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6.18 An Assessment

In his Yrjo Jahnsson lectures, given in 1978, James Tobin noted that ‘there is no

economic business cycle theory, new or old, involved in assuming that waves of

economic activity simply mirror waves in underlying technology and taste’

(Tobin, 1980a, p. 37). This state of affairs was to change dramatically during

the 1980s when, following the widespread rejection of the monetary misperception

version of equilibrium theory, real business cycle models proliferated.

The research initiated by Nelson and Plosser provided substantial support for

the view that shocks to aggregate output tend to have long-lasting effects.

Output does not appear to revert to a deterministic trend. This finding has had a

profound influence on business cycle research, in that it suggests that much of

the disturbance to aggregate output that we witness is caused by supply-side

influences. By demonstrating that equilibrium models are not inconsistent with

aggregate instability, real business cycle theorists have challenged the conventional

wisdom and forced theorists on all sides to recognize just how deficient

our knowledge is of business cycle phenomena. The real business cycle approach

has therefore performed a useful function in raising profound questions

relating to the meaning, significance and characteristics of economic fluctuations.

We have seen in this chapter how REBCT is a continuation of the research

programme, stimulated in the modern era by Lucas, that aims to explore the

general equilibrium intertemporal characteristics of macroeconomics (Wickens,

1995). In doing so, REBCT has integrated the theory of growth and fluctuations

and irreversibly changed the direction of business cycle research. New insights

have been gained, along with innovative modelling techniques.

More than 30 years ago, Harry Johnson (1971), in his lecture to the 1970

meeting of the American Economic Association, attempted to provide reasons

for the rapid propagation of the Keynesian revolution in order to better

understand the monetarist counter-revolution which during the late 1960s and

early 1970s had begun to fill the intellectual vacuum created by the retreat of

the Keynesian orthodoxy in the face of accelerating inflation. In Johnson’s

highly perceptive article, attention was drawn to the shared characteristics of

both the Keynesian revolution and the monetarist counter-revolution which

appear important in explaining the success of these developments. According

to Johnson, there are two types of factor which can help explain the rapid

acceptance and propagation of new ideas among professional economists.

The first factor relates to the ‘objective social situation in which the new

theory was produced’. The second important factor encompasses the ‘internal

scientific characteristics of the new theory’. We would argue that these factors

can help in understanding the rapid propagation of new classical ideas,

both the MEBCT and the REBCT (see Snowdon and Vane, 1996).

Although an established orthodoxy, such as trend-reverting cycles, which

is in apparent contradiction to the ‘most salient facts of reality’ is the ‘most

helpful circumstance for the rapid propagation of a new and revolutionary

theory’, Johnson also identified five internal scientific characteristics which

in his view were crucial because it was these aspects of the new theory which

appealed to the younger generation of economists. In summary, the five main

characteristics Johnson identified involved:

1. ‘a central attack, on theoretically persuasive grounds, on the central

proposition of the orthodoxy of the time’;

2. ‘the production of an apparently new theory that nevertheless absorbed

all that was valid in the existing theory’;

3. a new theory having an ‘appropriate degree of difficulty to understand’

that would ‘challenge the intellectual interest of younger colleagues and

students’;

4. ‘a new more appealing methodology’ than that prevailing;

5. ‘the advancement of a new and important empirical relationship suitable

for determined estimation’ by econometricians.

To what extent have these five internal scientific characteristics played an

important role in explaining the success of new classical macroeconomics, in

particular the REBCT?

The first characteristic (that is, an attack on a central proposition of the

established orthodoxy) can be straightforwardly identified in REBCT. Before

1980 the established consensus regarded business cycles as socially undesirable.

In sharp contrast, the main policy implication of real business cycle

theory is that because the existence of fluctuations in aggregate output does

not imply the failure of markets to clear, the government should refrain from

any attempt to reduce such fluctuations not only because such policies are

unlikely to achieve their desired objective, but also because reducing instability

would reduce welfare!

