Theories and Methods of the Business Cycle. Part 1: Dynamic Stochastic General Equilibrium Models

Theories and Methods of the Business Cycle. Part 1: Dynamic Stochastic General Equilibrium Models IV. Can RBC be saved? Jean-Olivier HAIRAULT, Professeur à Paris I Panthéon-Sorbonne et à l’Ecole d’Economie de Paris (EEP)

IV. 1. Extending the RBC approach • Two kinds of extensions: solving empirical puzzles and investigating other issues. • Some criticisms have been adressed into the RBC theory, ie. models where productivity shocks are the main perturbation of optimal fluctuations. • The canonical model has been extended to international fluctuations and to the study of particular historical episodes like the 1930’s crisis.

IV. 2. Public spending shocks w E’ E E’’ Ns, Nd

IV. 2. Public spending shocks • Government shocks have wealth effects which alters labor supply. The correlation between wages and hours is then negative in case of government shocks. • Taking into account both shocks leads to decrease this correlation. E’’ E E’

IV. 2. Public spending shocks

IV. 2. Public spending shocks • Business cycles properties with public expenditures shocks • From kprdea2.m to kprdea2G.m • The correlation between hours and wages is decreased but remains too high. Public expenditures shocks have a weaker impact on aggregates than technology shocks. • Artificially decreasing the volatility of the technology shocks could lead to a negative correlation.

IV. 2. Public spending shocks • Only Technology ShocksN Y C I P • standard deviation 0.0081 0.0142 0.0050 0.0523 0.0066 • relative st. dev. 0.5667 1.0000 0.3480 3.6733 0.4655 • Correlation 0.9745 1.0000 0.8910 0.9864 0.9623 • serial corr. 0.6750 0.6924 0.7972 0.6770 0.6924 • correlation N-W 0.8770 • +public spending shocks • standard deviation 0.0069 0.0134 0.0062 0.0486 0.0074 • relative st. dev. 0.5187 1.0000 0.4634 3.6346 0.5519 • Correlation 0.9290 1.0000 0.8569 0.9816 0.9380 • serial correlation 0.6808 0.6920 0.7715 0.6798 0.6920 • correlation N-W 0.7441

IV. 3.Back to the Lucas critique

IV. 3.Back to the Lucas critique • RBC methodology allows us to take into account all the implications of a change in public policy or in the environment of private agents. • The dynamics derive from the interaction between the environment (shocks, public policies) and fundamentals (Technology, preferences). • Which public spending rule does better stabilize the economy? • Volatility ? Which volatility? • Welfare? What are the market failures in our economy? • What are the size of business cycle costs? More on this issue in course 6.

IV. 4. The indivisible labor hypothesis

IV. 4. The indivisible labor hypothesis Ns Nd

IV. 4. The indivisible labor hypothesis • Eta=1 N Y C I P • standard deviation 0.0081 0.0142 0.0050 0.0523 0.0066 • relative st. dev. 0.5667 1.0000 0.3480 3.6733 0.4655 • Correlation 0.9745 1.0000 0.8910 0.9864 0.9623 • serial corr. 0.6750 0.6924 0.7972 0.6770 0.6924 • correlation N-W 0.8770 • Infinite elasticity • standard deviation 0.0124 0.0170 0.0057 0.0638 0.0057 • relative st. Dev. 0.7270 1.0000 0.3329 3.7442 0.3329 • Correlation 0.9750 1.0000 0.8759 0.9865 0.8759 • serial correlation 0.6706 0.6883 0.8034 0.6727 0.6883 • correlation N-W 0.7472

IV. 5. Capital utilization

IV. 6. Labor Hoarding • Taking into account the quality or intensity of worked hours • labor intensity increases (decreases) in expansions (contractions). • Firms prefer to adjust labor intensity rather employment. Individual hours are assumed to be indivisible and employment are submitted to adjustment costs. Employment gets predetermined. • Productivity cycle: labor productivity measured as output/employment leads employment in the data. • Correlation lagged and contemporanous productivity-employment: .11 0.37 0.47 0.47 0.34

IV. 6. Labor Hoarding • Y = A F(K, X(eH)) • The Solow Residual is no longer a pure measure of technology: variations of e must be eliminated. • Naive Solow residual overestimates the standart deviation of the technology innovation by 35%, as estimated by Burnside, Christiano and Rebelo. • Technology shocks are not volatile enough to replicate the variance of output. Only 58%. • Adding another real shock: public spending.

IV. 7. International Business Cycles • Backus, Kehoe and Kydland [1992], Journal of Political Economy, Baxter [1995], Hanbook of International Economics • More failures than in closed economies due to capital international mobility and portfolio diversification…but at the origin of the new open economy macroeconomics, Obstfeld and Rogoff [1995]. I will present some international RBC models in the open macroeconomics course…

IV. 7. International Business Cycles • After a technology shock abroad, aggregates increase as in the closed RBC economy. • As the capital return is higher abroad, domestic households invest abroad: the capital stock decreases in the domestic country, and so the labor demand decreases too. This explains why the model predicts a negative correlation between production factors across countries. • Output across countries is then less correlated in the model than in the data. • As there is perfect risk-sharing (complete markets), the marginal utility of consumption is equalized across countries: the wealth distribution does not vary over the business cycle. In case of positive shock abroad, the domestic receives a payment provided by a state-contingent security. • Consumption across countries is then more correlated in the model than in the data.

IV. 8. The Great Depression • Special issue of the Review of Economic Dynamics in 2002 investigating the 1930’s crisis in the main developed countries using the RBC model • P. Beaudry and F. Portier [2002], RED, The French Depression in the 1930’s

IV. 8. The Great Depression

IV. 9. Business Cycles Accounting

Theories and Methods of the Business Cycle. Part 1: Dynamic Stochastic General Equilibrium Models