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Real business cycle theory: wisdom or whimsy?

  • Martin Eichenbaum

This paper assesses the empirical plausibility of the view that aggregate productivity shocks account for most of the variability in post World War II US output. We argue that the type of evidence forwarded by proponents of this proposition is too fragile to be believable. First, our confidence in the evidence is fundamentally affected once we abandon the fiction that we actually know the true values of the structural parameters of standard Real Business Cycle (RBC) models. What the data are telling us is that, while productivity shocks play some role in generating the business cycle, there is simply an enormous amount of uncertainty about just what percent of aggregate fluctuations they actually do account for. The answer could be 70% as Kydland and Prescott (1989) claim, but the data contain almost no evidence against either the view that the answer is really 5% or that the answer is really 200%. Second, we show that point estimates of the importance of technology shocks are extremely sensitive to small perturbations in the theory. Allowing for labor hoarding behavior in an otherwise standard RBC model reduces the ability of technology shocks to account for aggregate fluctuations by 50%. This finding provides some support for the view that many of the movements in the Solow residual which are labelled as productivity shocks may be an artifact of labor hoarding type phenomena.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series, Macroeconomic Issues with number 90-13.

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Date of creation: 1990
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Handle: RePEc:fip:fedhma:90-13
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  1. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  2. Robert E. Hall, 1986. "The Relation Between Price and Marginal Cost in U.S. Industry," NBER Working Papers 1785, National Bureau of Economic Research, Inc.
  3. Kydland, Finn E & Prescott, Edward C, 1991. "Hours and Employment Variation in Business Cycle Theory," Economic Theory, Springer, vol. 1(1), pages 63-81, January.
  4. Prescott, Edward C., 1986. "Theory ahead of business-cycle measurement," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 11-44, January.
  5. Leamer, Edward E, 1983. "Let's Take the Con Out of Econometrics," American Economic Review, American Economic Association, vol. 73(1), pages 31-43, March.
  6. Gary D. Hansen, 1989. "Technical Progress and Aggregate Fluctuations," UCLA Economics Working Papers 546, UCLA Department of Economics.
  7. Hansen, Gary D., 1985. "Indivisible labor and the business cycle," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 309-327, November.
  8. Robert J. Hodrick & Edward Prescott, 1981. "Post-War U.S. Business Cycles: An Empirical Investigation," Discussion Papers 451, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  9. Richard Rogerson, 2010. "Indivisible Labor, Lotteries and Equilibrium," Levine's Working Paper Archive 250, David K. Levine.
  10. Kydland, Finn E. & Prescott, Edward C., 1988. "The workweek of capital and its cyclical implications," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 343-360.
  11. King, Robert G. & Rebelo, Sergio T., 1993. "Low frequency filtering and real business cycles," Journal of Economic Dynamics and Control, Elsevier, vol. 17(1-2), pages 207-231.
  12. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 1993. "Labor Hoarding and the Business Cycle," Journal of Political Economy, University of Chicago Press, vol. 101(2), pages 245-73, April.
  13. Lawrence J. Christiano & Martin Eichenbaum, 1990. "Current real business cycle theories and aggregate labor market fluctuations," Discussion Paper / Institute for Empirical Macroeconomics 24, Federal Reserve Bank of Minneapolis.
  14. Robert E. Hall, 1989. "Invariance Properties of Solow's Productivity Residual," NBER Working Papers 3034, National Bureau of Economic Research, Inc.
  15. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  16. Evans, Charles L., 1992. "Productivity shocks and real business cycles," Journal of Monetary Economics, Elsevier, vol. 29(2), pages 191-208, April.
  17. Lawrence H. Summers, 1986. "Some skeptical observations on real business cycle theory," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 23-27.
  18. Robert J. Gordon, 1979. "The "End-of-Expansion" Phenomenon in Short-Run Productivity Behavior," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 10(2), pages 447-462.
  19. Blanchard, Olivier Jean, 1989. "A Traditional Interpretation of Macroeconomic Fluctuations," American Economic Review, American Economic Association, vol. 79(5), pages 1146-64, December.
  20. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
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