A Nobel for Real Business Cycles

by on October 11, 2004 at 9:35 am in Economics | Permalink

Tyler has commented on the time-consistency problem so I will post on the other contribution for which Kydland and Prescott were awarded the Nobel, real business cycles. (I see now that Tyler also has a post on real business cycles – that guy is fast!.)

Recessions have almost always been thought of as a failure of market economies. Different theories point to somewhat different failures, in Keynesian theories it’s a failure of aggregate demand, in Austrian theories a mismatch between investment and consumption demand, in monetarist theories a misallocation of resource due to a confusion of real and nominal price signals. In some of these theories government actions may prompt the problem but the recession itself is still conceptualized as an error, a problem and a waste.

Kydland and Prescott show that a recession may be a purely optimal and in a sense desirable response to natural shocks. The idea is not so counter-intuitive as it may seem. Consider Robinson Crusoe on a desert island (I owe this analogy to Tyler). Every day Crusoe ventures onto the shoals of his island to fish. One day a terrible storm arises and he sits the day out in his hut – Crusoe is unemployed. Another day he wanders onto the shoals and he finds an especially large school of fish so he works long hours that day – Crusoe is enjoying a boom economy. Add to Crusoe’s economy some investment goods, nets for example, that take “time to build.” A shock on day one will now exert an influence on the following days even if the shock itself goes away – Crusoe begins making the nets when it rains but in order to finish them he continues the next day when it shines. Thus, Crusoe’s fish GDP falls for several days in a row – first because of the shock and then because of his choice to build nets, an optimal response to the shock.

An analogy is one thing but K and P showed that a model built from exactly the same microeconomic forces as in the Crusoe economy could duplicate many of the relevant statistics of the US economy over the past 50 years. This was a real shock to economists! There are no sticky prices in K & P’s model, no systematic errors or confusions over nominal versus real prices and no unexploited profit opportunities. A perfectly competitive economy with no deviations from classical Arrow-Debreu assumptions could/would exhibit behavior like the US economy.

Models like K & P’s called dynamic, stochastic, general equilibrium (DSGE) models are now the standard in macroeconomics but today they may also include demand side shocks and sticky prices as well as real shocks. Thus thesis has met anti-thesis and the synthesis has demand and supply shocks both contributing to business cycles.

Addendum: More at the Nobel site.

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