MSc Economics

Ec413 Macroeconomics
Real Business Cycles II

Christopher A Pissarides

November 2009

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Uncertainty
In a GE model with stochastic shocks rates of return and incomes are
uncertain. The conventional Euler equations are replaced by their
stochastic equivalents, e.g., for consumption we know that in general
1 + rt +1 0
u 0 (Ct ) = Et u (Ct +1 ) (1)
1+
With leisure in the utility function as well it is not possible to obtain
explicit solutions unless we restrict the functional forms severely,
something we do not generally want to do. Solutions have to be
quantitative. For log utility the Euler equation is
1 1 1 + rt +1
= Et . (2)
Ct 1+ Ct +1

Note that because Et (1/Ct +1 ) 6= 1/Et (Ct +1 ) and

Et 1C+tr+t +1 1 6= Et (1 + rt +1 ) Et (1/Ct +1 ), this Euler equation still cannot be
solved explicitly.
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The trade-o between consumption and leisure
Combine now the rst-order conditions for C0 and L0 to obtain a relation
between contemporaneous consumption and leisure. We can illustrate the
issue in hand either with and equal to 1 or dierent from it. Suppose
they are dierent from 1. Let be a Lagrangian multiplier on the budget
constraint.
FOC for C0
(1 L0 )1
bC0 = (3)
1
FOC for L0
C01
b (1 L0 ) = w (4)
1
Divide the second by the rst
C0 1
= w (5)
1 L0 1

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What does it all mean?

The Euler equation for consumption is the fundamental equation on the

consumer side. Once we get a time series for consumption from it we can
use (5) to get a time series for hours of work. But there is already a
problem with (5). Consider a boom phase of the cycle. Consumption is
high and hours of work are high, because they are both pro-cyclical.
Therefore in (5) C0 is above trend, 1 L0 is below trend and so their ratio
is even more pro-cyclical than the parts. But on the right-hand side we
know and are constants and w is not very procyclical in the data. So
there is a failure somewhere. It is likely to be in both the consumption
model and the labour supply model: it could be due to what is known as
excess volatility in consumption; or not enough pro-cyclical volatility
problem in leisure.

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A special case

Nevertheless, lets solve a special case, to see how things work in a simple
DSGE model
Problem with getting an explicit solution is due to the fact that the
model combines linear with log-linear equations. So we need more
than cosmetic simplication.
Suppose that all capital depreciates in one period. This happens when
capital goods are intermediate goods. We already know that in this
version of the model we will not predict correctly the low volatility of
the capital stock.
Suppose also that the utility function is log-linear in both Ct and
1 Lt .
There is no government.

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Equilibrium equations

Kt +1 = Yt Ct (6)
1
At Lt
1 + rt = (7)
Kt
1 1 1 + rt +1
= Et (8)
Ct 1+ Ct +1
Ct wt
= (9)
1 Lt b
To understand the last condition, recall that with log utility the utility
function is u = log C + b log(1 L)

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Whats special about it?

The reason this model works is that savings are independent of

technology. The savings rate s is constant, and so this gives a convenient
equation for consumption and investment. It reproduces the Solow model
but with stochastic shocks.
To solve it guess a constant s solution. Substitute in the equations of
the model to check if it works. In this case it does, giving:

s = constant (10)
1
1
Lt = constant (11)
(1 ) + b (1 s )
log Yt = log Yt 1 + (1 ) log At + log s + (1 ) log Lt (12)

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Output dynamics

We can write the last equation in log deviations from constant growing
paths, denoted by tilde, and use the stochastic process imposed on At to
get
Y t = ( + A )Y t 1 A Y t 2 + (1 )A,t , (13)
a second-order log-linear equation in the cyclical component of Y with
stochastic shocks. This was our initial objective. In principle it works
Driving force: productivity shocks, A,t
Impulse: immediate rise in Yt , Ct , Kt +1
Propagation: current shock impacts directly on future capital stock
and through on future income

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Evaluation

Dont take the model seriously as a description of the business cycle! Its
meant to show you how to solve DSGE models
Whereas the second order dierence equation in income could work well,
here realistic values of the models main parameter are too low.
= 1/3, which gives very fast adjustment. Propagation mainly comes
from a high exogenous A = 0.95. With these parameters the models
articial series for Y looks good but, the model predicts
Ct = (1 s )Yt , Kt +1 = sYt , so both consumption and investment
are as volatile as output, false
Lt constant, no employment volatility, false
wt = ( 1 )Yt /Lt as volatile as output, false

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Generalizing the model
1. Depreciation

Reducing depreciation from 100% to realistic values (about 10% p.a.) and
introducing real demand shocks - in this case shocks to government
expenditure - improves the models performance
Low depreciation means that households want to invest more when
there is a positive technology shock.
Expected future consumption rises and so the interest rate has to rise
to balance the intertemporal consumption choice
Labour supply rises because the interest rate is higher

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Generalizing the model
1. Government spending

Introducing government spending shocks also improves performance for

reasons anticipated in old-fashioned Keynesian models, but with a
Ricardiantwist
A positive shock to government spending makes households
anticipate future taxes
Their anticipated wealth falls and so they consume less leisure
With higher labour supply output rises and because technology is
unaected the wage rate falls
So G shocks break the link between wages and output: output and
wages move in opposite directions and so with both A and G shocks
wages will be less volatile than output.

