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6.16 Criticisms of Real Business Cycle Theory

In this section we will review some of the more important criticisms of real

business cycle theory. For critical surveys of the literature, the reader is

referred to Summers (1986), Hoover (1988), Sheffrin (1989), Mankiw (1989),

McCallum (1989), Phelps (1990), Eichenbaum (1991), Stadler (1994), and

Hartley et al. (1997, 1998).

The conventional neoclassical analysis of labour supply highlights two

opposing effects of an increase in the real wage. A higher real wage induces

an increase in labour supply through the substitution effect, but at the same

time a higher real wage also has an income effect that induces a worker to

consume more leisure. In real business cycle models the substitution effect

must be very powerful compared to the income effect if these models are to

plausibly explain large variations of employment induced by technology

shocks. But, as we have already noted, the available micro evidence relating

to the intertemporal elasticity of substitution in labour supply indicates a

weak response to transitory wage changes. If the wage elasticity of labour

supply is low, then technological shocks that shift the labour demand curve

(see Figure 6.3) will produce large variability of real wages and lower variability

of employment. However, the variations in employment observed over

the business cycle seem to be too large to be accounted for by intertemporal

substitution. In addition, Mankiw (1989) has argued that the real interest rate

is not a significant consideration in labour supply decisions. How, for example,

can agents be expected to accurately predict future interest rates and real

wages in order to engage in intertemporal substitution?

A second major criticism of real business cycle theory relates to the reliance

of these models on mainly unobservable technology shocks. Many

economists doubt whether the technology shocks required in order to generate

business cycle phenomena are either large enough or frequent enough. In

these models large movements in output require significant aggregate disturbances

to technology. Muellbauer (1997) argues that the kind of technological

volatility implied by REBCT is ‘quite implausible’ for three reasons, namely:

(i) technological diffusion tends to be slow; (ii) aggregation of diffusion

processes tends to produce a smooth outcome in aggregate; and (iii) the

technical regress required to produce recessions cannot be given plausible

microfoundations. In relation to this issue, Summers (1986) rejects Prescott’s

use of variations in the Solow residual as evidence of significant shocks to

technology. Large variations in the Solow residual can be explained as the

outcome of ‘off the production function behaviour’ in the form of labour

hoarding. Whereas real business cycle theorists interpret procyclical labour

productivity as evidence of shifts in the production function, the traditional

Keynesian explanation attributes this stylized fact to the quasi-fixity of the

labour input. The reason why productivity falls in recessions is that firms

retain more workers than they need, owing to short-run adjustment costs. In

such circumstances it will pay firms to smooth the labour input over the

cycle, which implies the hoarding of labour in a cyclical downturn. This

explains why the percentage reduction in output typically exceeds the percentage

reduction in the labour input during a recession. As the economy

recovers, firms utilize their labour more intensively, so that output increases

by a larger percentage than the labour input.

In general many economists explain the procyclical movement of the Solow

residual by highlighting the underutilization of both capital and labour during

periods of recession. Following Abel and Bernanke (2001), we can illustrate

this idea by rewriting the production function given by (6.13) and (6.14) as

(6.18):

Y AF(KK,LL) A(KK)(LL)1−(6.18)

where K represents the underutilization rate of the capital input, and L

represents the underutilization rate of labour input. Substituting (6.18) for Y

in (6.15) we obtain a new expression (6.19) for the Solow residual that

recognizes that the capital and labour inputs may be underutilized.

Solow residual A(KK)(LL)1−/KL1−AK L 1−(6.19)

Equation (6.19) shows that the Solow residual can vary even if technology

remains constant. If the utilization rates of capital and labour inputs are

procyclical, as the empirical evidence suggests is the case, then we will

observe a procyclical Solow residual that reflects this influence (for discussions

of this issue see Fay and Medoff, 1985; Rotemberg and Summers,

1990; Bernanke and Parkinson, 1991; Burnside et al., 1995; Braun and Evans,

1998; Millard et al., 1997).

A third line of criticism relates to the idea of recessions being periods of

technological regress. As Mankiw (1989, p. 85) notes, ‘recessions are important

events; they receive widespread attention from the policy-makers and the

media. There is, however, no discussion of declines in the available technology.

If society suffered some important adverse technological shock we

would be aware of it.’ In response to this line of criticism, Hansen and

Prescott (1993) have widened the interpretation of technological shocks so

that any ‘changes in the production functions, or, more generally, the production

possibility sets of the profit centres’ can be regarded as a potential source

of disturbance. In their analysis of the 1990–91 recession in the USA, they

suggest that changes to the legal and institutional framework can alter the

incentives to adopt certain technologies; for example, a barrage of government

regulations could act as a negative technology shock. However, as

Muellbauer (1997) points out, the severe recession in the UK in the early

1990s is easily explained as the consequence of a ‘massive’ rise in interest

rates in 1988–9, an associated collapse of property prices, and UK membership,

at an overvalued exchange rate, of the ERM after October 1990. Few of

these influences play a role in REBCT.

An important fourth criticism relates to the issue of unemployment. In real

business cycle models unemployment is either entirely absent or is voluntary.