The application of Johnson’s second internal characteristic (that is, the

ability of a new theory to absorb as much as possible of the valid components

of the existing orthodox theory) can also be applied to REBCT, which has

pioneered the use of the orthodox neoclassical growth model as a framework

for the quantitative analysis of aggregate fluctuations as well as absorbing

much of the methodology advocated by Lucas in the 1970s.

Johnson’s third characteristic (that is, an intellectually challenging new

theory with appeal to the younger generation of economists) is one that again

can be readily applied to REBCT. There is no question that the new classical

revolution pushed macroeconomic theory into new, more abstract directions

involving the introduction of techniques not found in the ‘kit bags of the

older economists’ (Blinder, 1988b). Being better trained mathematically, the

younger generation has been able to absorb the new techniques, such as

calibration, giving them a ‘heavy competitive edge’ over the ‘older’ economists.

Turning to the fourth characteristic (that is, a new methodology), the

REBCT programme has wholeheartedly embraced a methodological framework

involving a formal general equilibrium approach. Responding to the

‘Lucas critique’ has fostered an emphasis on a return to first principles in the

quest to establish sound microfoundations for general equilibrium macroeconomic

models. Since real business cycle methodology is in principle

ideologically neutral, it has the capability of fostering models with enormous

diversity.

The fifth characteristic (concerning a ‘new and important empirical relationship’

for estimation) is more difficult to apply to REBCT developments.

Rather than attempting to provide models capable of conventional econometric

testing, real business cycle theorists have instead developed the ‘calibration

method’ in which the simulated results of their specific models (when hit by

random shocks) in terms of key macroeconomic variables are compared with

the actual behaviour of the economy. Unfortunately calibration does not

provide a method that allows one to judge between the performance of real

and other (for example Keynesian) business cycle models.

From the above discussion it should be evident that while Johnson put

forward five main ‘internal’ characteristics to help explain the success of the

Keynesian revolution and monetarist counter-revolution, the first four of these

same characteristics also help in understanding why REBCT has made such

an important impact on the development of macroeconomics since the early

1980s. In assessing whether or not REBCT has constituted a ‘fashion’ or a

‘revolution’ in macroeconomics, Kirschner and Rhee (1996) conclude from

their statistical analysis of the spread of scientific research that data on

publications and researchers in the REBCT field exhibit ‘mini-revolution’

characteristics.

A distinguishing feature of the early REBCT is the downplaying of monetary

influences as a major cause of business cycles. Instead random shocks

to technology play the major role in creating disturbances, and the desire of

economic agents for consumption smoothing and ‘time to build’ constraints

acts as a major propagation mechanism leading to persistence. While the

early REBCT models had too narrow a focus, more recent work has also

begun to add monetary and financial variables into the model, as well as to

extend this line of research to include government and open economy influences

(see Mendoza, 1991; Backus et al., 1992; Hess and Shin, 1997). Going

further and adding market imperfections to REBCT will provide a bridge

between new classical and new Keynesian approaches to business cycle research

(Wickens, 1995). We should also note that the real business cycle

approach has furthered the cause of those economists who insist that macro

models need to be based on a firmer microeconomic base. This in turn has

strengthened the general move to improve our understanding of the supply

side. If anyone seriously questioned it before, no one now doubts that macroeconomics

is about demand and supply and their interaction. As Blinder

(1987b) notes, ‘events in the 1970s and 1980s demonstrated to Keynesian

and new classical economists alike that Marshall’s celebrated scissors also

come in a giant economy size’.

