assessing RBC model

Question 1

Why some shocks can produce cyclical fluctuations (technology perturbations), while
others don’t (optimism shock or impatience shock)?

Answer 1

As long as nothing changes the marginal utility of leisure time against consumption
goods (i.e., there is no shift of the consumption-leisure curve), then anything that
raises consumption must lower employment!
TFP shocks affect how households perceive the trade-off between dedicating time
to work or to leisure
Optimism shock or impatience shock do not influence the ratio ν′(l)
/u′(C1) = A1F ′(L)
=⇒ cannot make consumption and employment move in the same direction

Question 2

what is the effect of fiscal shocks on the RBC model?

Answer 2

Government spending are financed by lump-sum taxes (Ricardian Equivalence)
↑ G1 ⇒ ↑ present value of household tax liabilities ⇒ ↓ household wealth
Households reduce their consumption and leisure ⇒ increase the number of hours
they work: ↓ C1+ ↓ l ⇒↑ L ⇒ ↑ Y1
↑u′(C1)
u′(C2) = ¯β ¯A2 ¯F ′(K ) ⇒ ↑u′(C2) ⇒ consumption is reduced both today and in
the future
Given that the reduction in consumption today plus the expansion in output are
generally smaller than the government spending increase, there is a decline in
investment: ↓ I

Question 3

is there room for macroeconomic policy in the RBC model?

Answer 3

There is no room for macro policy because equilibrium in the RBC model exhibits
Pareto-efficiency (First Welfare Theorem): nothing should be done to prevent or
stabilize business cycles
Business cycles are just the efficient way for the economy to respond to changes in TFP
Any attempt to intervene would worsen the resource allocation and reduce the welfare of
the representative household!

Question 4

what are the critisms of the RBC model?

Answer 4

1 mechanism for generating recessions is not plausible
2 It is inappropriate to treat measured TFP (Solow residuals) as productivity shocks
(exogenous technological advances or disasters
3) the model does not feature any unemployment
4) the model requires implausible parameter values

Question 5

what does the critism “Mechanism for generating recessions is not plausible” mean?

Answer 5

Main RBC statement, taken literally: recessions are times of technological regress
Prescott 1986: exogenous technology shocks ’account for more than half the
fluctuations in the postwar period with a best point estimate near 75%’
Gali 1999: TFP shocks cannot be considered a business cycle impulse
Empirical finding: hours worked fall in response to a positive shock to technology
RBC models can only explain normal fluctuations rather than crises (mild fluctuations
rather than dramatic episodes)
What caused the Great Depression?
RBC answer: unusual combination of bad shocks compounded by bad policy

Question 6

what does the critism “Mechanism for generating recessions is not plausible” mean?

Answer 6

TFP not equal to technology.
Wedges between TFP and technology:
Variable capital utilization (captured by changes in energy consumption or by
changes in material inputs: iron ore, plastic, fabrics…)
Variability in labour effort ⇔ labour hoarding
Hall 1988: Solow residual is correlated with the political party of the president,
millitary purchases, and oil price movements

Question 7

what does the critism “ the model does not feature any unemploymen” mean?

Answer 7

in RBC, households can choose how much labour to provide each period at the
market wage =⇒ no one is ever unemployed!
The model provides a theory of changes in employment but not of changes in
unemployment

Question 8

what does the critism “the model requires implausible parameter values “ mean?

Answer 8

RBC is based on the correlation between working hours and productivity
Early versions of RBC needed implausibly high labour supply elasticity (possibly
infinite) to generate fluctuations in aggregate hours comparable to the data