RBC Model

Basic Model

Key assumptions:

• Productivity shocks ($A$) are primary cause of business cycles
• Prices and wages adjust rapidly
  • economy always in or near General Eq

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Negative Productivity Shock (A↓)

$$\begin{array}{r}\bar{N}\uparrow ⟹\underrightarrow{\mathrm{FE}}\\ P\uparrow ⟹\underleftarrow{\mathrm{LM}}\end{array}$$

Real consumption: ↓ as Y ↓

Real investment: ↓ as $r$ ↑

Real wage: ↓ as MPN ↓

Inflation: ↑ as $P$ ↑

Graph

Solow Residual: the part of output that cannot be directly explained by measured capital and labor inputs

• strongly procyclical

$\frac{Y}{K^{\alpha }{N}^{1-\alpha }}=A$

Critiques of RBC

Source of Productivity Shocks

Measurement - Solow Residual

$$\frac{Y}{K^{\alpha }{N}^{1-\alpha }}=A$$

Output not directly explained by $K$ or $N$ is attributed to $A$ empirically it is strongly procyclical, however this does not necessarily mean that A is solely responsible.

• Solow residual captures changes in utilization as well as $A$
• Solow residual predicted by factors such as $G$

Cyclicality of Unemployment

Unemployment rises in recessions because productivity shocks cause increased mismatches between workers and jobs

• this idea is not supported by the evidence

Gov Responses in RBC

Fiscal Policy

Assume Ricardian Equivalence: $G\uparrow ⟹T\uparrow$

Government Spending Increase (G↑)

IS curve shifts right

FE curve shifts right: $T\uparrow ⟹N\uparrow$

LM curve shifts left: $Y>\bar{Y}⟹P\uparrow$

Real consumption: ↓ as Y ↓

Real investment: ↓ as $r$ ↑

Real wage: ↓ as $P\uparrow$

Labor Productivity: $\downarrow$ as $N\uparrow$

Graph

Benefits of Fiscal Policy: Y $\uparrow$

Costs of Fiscal Policy:

• workers may be worse off $N\uparrow$ but $w\downarrow$
• may be lags in implementing fiscal policy

RBC: gov should only $G\uparrow$ when benefits exceed costs

Monetary Policy

Neutrality of money: no real effects

• this does not align with empiricism

Misperception Theory

motivated by empirical facts not matching up with model in terms of monetary policy

• Producers form expectations about the general price level
• Producers have imperfect information
• When expectations $\ne$ actual price changes, they perceive the change in general price level as a change in the relative price of their products (misperception)

New SRAS curve

$$Y-\bar{Y}=b(P-P^e)$$

where $P^e$ is the expected price level and $b$ is positive constant that describes how strongly output reacts to deviation in $P-P^e$

In the short run $P$ changes but $P^e$ does not In the long run $P^e$ changes

Factors that shift SRAS

• changes in $\bar{Y}$ or $P^e$

$\bar{Y}\uparrow ⟹$ SRAS shifts right $P^e\uparrow ⟹$ SRAS shifts left