What’s Wrong with Modern Macro? Part 3 Real Business Cycle and the Birth of DSGE Models

Part 3 in a series of posts on modern macroeconomics. Part 1 looked at Keynesian economics and part 2 described the reasons for its death. In this post I will explain dynamic stochastic general equilibrium (DSGE) models, which began with the real business cycle (RBC) model introduced by Kydland and Prescott and have since become the dominant framework of modern macroeconomics.


Ed Prescott and Finn Kydland meet with George W. Bush after receiving the Nobel Prize in 2004
Ed Prescott and Finn Kydland meet with George W. Bush after receiving the Nobel Prize in 2004 (Wikimedia Commons)

“What I am going to describe for you is a revolution in macroeconomics, a transformation in methodology that has reshaped how we conduct our science.” That’s how Ed Prescott began his Nobel Prize lecture after being awarded the prize in 2004. While he could probably benefit from some of Hayek’s humility, it’s hard to deny the truth in the statement. Lucas and Friedman may have demonstrated the failures of Keynesian models, but it wasn’t until Kydland and Prescott that a viable alternative emerged. Their 1982 paper, “Time to Build and Aggregate Fluctuations,” took the ideas of microfoundations and rational expectations and applied them to a flexible model that allowed for quantitative assessment. In the years that followed, their work formed the foundation for almost all macroeconomic research.

Real Business Cycle

The basic setup of a real business cycle (RBC) model is surprisingly simple. There is one firm that produces one good for consumption by one consumer. Production depends on two inputs, labor and capital, as well as the level of technology. The consumer chooses how much to work, how much to consume, and how much to save based on its preferences, the current wage, and interest rates. Their savings are added to the capital stock, which, combined with their choice of labor, determines how much the firm is able to produce.

There is no money, no government, no entrepreneurs. There is no unemployment (only optimal reductions in hours worked), no inflation (because there is no money), and no stock market (the one consumer owns the one firm). There are essentially none of the features that most economists before 1980 as well as non-economists today would consider critically important for the study of macroeconomics. So how are business cycles generated in an RBC model? Exclusively through shocks to the level of technology (if that seems strange it’s probably even worse than you expect – stay tuned for part 4). When consumers and firms see changes in the level of technology, their optimal choices change which then causes total output, the number of hours worked, and the level of consumption and investment to fluctuate as well. Somewhat shockingly, when the parameters are calibrated to match the data, this simple model does a good job capturing many of the features of measured business cycles. The following graphs (from Uhlig 2003) demonstrate a big reason for the influence of the RBC model.

Source: Harald Uhlig (2003): How well do we understand business cycles and growth? Examining the data with a real business cycle model.
Comparison of simple RBC model (including population growth and government spending shocks) and the data. Both simulated data (solid line) and true data (dashed) have been H-P filtered. Source: Harald Uhlig (2003): “How well do we understand business cycles and growth? Examining the data with a real business cycle model.”

Looking at those graphs, you might wonder why there is anything left for macroeconomists to do. Business cycles have been solved! However, as I will argue in part 4, the perceived closeness of model and data is largely an illusion. There are, in my opinion, fundamental issues with the RBC framework that render it essentially meaningless in terms of furthering our understanding of real business cycles.

The Birth of Dynamic Stochastic General Equilibrium Models

Although many economists would point to the contribution of the RBC model in explaining business cycles on its own, most would agree that its greater significance came from the research agenda it inspired. Kydland and Prescott’s article was one of the first of what would come to be called Dynamic Stochastic General Equilibrium (DSGE) models. They are dynamic because they study how a system changes over time and stochastic because they introduce random shocks. General equilibrium refers to the fact that the agents in the model are constantly maximizing (consumers maximizing utility and firms maximizing profits) and markets always clear (prices are set such that supply and demand are equal in each market in all time periods).

Due in part to the criticisms I will outline in part 4, DSGE models have evolved from the simple RBC framework to include many of the features that were lost in the transition from Keynes to Lucas and Prescott. Much of the research agenda in the last 30 years has aimed to resurrect Keynes’s main insights in microfounded models using modern mathematical language. As a result, they have come to be known as “New Keynesian” models. Thanks to the flexibility of the DSGE setup, adding additional frictions like sticky prices and wages, government spending, and monetary policy was relatively simple and has enabled DSGE models to become sufficiently close to reality to be used as guides for policymakers. I will argue in future posts that despite this progress, even the most advanced NK models fall short both empirically and theoretically.

What’s Wrong With Modern Macro? Part 1 Before Modern Macro - Keynesian Economics

Part 1 in a series of posts on modern macroeconomics. This post focuses on Keynesian economics in order to set the stage for my explanation of modern macro, which will begin in part 2. 