While recognizing the achievements of the real business research programme,

the critics remain convinced that this approach has serious

deficiencies. A majority of economists believe that the short-run aggregate

demand disturbances that arise from monetary policy can have significant

real effects because of the nominal price and wage rigidities which characterize

actual economies (see Chapter 7). This important line of criticism

challenges the new classical assumption that markets continuously clear,

even in a recession. If markets do not clear quickly and the world is characterized

by both aggregate demand and aggregate supply disturbances, the

actual fluctuations that we observe will consist of a stochastic trend around

which output deviates as the result of demand shocks. This view is well

represented by Blanchard and Quah (1989) where they ‘interpret fluctuations

in GNP and unemployment as due to two types of disturbances: disturbances

that have a permanent effect on output and disturbances that do not. We

interpret the first as supply disturbances, the second as demand disturbances.’

Clearly the role of stabilization policy in such a world is immensely complicated,

even if we accept that demand disturbances are important. How, for

example, can a government make the requisite distinction between demand

and supply shocks, especially when such shocks are not independent but

interdependent? (see Friedman, 1992).

Further support for keeping an open mind on the causes of aggregate

instability is provided by G.M. Caporale (1993). In an investigation of business

cycles in the UK, France, Finland, Italy, Norway, Sweden and West

Germany, Caporale found that that neither demand nor supply shocks alone

could account for economic fluctuations. Recent empirical research by Temin

(1998) also finds a variety of causes responsible for US business cycles.

Temin suggests a four-way classification of the causes of US business cycles

over the twentieth century, namely Domestic Real, Domestic Monetary, Foreign

Real and Foreign Monetary. According to Temin’s data it appears that

domestic causes far outweigh foreign shocks (16.5 v. 7.5), and real disturbances

dominate monetary disturbances (13.5 v. 10.5). The real domestic

shocks are diverse and include all manner of real demand disturbance. Temin

concludes that ‘all four types of shock have acted as a source of the American

business cycle’ and the dominant conclusion of his enquiry is that ‘the sources

of instability are not homogeneous’. In his study of large recessions in the

twentieth century, Dow (1998) discusses three major findings. First, major

recessions and growth slowdowns are mainly due to aggregate demand shocks.

Second, these demand shocks can be identified, for example, the 1979–82

recession in the UK was largely the result of a decline in exports brought

about by an appreciation of the exchange rate in response to the new monetary

and fiscal regime under Prime Minister Margaret Thatcher. Third,

recessions are not predictable given economists’ present state of knowledge.

A balanced conclusion from the above discussion would seem to point

towards the advantage of taking an eclectic approach when analysing the

causes of business cycles. There is no evidence that the business cycle is dead

or that governments now have the ability and knowledge to offset the various

shocks that buffet every economy. While governments can never hope to

eliminate the business cycle, they should have the knowledge and capacity to

avert another Great Depression or Great Inflation.

In a recent assessment of the contribution of REBCT to twentieth-century

macroeconomics (see Snowdon, 2004a), Axel Leijonhufvud commented:

I think the legacy of Ed Prescott’s work will be in terms of the analytical machinery

available to technically minded economists, although those techniques are not

always appropriate and you cannot always apply them. In particular, you cannot

meaningfully run these dynamic stochastic general equilibrium models across the

great catastrophes of history and hope for enlightenment.

Even taking into account these important deficiencies, there is no doubt that

the REBCT research programme has been ‘extremely influential’ and current

work in the field is ‘a far cry’ from the initial representative agent competitive

(and unique) equilibrium model constructed by Kydland and Prescott in the

early 1980s (Williamson, 1996). However, while noting that new and controversial

ideas are often the most fruitful, even when false, Hartley et al. (1998)

conclude that ‘real business cycle models are bold conjectures in the Popperian

mould and that, on the preponderance of the evidence, they are refuted’.

However, for those economists who reject the real business cycle view that

stabilization policy has no role to play, there remains the theoretical difficulty

of explaining in a coherent way why markets fail to clear.

Beginning in the late 1970s, and continuing thereafter, many economists

have taken up this challenge of attempting to explain why the adjustment of

prices and wages in many markets is sluggish. ‘The rationality of rigidities’

theme is a major feature of the research of new Keynesian economists and it

is to this work that we turn in the next chapter.