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How do we solve the general model?

Answer: with great di culty

Two methods
1 Predominant: feed the equations with reasonable parameter values
and a time series for the shocks into the computer, and compute the
variances and covariances of the resulting time series of the
endogenous variables
2 Alternative: the method of undetermined coe cients.
1 Write the cyclical deviation of the endogenous variables as log-linear
functions of the cyclical deviation of the exogenous variables, with
undetermined coe cients
2 Obtain values for the coe cients by making use of the equations of the
model after log-linearizing them using Taylors rule

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Pros and cons

Using the computer is straightforward. You get precise solutions. Lots

of software that will do it for you
But you dont really know much about what is going on in the
background, e.g., sometimes even whats driving the variances and
covariances
Log-linearizing can be dodgy because the equations are
approximations
Getting the values of the undetermined coe cients is no mean feat
But you can trace the response of each variable to each shock
precisely and you know what exogenous shock is driving what
endogenous deviation

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Method of undetermined coe cients

The models exogenous shocks are A t , G t , the exogenous (predetermined)

variable generated from within the model given an initial condition is K t .
Then for each endogenous variable, e.g., Ct and Lt , write

C t = aCK K t + aCA A t + aCG G (14)

L t = aLK K t + aLA A t + aLG G (15)

The aij are the undetermined coe cients.

Now log-linearize the Euler conditions and other equations of the
model.
Find values for the aij that satisfy the log-linear approximations of the
model

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What do we discover?
1. Following a technology shock

Output rises most on impact, eect then dissipates. Main

propagation comes from the high AR1 coe cient on A t ( = 0.95)
A
Investment rises fast, so consumption rises less at rst but picks up as
capital builds up
The interest rate rises at rst but then falls as K builds up,
r = (AL/K )1
This is due to the depreciation eect and causes a rise in labour
supply
Wage rate rises less than technology but its path is at,
w = (1 )A1 (K /L)
Because the path is at there is no intertemporal substitution eect,
so employment response is mainly the result of interest rate changes

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What do we discover?
2. Following a government spending shock

Output rises by about one-half the rise in G , the remaining one-half is

nanced by a fall in consumption of 2/6 and of investment of 1/6.
Output rise coming from rise in employment for the reasons we said:
a negative wealth eect
Not a Keynesian eect!
Wages fall because of the rise in L with constant A, K

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Calibration

For calibration we choose functional forms and parameters, on the basis of

long-run trends or econometric estimates, and parameters.
The absence of long-run trends in factor shares implies that
Cobb-Douglas is a good approximation to the production function
The share of capital is about one-third, so = 0.33, sometimes a bit
higher
We saw how observations on consumption and leisure trends justify a
utility function
u = log C + b log(1 L) (16)
(Elasticities and approximately 1). On average about 2/3 of the
day is non-work time, so choose b = 2.
Rate of time preference about same as interest rate, = 0.04 per
year.

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 Technology shock is the Solow residual

log At = log Yt log Kt (1 ) log Lt (17)

and its deviation from trend found to satisfy, in quarterly data,

t = 0.95A
A t 1 + At = 0.011 (18)

Depreciation = 0.1 p.a. (capital stock mean life 10 years).

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Results

When these parameter values are plugged into the model and the model
solved, the result is reasonably good but
consumption is less volatile than output but not as volatile as in the
data
investment is more volatile than output but also more volatile than in
the data
employment is more volatile in the data
correlation between L and Y /L is negative or zero in the data,
positive in the model
Adding G shocks reduces correlation between Y /L and L but still not
matching data
The biggest distance between model results and data is in the employment
results.

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Criticisms, beyond failure to predict

Solow residual is a poor measure of technology shocks: it exaggerates

them. Varying utilization of capital, increasing returns, sectoral
shocks, can lead to mismeasurement
There is no microeconomic evidence on labour supply consistent with
large elasticities of intertemporal substitution of leisure, the key
employment mechanism of the model
There is evidence that monetary disturbances have real eects. But in
the RBC model they do not. So, if the evidence is correct, the
structure of the model needs to be re-thought
The propagation mechanism of the RBC model is mainly in the
shocks, which are exogenous. Output deviations from trend follow the
shocks closely, with little input from the structure of the model

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Conclusions: where do we stand?

Clearly RBC is not the end of the business cycle story: a lot more is
happening during the cycle
But real shocks are important, the hard question is what are they and
how important are they?
Monetary shocks and non-competitive elements are also important in
a modern economy
DSGE models with Keynesianfeatures have a lot of appeal but they
rely on exogenous price stickiness (and they are hard to solve!)
Compromise seems to be that partial analysis of complicated
mechanisms will survive, but eventually good models of the cycle will
have to be cast within a DSGE framework

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