Real Business Cycle models – scientific joke of the century?

25 April, 2012 at 08:54 | Posted in Economics | 1 Comment

From Noahpinion we get this nice piece on Real Business Cycle models:

It has often been said of the Holy Roman Empire that it was “neither Holy, nor Roman, nor an Empire.” However, that joke has gotten a bit stale since Voltaire wrote it in the 1700s, so I think it’s time for a new one. Real Business Cycle models, it turns out, are neither Real, nor about Business, nor about Cycles.

They are, however, the macro models that annoy me far more than any other (and I’m not alone). I’ll explain the joke in increasing order of the things that annoy me.

First, “Cycles”. The “business cycles” in RBC models are not periodic, like cycles in physics. But they are also not “cycles” in the sense that a bust must follow a boom. Booms and busts are just random shocks. The “business cycle” that we think we see, according to these models, is simply a statistical illusion. (Actually, RBC shares this property with New Keynesian and Old Keynesian models alike. Very few people dare to write down a model in which knowing you’re in a boom today allows you to predict a bust tomorrow!)

Next, “Business”. Businesses are called “firms” in economic models. But if you look at the firms in an RBC model, you will see that they bear very little resemblance to real-life firms. For one thing, they make no profits; their revenues equal their costs. For another thing, they produce only one good. (Also, like firms in many economic models, they are all identical, they live forever, they make all their decisions to serve the interests of households, and they make all decisions perfectly. Etc. etc.) In other words, they display very few of the characteristics that real businesses display. This means that the “business cycle” in an RBC model is not really the result of any interesting characteristics of businesses; everything is due to the individual decisions of consumers and workers, and to the outside force of technological progress.

Finally, “Real”. This is the one that really gets me. “Real” refers to the fact that the shocks in RBC models are “real” as opposed to “nominal” shocks (I’ve actually never liked this terminology, since it seems to subtly imply that money is neutral, which it isn’t). But one would have to be a fool not to see the subtext in the use of the term – it implies that business-cycle theories based on demand shocks are not, in fact, real; that recessions and booms are obviously caused by supply shocks. If RBC is “real”, then RBC’s competitors – Keynesian models and the like – must be fantasy business cycle models.

However, it turns out that RBC and reality are not exactly drinking buddies. I hereby outsource the beatdown of the substance of RBC models to one of the greatest beatdown specialists in the history of economics: the formidable Larry Summers. In a 1986 essay … Summers identified three main reasons why RBC models are not, in fact, real:

1. RBC models use parameter values that are almost certainly wrong,

2. RBC models make predictions about prices that are completely, utterly wrong, and

3. The “technology shocks” that RBC models assume drive the business cycle have never been found.

I encourage everyone to go read the whole thing. Pure and utter pulpification! Actually, this essay was assigned to me on the first day of my intro macro course, but at the time I wasn’t able to appreciate it.

So Real Business Cycle models are neither Real, nor about Business, nor about Cycles. Are they models? Well, sadly, yes they are…of a sort. You actually can put today’s data into an RBC model and get a prediction about future data. But see, here’s the thing: that prediction will be entirely driven by the most ad-hoc, hard-to-swallow part of the model!

 

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  1. I like this part:

    “For one thing, they make no profits; their revenues equal their costs. For another thing, they produce only one good. (Also, like firms in many economic models, they are all identical, they live forever, they make all their decisions to serve the interests of households, and they make all decisions perfectly. Etc. etc.)”

    When I studied basics in Economy in my youth, I understood that these “firms” were models of firms used to create another model. It never entered my mind that these “firms” where used also in the very, very advanced high-brow Economics, and definitely not to make predictions. I thought this was simply a way to teach beginners the basics. Why do journalist never discuss this fundamental flaw, at least not in Sweden?

    Very soon someone employed at Cambridge will say something like: This is a better model than any other we have, and very much better than any Old-Keynesian model, and anyway I haven’t read General Theory, because my gurus have told me it is incomprehensible.

    I will try to live with that, I can’t afford to send my children to Cambridge anyway.


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