Chapter13 - Chapter 13 Real Business Cycle Theory Real Business Cycle(RBC Theory is the other dominant strand of thought in modern macroeconomics For

Chapter13 - Chapter 13 Real Business Cycle Theory Real...

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© Sanjay K. Chugh 155 Spring 2008 Chapter 13 Real Business Cycle Theory Real Business Cycle (RBC) Theory is the other dominant strand of thought in modern macroeconomics. For the most part, RBC theory has held much less sway amongst policy-makers than has New Keynesian theory. Among theoretical macroeconomists, however, RBC theory is very well-known and well-understood and even provides the foundations for some of New Keynesian theory. 85 Although there are a number of ways in which RBC theory differs from New Keynesian theory, we will focus on two differences. The most important difference by far is that RBC theory eschews the idea of sticky prices, while New Keynesian theory embraces it. RBC theory views prices as fully flexible – that is, all prices can be and are re-set very frequently. Even more precisely, RBC theory supposes that perfect competition in all markets is a good starting point for analyzing the macroeconomy. Second, RBC theory does not view exogenous shifts of consumption demand as a good description of data, but rather “shifts in supply” as the predominant reason for macroeconomic fluctuations. The basic mechanics that we will use to sketch out the main elements of RBC theory are the theory of the representative firm, the simple consumption-savings model, and the static consumption-leisure model. We could instead employ the intertemporal consumption-leisure model, rather than the simple consumption-savings model and the static consumption-leisure model in tandem. As we saw earlier, though, the algebra becomes quite messy and graphical tools become difficult to use. RBC theorists do in fact use the intertemporal consumption-leisure model in their workhorse models, but we will be able to develop the basic results using the two models together. The RBC Technology Shock Recall from our discussion of the aggregate production function ( , ) f k n that we could augment it with a technology parameter A , so that total output is given by ( , ) A f k n . This technology parameter is usually identified with the Solow Residual, which is a measure constructed from data on output, capital, and labor. We describe how to compute Solow Residuals soon. This way of measuring technology has the virtue that it does not require taking a stand on what constitutes “technology” – i.e., it does not require identifying the state of “technology” of an economy with, say, the number of computers it uses or with the number of Ph.D.’s it employs or with how many people use wireless 85 Although not the staggered price-setting that we emphasized. RBC theory has made important contributions to the understanding of macroeconomics despite never having taken center stage in policy debates. The pioneering work of Ed Prescott and Finn Kydland, widely viewed as the “fathers” of RBC theory, was finally widely-recognized in 2004 when they were jointly awarded the Nobel Prize in Economic Sciences.