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6.2 The Transition from Monetary to Real Equilibrium Business Cycle Theory

As we have seen in Chapter 5, the dominant new classical theory of the

business cycle during the period 1972–82 was the monetary surprise model

(MEBCT) initially developed by Lucas (1975, 1977). Since the early 1980s

the leading new classical explanation of aggregate instability has focused on

real rather than monetary shocks, and after the contribution of Long and

Plosser (1983) became known as real (equilibrium) business cycle theory

(REBCT). The best-known advocates or contributors to this approach are

Edward Prescott of the University of Minnesota, Finn Kydland of Carnegie-

Mellon University, Charles Plosser, John Long and Alan Stockman of the

University of Rochester, Robert King of Boston University, Sergio Rebelo of

Northwestern University and Robert Barro of Harvard University (see interviews

with Robert Barro and Charles Plosser in Snowdon et al. 1994).

In the early 1980s, in response to recognized weaknesses in the MEBCT

some new classical theorists sought to provide a rigorous equilibrium account

of the business cycle which is both free from the theoretical flaws of earlier

new classical models and would, at the same time, be empirically robust. The

result has been the development of REBCT, which replaces the impulse

mechanism of the earlier models (that is, unanticipated monetary shocks)

with supply-side shocks in the form of random changes in technology. The

propagation mechanisms of the earlier new classical models are, however,

retained and developed. Ironically it was Tobin (1980b) who was one of the

first to recognize this unlikely escape route for equilibrium theorists. In

criticizing the monetary misperception stories of Lucas, Tobin noted that the

‘real equilibrium of a full information model could move around, driven by

fluctuations in natural endowments, technologies and tastes’ and, if such

fluctuations were seriously persistent random processes, the observations

generated ‘may look like business cycles’. Meanwhile, around 1980, Kydland

and Prescott were working on just such a model and two years after Tobin

made his comments Econometrica published Kydland and Prescott’s paper

containing their prototype non-monetary equilibrium model.

Before moving on to consider real business cycle theory in more detail, it

is interesting to note the reaction to this second phase of equilibrium theorizing

of two of the leading pioneers of the new classical mark I approach. In

Robert Lucas’s view, Kydland and Prescott have taken macroeconomic modelling

‘into new territory’ (Lucas, 1987). However, Lucas’s initial reaction to

REBCT was to suggest that the exclusive focus of such models on real as

opposed to monetary considerations was ‘a mistake’ and argued the case for a

‘hybrid’ model as a fruitful way forward. Nevertheless Lucas warmly approved

of the methodology adopted by real business cycle theorists who have

followed his own earlier recommendation that an understanding of business

cycles is best achieved ‘by constructing a model in the most literal sense: a

fully articulated artificial economy which behaves through time so as to

imitate closely the time series behaviour of actual economies’ (Lucas, 1977).

Such artificial economic systems can serve as laboratories ‘in which policies

that would be prohibitively expensive to experiment with in actual economies

can be tested out at much lower cost’ (Lucas, 1980a). This is exactly what

real business cycle theorists established as their research agenda during the

1980s, and Lucas’s (1980a) paper is the reference point for the modern era of

equilibrium theorizing. As Williamson (1996) points out, ‘in Lucas one finds

a projection for future research methodology which is remarkably close to

the real business cycle program’.

By 1996 Lucas admitted that ‘monetary shocks just aren’t that important.

That’s the view that I’ve been driven to. There is no question that’s a retreat

in my views’ (see Gordon, 2000a, p. 555). Meanwhile Lucas has put forward

the view several times that he considers the business cycle to be a relatively

‘minor’ problem, at least at the level experienced since 1945 (Lucas, 1987,

2003). In his view it is far more important to understand the process of

economic growth if we are really interested in raising living standards, rather

than trying to devise ever more intricate stabilization policies in order to

remove the residual amount of business cycle risk (see Lucas, 1988, 1993,

2002, 2003, and Chapter 11).

By the late 1980s Robert Barro (1989a, 1989c) also declared that the

emphasis given by new classical economists during the 1970s to explaining

the non-neutrality of money was ‘misplaced’ because the ‘new classical

approach does not do very well in accounting for an important role for money

in business fluctuations’. By the mid-1980s, Barro regarded the contributions

of real business cycle theorists as ‘especially promising’ and representing

‘real progress’ (Barro, 1984). Furthermore, his own work had provided a

bridge between the mark I and mark II versions of new classical macroeconomics

(see Barro, 1981). In any case the lack of robust empirical success of

the earlier models does not invalidate the achievements of the new classical

theorists in the 1970s which in Barro’s view led to ‘superior methods of

theoretical and empirical analysis’ (Barro, 1984).

The three main new classical achievements identified by Barro (1989a) are

(i) the application of equilibrium modelling to macroeconomic analysis, (ii)

the adoption and promotion of the rational expectations hypothesis, and (iii)

the application of game theory to policy making and evaluation. The first two

contributions satisfy the objectives of building macro models on choicetheoretic

microfoundations, as well as providing an analytical framework

which can better withstand the Lucas (1976) critique. The third area relating

to dynamic games has drawn out the importance in policy analysis of the

roles of commitment, credibility and reputation as well as clarifying the

distinction between rules and discretion. The insights gained relating to the

time inconsistency of policy have now been applied to a wide variety of areas

other than the conduct of monetary policy. Although Barro remains enthusiastic

about real business cycle theory, he, like Lucas, began to redirect his

research work in the late 1980s primarily towards issues related to economic

growth (see Barro, 1991, 1997; Barro and Sala-i-Martin, 1995).

For detailed surveys of the evolution and development of REBCT, the

reader is referred to Walsh (1986), Rush (1987), Kim (1988), Plosser (1989),

Mullineux and Dickinson (1992), McCallum (1992), Danthine and Donaldson

(1993), Stadler (1994), Williamson (1996), Ryan and Mullineux (1997), Snowdon

and Vane (1997a), Hartley et al. (1998), Arnold (2002), and Kehoe and

Prescott (2002).