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6.14 Real Business Cycle Theory and the Stylized Facts

The rapidly expanding business cycle literature during the 1980s provoked

considerable controversy and discussion with respect to the ability of different

macroeconomic models to explain the ‘stylized facts’. As Danthine and

Donaldson (1993) point out, the real business cycle programme ‘has forced

theorists to recognise how incomplete our knowledge of business cycle phenomena

actually was’, and a major achievement of this literature has been to

‘free us to reconsider what we know about the business cycle’. Research in

this area has called into question much of the conventional wisdom with

respect to what are the established stylized facts. Controversy also exists over

which model of the business cycle best explains the agreed stylized facts. For

a detailed discussion of this debate, the reader is referred to Greenwald and

Stiglitz (1988), Kydland and Prescott (1990), Hoover (1991), Blackburn and

Ravn (1992), Smith (1992), Zarnowitz (1992b), Danthine and Donaldson

(1993); Judd and Trehan (1995); Ryan and Mullineux (1997); and Ryan

(2002). Here we will briefly discuss the controversy relating to the cyclical

behaviour of real wages and prices.

In both orthodox Keynesian and monetarist macroeconomic theories where

aggregate demand disturbances drive the business cycle, the real wage is

predicted to be countercyclical. In Keynes’s General Theory (1936, p. 17) an

expansion of employment is associated with a decline in the real wage and

the Keynesian models of the neoclassical synthesis era also assume that the

economy is operating along the aggregate labour demand curve, so that the

real wage must vary countercyclically.

Source: Plosser (1989).

Figure 6.9 The annual growth rates of technology and output in the USA,

1955–85

Referring back to Figure 2.6 panel (b) in Chapter 2, we can see that for a

given money wage W0 the real wage must vary countercyclically as aggregate

demand declines and the economy moves into a recession. The fall in aggregate

demand is illustrated by a shift of the AD curve from AD0 to AD1. If

prices are flexible but nominal wages are rigid, the economy moves from e0

to e1 in panel (b). With a fall in the price level to P1, and nominal wages

remaining at W0, the real wage increases to W0/P1 in panel (a) of Figure 2.6.

At this real wage the supply of labour (Ld) exceeds the demand for labour (Lc)

and involuntary unemployment of cd emerges. With the money wage fixed, a

falling price level implies a countercyclical real wage.

The theories associated with Friedman’s monetarism, as well as some early

new classical and new Keynesian models, also incorporate features which

imply a countercyclical real wage (see Fischer, 1977; Phelps and Taylor,

1977). In Gordon’s (1993) view, apart from the big oil shocks of the 1970s,

there is no systematic movement of real wages but, if anything, ‘there is

slight tendency of prices to rise more than wages in booms, implying counter-

cyclical real wages’. However, Kydland and Prescott (1990) find that the

real wage behaves in a ‘reasonably strong’ procyclical manner, a finding that

is consistent with shifts of the production function. The current consensus is

that the real wage is mildly procyclical, and this poses problems for both

traditional monetary explanations of the business cycle and real business

cycle theory (see Fischer, 1988; Brandolini, 1995; Abraham and Haltiwanger,

1995; Snowdon and Vane, 1995). If the real wage is moderately procyclical,

then shocks to the production function can significantly influence employment

only if the labour supply curve is highly elastic (see panel (b) of Figure

6.3). However, the empirical evidence does not offer strong support for the

significant intertemporal substitution required for real business cycles to

mimic the large variations in employment which characterize business cycles

(see Mankiw et al., 1985; Altonji, 1986; Nickell, 1990).

While the behaviour of the real wage over the cycle has been controversial

ever since Dunlop (1938) and Tarshis (1939) debated this issue with Keynes

(1939a), the assumption that prices (and inflation) are generally procyclical

was accepted by economists of varying persuasions. The procyclical behaviour

of prices is a fundamental feature of Keynesian, monetarist and the

monetary misperception version of new classical models (Lucas, 1977).

Mankiw (1989) has argued that, in the absence of recognizable supply shocks,

such as the OPEC oil price rises in the 1970s, the procyclical behaviour of the

inflation rate is a ‘well documented fact’. Lucas (1977, 1981a) also lists the

procyclical nature of prices and inflation as a basic stylized fact. In sharp

contrast to these views, Kydland and Prescott (1990) show that, in the USA

during the period 1954–89, ‘the price level has displayed a clear countercyclical

pattern’. This leads them to the following controversial conclusion:

 ‘We caution that any theory in which procyclical prices figure crucially in

accounting for postwar business cycle fluctuations is doomed to failure.’ This

conclusion is supported by Cooley and Ohanian (1991) and also in a study of

UK data by Blackburn and Ravn (1992), who describe the conventional

wisdom with respect to the procyclical behaviour of the price level as ‘a

fiction’. In their view the traditional presumption that prices are procyclical is

overwhelmingly contradicted by the evidence and they interpret their findings

as posing a ‘serious challenge’ for monetary explanations of the business

cycle. The evidence presented by Backus and Kehoe (1992), Smith (1992)

and Ravn and Sola (1995) is also supportive of the real business cycle view.

(For a defence of the conventional view, see Chadha and Prasad, 1993.)

To see why evidence of a countercyclical price level is supportive of real

business cycle models, consider Figure 6.10. Here we utilize the conventional

aggregate demand and supply framework with the price level on the vertical

axis. Because prices and wages are perfectly flexible, the aggregate supply

curve (AS) is completely inelastic with respect to the price level (although it

will shift to the right if technology improves or the real rate of interest

increases, leading to an increase in labour supply and employment; see Jansen

et al., 1994). The economy is initially operating at the intersection of AD and

AS0. If the economy is hit by a negative supply shock which shifts the AS

curve from AS0 to AS2, the equilibrium level of output falls from Y0 to Y2 for a

Figure 6.10 Supply shocks and the price level

given money supply. Aggregate demand and supply are brought into equilibrium

by a rise in the price level from P0 to P2. A favourable supply shock

which shifts the AS curve from AS0 to AS1 will lead to a fall in the price level

for a given money supply. The equilibrium positions a, b and c indicate that

the price level will be countercyclical if real disturbances cause an aggregate

supply curve to shift along a given aggregate demand curve. Referring back

to panel (b) of Figure (2.6), it is clear that fluctuations brought about by shifts

of the aggregate demand curve generate observations of a procyclical price

level. Keynesians argue that the countercyclical behaviour of the price level

following the clearly observable oil shocks of the 1970s does not present a

problem for the conventional aggregate demand and supply model and that

such effects had already been incorporated into their models by 1975 (see

Gordon, 1975; Phelps, 1978; Blinder, 1988b). What Keynesians object to is

the suggestion that the business cycle is predominantly caused by supply

shocks. The consensus view that prices are sometimes procyclical and sometimes

countercyclical indicates to an eclectic observer that both demand and

supply shocks are important in different periods. Judd and Trehan (1995) also

show that this debate is further complicated by the fact that the observed

correlations between prices and output in response to various shocks reflect

complex dynamic responses, and it is ‘not difficult to find plausible patterns

that associate either a demand or a supply shock with either negative or

positive correlations’.