John Maynard Keynes – Wikimedia Commons

If you’ve never taken a macroeconomics class, you almost certainly have no idea what macroeconomists do. Even if you have an undergraduate degree in economics, your odds of understanding modern macro probably don’t improve much (they didn’t for me at least. I had no idea what I was getting into when I entered grad school). The gap between what is taught in undergraduate macroeconomics classes and the research that is actually done by professional macroeconomists is perhaps larger than in any other field. Therefore, for those of you who made the excellent choice not to subject yourself to the horrors of a first year graduate macroeconomics sequence, I will attempt to explain in plain English (as much as possible), what modern macro is and why I think it could be better.

But before getting to modern macro itself, it is important to understand what came before. Keep in mind throughout these posts that the pretense of knowledge is quite strong here. For a much better exposition that is still somewhat readable for anyone with a basic economic background, Michael De Vroey has a comprehensive book on the history of macroeconomics. I’m working through it now and it’s very good. I highly recommend it to anyone who is interested in what I say in this series of posts.

Keynesian Economics

Although Keynes was not the first to think about business cycles, unemployment, and other macroeconomic topics, it wouldn’t be too much of an exaggeration to say that macroeconomics as a field didn’t truly appear until Keynes published his General Theory in 1936. I admit I have not read the original book (but it’s on my list). My summary here will therefore be based on my undergraduate macro courses, which I think capture the spirit (but probably not the nuance) of Keynes.

Keynesian economics begins by breaking aggregate spending (GDP) into four pieces. Private spending consists of consumption (spending by households on goods and services) and investment (spending by firms on capital). Government spending on goods and services makes up the rest of domestic spending. Finally, net exports (exports minus imports) is added to account for foreign expenditures. In a Keynesian equilibrium, spending is equal to income. Consumption is assumed to be a fraction of total income, which means that any increase in spending (like an increase in government spending) will cause an increase in consumption as well.

An important implication of this setup is that increases in spending increase total income by more than the initial increase (called the multiplier effect). Assume that the government decides to build a new road that costs $1 million. This increase in expenditure immediately increases GDP by $1 million, but it also adds $1 million to the income of the people involved in building the road. Let’s say that all of these people spend 3/4 of their income and save the rest. Then consumption also increases by $750,000, which then becomes other people’s incomes, adding another $562,500, and the process continues. Some algebra shows that the initial increase of $1 million leads to an increase in GDP of $4 million. Similar results occur if the initial change came from investment or changes in taxes.

The multiplier effect also works in the other direction. If businesses start to feel pessimistic about the future, they might cut back on investment. Their beliefs then become self-fulfilling as the reduction in investment causes a reduction in consumption and aggregate spending. Although the productive resources in the economy have not changed, output falls and some of these resources become underutilized. A recession occurs not because of a change in economic fundamentals, but because people’s perceptions changed for some unknown reason – Keynes’s famous “animal spirits.” Through this mechanism, workers may not be able to find a job even if they would be willing to work at the prevailing wage rate, a phenomenon known as involuntary unemployment. In most theories prior to Keynes, involuntary unemployment was impossible because the wage rate would simply adjust to clear the market.

Keynes’s theory also opened the door for government intervention in the economy. If investment falls and causes unemployment, the government can replace the lost spending by increasing its own expenditure. By increasing spending during recessions and decreasing it during booms, the government can theoretically smooth the business cycle.

IS-LM

The above description is Keynes at its most basic. I haven’t said anything about monetary policy or interest rates yet, but both of these were essential to Keynes’s analysis. Unfortunately, although The General Theory was a monumental achievement for its time and probably the most rigorous analysis of the economy that had been written, it is not exactly the most readable or even coherent theory. To capture Keynes’s ideas in a more tractable framework, J.R. Hicks and other economists developed the IS-LM model.

I don’t want to give a full derivation of the IS-LM model here, but the basic idea is to model the relationship between interest rates and income. The IS (Investment-Savings) curve plots all of the points where the goods market is in equilibrium. Here we assume that investment depends negatively on interest rates (if interest rates are high, firms would rather put their money in a bank then invest in new projects). A higher interest rate then lowers investment and decreases total income through the same multiplier effect outlined above. Therefore we end up with a negative relationship between interest rates and income.

The LM (Liquidity Preference-Money) curve plots all of the points where the money market is in equilibrium. Here we assume that the money supply is fixed. Money demand depends negatively on interest rates (since a higher interest rate means you would rather keep money in the bank than in your wallet) and positively on income (more cash is needed to buy stuff). Together these imply that a higher level of income results in a lower interest rate required to clear the money market. An equilibrium in the IS-LM model comes when both the money market and the goods market are in equilibrium (the point where the two lines cross).

The above probably doesn’t make much sense if you haven’t seen it before. All you really need to know is that an increase in government spending or investment shifts the IS curve right, which increases both income and interest rates. If the central bank increases the money supply, the LM curve shifts right, increasing income and decreasing interest rates. Policymakers then have two powerful options to combat economic downturns.

In the decades following Keynes and Hicks, the IS-LM model grew to include hundreds or thousands of equations that economists attempted to estimate econometrically, but the basic features remained in place. However, in the 1970s, the Keynesian model came under attack due to both empirical and theoretical failures. Part 2 will deal with these failures and the attempts to solve them.