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.

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