School founded by Lucas. These models were proposed to address some of the critiques of Lucas’s model, and in a criticism of Lucas’s business cycles theory made by Tobin (1980: 798), we can find an exact description of these future RBC models.
Real business cycles models were presented as directly inspired by Frisch (1933) and Schumpeter - Frisch because RBC theory distinguishes between impulse and propagation mechanisms, and Schumpeter because it considers innovations (here productivity shifts) as the main driving force of business cycles. However, for historians of economic thought, the links between these two literatures are rather tenuous.Real business cycles models - the first of which was proposed by Kydland and Prescott (1982) - were an attempt to avoid the criticisms levelled at Lucas’s model - mainly its inability to explain (and to reproduce) the persistence of shocks, and the exclusive reliance on the occurrence of regular monetary shocks (a somewhat doubtful hypothesis) in order to depict (recurrent) fluctuations. Real business cycles were built on optimal growth models in which fluctuations are driven by productivity shocks - either temporary or permanent- which have a direct impact on fully informed and rational agents’ (optimal) decisions. Consequently, business cycles are expressed not only in equilibrium terms but are also the direct outcome of fully rational economic and perfectly informed agents. That is, they are also optimal positions. So the trend became both an equilibrium and optimal position, and cycles were interpreted as fluctuations of the trend. This can be considered as a sterilized version of business cycles, that is, a conception of cycles that is unrelated to the idea of disequilibrium or instability, in other words a totally new perspective on fluctuations.
Supported by Nelson and Plosser (1982), RBC models interpreted fluctuations of the level of productivity as a random walk (see Mata and Louςa 2009 for a history of “residual” interpretation).
The main criticisms of these models were (1) the exclusive reliance of RBC models on technological shocks, a hypothesis which implied that recessions should be seen as periods of technological regress, which is a questionable interpretation, (2) their neglect of the role played by monetary and financial factors, and, more generally, that demand-side shocks could not, by definition, generate any consequences for long-run dynamics, and (3) their totally unrealistic reliance on the elasticity of substitution in order to generate fluctuations. These affected the credibility of their analysis of the persistence of fluctuations (for detailed critiques, see, for example, Summers 1986; Hoover 1988; Stadler 1994). The two generations of models (Lucas’s and RBC) reveal a clear inclination among economists at that time to progressively exclude any sort of instability from the core of the model. Nevertheless, as in the interwar period, business cycles were analysed by a shock/propagation representation, and the notion of (endogenous) instability progressively disappeared to be substituted by a deeper analysis of shocks.Thus, there is a sort of paradox in the RBC approach: while it relies exclusively on technological progress in order to generate fluctuations, it still considers it to be an exogenous factor. In addition, growth is also exogenous. The consequence of this is that despite growth and cycles being modelled jointly, this framework fails to explain business cycles and especially growth-cycles interactions. At best RBC models can only mimic observed fluctuations, a position for which RBC economists take credit but which remains controversial.
More on the topic Real business cycles: cycles interpreted as random walk:
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