Edward Prescott was born in 1940 in Glens Falls, New York and obtained his

BA (Maths) from Swarthmore College in 1962, his MS (Operations Research)

from Case Institute of Technology in 1963 and his PhD from

Carnegie-Mellon University in 1967. He was Assistant Professor of Economics

at the University of Pennsylvania (1966–71), Assistant Professor (1971–2),

Associate Professor (1972–5) and Professor of Economics (1975–80) at

Carnegie-Mellon University, and Regents’ Professor at the University of Minnesota

(1980–2003). Since 2003 he has been Professor of Economics at

Arizona State University .

Professor Prescott is best known for his highly influential work on the

implications of rational expectations in a variety of contexts and more

recently the development of stochastic dynamic general equilibrium theory.

He is widely acknowledged as a leading advocate of the real business cycle

approach to economic fluctuations. In 2004 he was awarded, with Finn

Kydland, the Nobel Memorial Prize in Economics for ‘contributions to

dynamic macroeconomics: the time consistency of economic policy and the

driving forces behind business cycles’. Among his best-known books are:

Recursive Methods in Economic Dynamics (Harvard University Press, 1989),

co-authored with Nancy Stokey and Robert E. Lucas Jr, and Barriers to

Riches (MIT Press, 2000), co-authored with Stephen Parente. His most

widely read articles include: ‘Investment Under Uncertainty’, Econometrica

EDWARD C. PRESCOTT

Edward C. Prescott 345

(1971), co-authored with Robert E. Lucas Jr; ‘Rules Rather Than Discretion:

The Inconsistency of Optimal Plans’, Journal of Political Economy

(1977), co-authored with Finn Kydland; ‘Time to Build and Aggregate

Fluctuations’, Econometrica (1982), co-authored with Finn Kydland; ‘Theory

Ahead of Business Cycle Measurement’, Federal Reserve Bank of

Minneapolis Quarterly Review (1986); ‘Business Cycles: Real Facts and a

Monetary Myth’, Federal Reserve Bank of Minneapolis Quarterly Review

(1990), co-authored with Finn Kydland; ‘The Computational Experiment:

An Econometric Tool’, Journal of Economic Perspectives (1996), co-authored

with Finn Kydland; and ‘Prosperity and Depression’, American Economic

Review (2002).

We interviewed Professor Prescott in Chicago, in his hotel room, on 3 January

1998, while attending the annual conference of the American Economic

Association.

Background Information

Where and when did you first study economics?

I first studied economics as a graduate student at Carnegie-Mellon in 1963,

which was then the Carnegie Institute of Technology. As an undergraduate I

initially started out as a physics major – back then it was the Sputnik era and

that was the glamorous field. I had two boring laboratory courses, which I

didn’t enjoy, so I transferred into math.

What was it about economics that attracted you?

Having transferred from physics to math I first considered doing applied math

– I got my degree in operations research. Then I went to an interdisciplinary

programme and it seemed to me that the smartest, most interesting people were

doing economics. Bob Lucas was a new assistant professor when I arrived at

Carnegie-Mellon. My mentor, though, was Mike Lovell, a wonderful person.

Apart from Bob Lucas and Mike Lovell, did any of your other teachers stand

out as being particularly influential or inspirational?

Sure. Morie De Groot, a great Bayesian statistician.

With respect to your own research which economists have had the greatest

influence?

I would say Bob Lucas. Also Finn Kydland, who was a student of mine –

perhaps my two most important papers were written with Finn [Kydland and

Prescott, 1977, 1982].

For over 20 years you have had a very productive relationship with Finn

Kydland. When did you first meet him?

My first position after leaving Carnegie-Mellon was at the University of

Pennsylvania. When I came back to Carnegie-Mellon Finn was an advanced

graduate student there, ready to work on research. We had a very small

economics programme with approximately seven faculty members and seven

students. It was a good programme where students worked quite closely with

faculty members. Bob Lucas and I had a number of joint students – unlike

Bob I didn’t scare the students [laughter].