What does real business cycle theory predict about the cyclicality of prices?

by on July 7, 2014 at 7:35 am in Economics, Uncategorized | Permalink

At least since King and Plosser 1984, the core prediction is that prices are procyclical and perhaps a leading indicator as well.  Think of inside money/credit as another input into production, and real business cycle theory as showing a general comovement of economic variables.  That means broader measures of the money supply go up in good times and fall in bad times.  Of course you don’t need real business cycle theory to get to those rather general conclusions, but they are fully consistent with real business cycle theory and will fall out of most sensible models with credit.

Now consider prices.  If money supply expansions/contractions come more quickly than output expansions/contractions, the price level will be pro-cyclical in an RBC model, at least during the early stages of the cycle before other outputs adjust.  Especially on the upswing it is easy to imagine how optimistic expectations give rise to some M2 which comes before the actual output rise.  And in bad times the broader aggregates won’t put much pressure on prices.  You can think of the broader “comovement effects” as outweighing possible interest rate effects.

Paul Krugman has a post attacking a bunch of people, but he is not focusing on what RBC models actually imply, and have implied for a long time.  (He sticks with attacking the easier target, namely those who predicted very high inflation from the high monetary base.)  It is not that “RBC models explain the crisis,” but rather demand and supply side models have more in common than is often recognized, all the more once you move beyond the immediate short run.

Furthermore there is nothing in the behavior of prices which rules out a significant (and I would say non-exclusive) role for the supply side.  On top of that the pure demand side theories predicted more deflation than we have ended up seeing and thus they would do well to incorporate some supply-side considerations.

1 Andrew' July 7, 2014 at 7:43 am

We had high inflation. It was called the housing bubble and prices staying the same as all the production moved overseas.

2 Rob Clark July 7, 2014 at 12:48 pm

Not really. Since 2007, which is when quantitative easing began and prediction of high inflation began as well, housing prices decreased rather than increased, so the bubble is irrelevant to those predictions. That was when the bubble was bursting. Prices staying the same is kind of the definition of no inflation.

3 andrew' July 7, 2014 at 8:58 pm

The “definition” of inflation is what got us here.

The prediction of hyper inflation was part myth and part internal debate.

4 Noah Smith July 7, 2014 at 7:49 am

Tyler, I’m not sure you’re right about King & Plosser (1984). On p. 372, they say that the core RBC model is likely to produce countercyclical prices, and suggest some tweaks that could be done if it is “necessary” to produce procyclical price movements. http://www.fep.up.pt/docentes/pcosme/S-E-1/se1_trab_0910/se5.pdf

It was my understanding that not until the “news shock” literature of the 2000s did RBC models reliably and convincingly generate procyclical price movements.

5 rayward July 7, 2014 at 8:57 am

I suppose Cowen is being conciliatory. Krugman, not so much. How can he be conciliatory, after spending the past six years emphasizing aggregate demand as the source of our problems, until very recently even criticizing anybody who raised inequality as a possible source of our problems because he deemed it a distraction. Never the twain shall meet. But that’s okay. There’s a move afoot to change the way we measure value in economics, reflected in a guest op/ed in today’s NYT by Lew Daly (with regard to the value of public goods) and by Erik Brynjolfsson and Andrew McAfee’s new book (with regard to the value of digital goods). Can’t agree on the significance of output? Simple solution: change the way we measure it.

6 Spencer July 7, 2014 at 10:22 am

My favorite measure of velocity is monthly PERSONAL INCOME/MZM (m2 plus money market funds).
The BEA and the St Louis Fed use to calculate M2 velocity using monthly personal income.

From 1950 to 1980 it had a long up-sweep with no major downturns, although it did flatten out sometimes.

Since 1980 it has been on a long term downward trajectory without any major upturns. It is not showing any signs of bottoming..

It has very closely paralleled bond yields.

But this measure of velocity shows no sign of bottoming..

Nor does it appear to be consistent with real business cycle theory.

7 8 July 7, 2014 at 11:22 am

Total credit market debt outstanding. Based on the average growth rate from the 1950s through 2000s, this year there should be $30 trillion more in credit than there is; the U.S. should be pushing $90 trillion in total credit, but its still below $60 trillion.

Cycles are fractal. Need to go up one order of magnitude at least to understand what is happening.

8 Andrew' July 7, 2014 at 11:55 am

How do we know what it “should” be?

Economics seems fun and I don’t understand all the inside baseball, but it seemed like Krugman quietly published a paper on debt deflation without making much fanfare about the topic.

9 Tom July 7, 2014 at 6:38 pm

RBC models that incorporate credit etc remind me of nail soup. If you add enough additional ingredients, and most importantly credit, even nail soup can pass the taste test. That doesn’t change the fact that nails don’t taste good and technological progress is not inherently cyclical.

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