Critics find this argument unconvincing and point to the experience of the

Great Depression, where ‘it defies credulity to account for movements on this

scale by pointing to intertemporal substitution and productivity shocks’ (Summers,

1986). Carlin and Soskice (1990) argue that a large proportion of the

European unemployment throughout the 1980s was involuntary and this represents

an important stylized fact which cannot be explained within a new

classical framework. Tobin (1980b) also questioned the general approach of

new classical economists to treat all unemployment as voluntary. The critics

point out that the pattern of labour market flows is inconsistent with equilibrium

theorizing. If we could explain unemployment as the result of voluntary

choice of economic agents, then we would not observe the well-established

procyclical movement of vacancy rates and voluntary quits. Recessions are

not periods where we observe an increase in rate of voluntary quits! In

Blinder’s view, the challenge posed by high unemployment during the 1980s

was not met by either policy makers or economists. In a comment obviously

directed at real business cycle theorists, Blinder (1988b) notes that ‘we will

not contribute much toward alleviating unemployment while we fiddle around

with theories of Pareto optimal recessions – an avocation that might be called

Nero-Classical Economics’. Although the intersectoral shifts model associated

with Lilien (1982) introduces unemployment into a model where

technology shocks motivate the need to reallocate resources across sectors,

the critics regard the neglect of unemployment in real business cycle theory

as a major weakness (see Hoover, 1988).

A fifth objection to real business cycle theory relates to the neutrality of

money and the irrelevance of monetary policy for real outcomes. It is a matter

of some irony that these models emerged in the early 1980s when in both the

USA and the UK the monetary disinflations initiated by Volcker and Thatcher

were followed by deep recessions in both countries. The 1990–92 economic

downturn in the UK also appears to have been the direct consequence of

another dose of monetary disinflation. In response to this line of criticism,

real business cycle theorists point out that the recessions experienced in the

early 1980s were preceded by a second major oil shock in 1979. However,

the majority of economists remain unconvinced that money is neutral in the

short run (see Romer and Romer, 1989, 1994a, 1994b; Blanchard, 1990a;

Ball, 1994; and Chapter 7).

A sixth line of criticism relates to the important finding by Nelson and

Plosser that it is hard to reject the view that real GNP is as persistent as a

random walk with drift. This finding appeared to lend support to the idea that

fluctuations are caused by supply-side shocks. The work of Nelson and

Plosser (1982) showed that aggregate output does not appear to be trendreverting.

If fluctuations were trend-reverting, then a temporary deviation of

output from its natural rate would not change a forecaster’s estimate of output

in ten years’ time. Campbell and Mankiw (1987, 1989), Stock and Watson

(1988) and Durlauf (1989) have confirmed the findings of Nelson and Plosser.

As a result, the persistence of shocks is now regarded as a ‘stylised fact’ (see

Durlauf, 1989, p. 71). However, Campbell, Mankiw and Durlauf do not accept

that the discovery of a near unit root in the GNP series is clear evidence

of real shocks, or that explanations of fluctuations based on demand disturbances

should be abandoned. Aggregate demand could have permanent effects

if technological innovation is affected by the business cycle or if hysteresis

effects are important (see Chapter 7). Durlauf has shown how, in the presence

of coordination failures, substantial persistence in real activity can result

from aggregate demand shocks. This implies that demand-side policies can

have long-lasting effects on output. Stadler (1990) has also shown how the

introduction of endogenous technological change fundamentally alters the

properties of both real and monetary theories of the business cycle. REBCT

does not provide any deep microeconomic foundations to explain technologi336

cal change and innovative activity. But the plausible dependence of technological

progress on economic factors such as demand conditions, research

and development expenditures and ‘learning by doing’ effects (Arrow, 1962)

implies that changes on the supply side of the economy are not independent

of changes on the demand side. Hence an unanticipated increase in nominal

aggregate demand can induce technology changes on the supply side which

permanently increase output. In such a model the natural rate of unemployment

will depend on the history of aggregate demand as well as supply-side

factors. A purely monetary model of the business cycle where technology is

endogenous can also account for the Nelson and Plosser finding that output

appears to follow a random walk.

A seventh criticism relates to the pervasive use of the representative agent

construct in real business cycle theory. Real business cycle theorists sidestep

the aggregation problems inherent in macroeconomic analysis by using a

representative agent whose choices are assumed to coincide with the aggregate

choices of millions of heterogeneous individuals. Such models therefore

avoid the problems associated with asymmetric information, exchange and

coordination. To many economists the most important questions in macroeconomic

theory relate to problems associated with coordination and

heterogeneity. If the coordination question and the associated possibility of

exchange failures lie at the heart of economic fluctuations, then to by-pass the

problem by assuming that an economy is populated only by Robinson Crusoe

is an unacceptable research strategy for many economists (see Summers,

1986; Kirman, 1992; Leijonhufvud, 1992, 1998a; Akerlof, 2002; Snowdon,

2004a).

A final important criticism relates to the lack of robust empirical testing

(see Fair, 1992; Laidler, 1992a; Hartley et al., 1998). As far as the stylized

facts are concerned, both new Keynesian and real business cycle theories can

account for a broad pattern of time series co-movements (see Greenwald and

Stiglitz, 1988). In an assessment of the empirical plausibility of real business

cycle theory, Eichenbaum (1991) finds the evidence put forward by its proponents

as ‘too fragile to be believable’.