3-equation:
• As output shifts away from the equilibrium there is a role for economics policy to
minimize the cost of the shock. Cycles are therefore modelled as disequilibrium
phenomena
•Example: -ve shock -> firms reduce production -> fewer jobs available ->
unemployment is involuntary therefore welfare can be improved by policy
intervent
3-equation model – simplified version of NK:
• Both models share the 𝐼𝑆 − 𝑃𝐶 − M𝑅 equations and include monopolistic firms with
price-setting power which respond to changes in 𝐴𝐷 by adjusting output (due to
sticky prices)
• The difference: NK assumes forward-looking & rational expectations behaviour for
all actors, while 3-Eq assumes that only the CB & Forex market follow REH
In RBC and NK since all agents have model-consistent expectations, the economy is in a
rational expectations equilibrium even when it is away from the steady state equilibrium.
RBC:
In general: Agents follow REH, and business cycles are due to exogenous technological
shocks, which are persistent and cause shifts in working hours and intertemporal
consumption because of agents re-optimizing.
• Business cycles are the result of exogenous technology shocks (it assumes
intertemporal elasticity of labour supply - workers shift both their hours of work and
consumption between periods to make best use of changes in the returns to working
and to saving arising from the shock). Business cycles arise because of exogenous
technology shocks which result in economic fluctuations because of the way agents
respond to the new opportunities they face.
• Example: -ve shock -> falling real wages -> reduction in aggregate hours because
employees choose to supply less labour -> unemployment is voluntary (hence
cannot be improved by intervention)
• In RBC we have optimizing households who choose their savings rate. We add to it
rational expectations and shocks to technology
• It is a basis of the New Keynesian DSGE (NK is modified by introduction of sticky
prices which gives a role for inflation-targeting monetary policy)
• Behaviour of all agents is captured by deep parameters, which characterise
production and utility functions
• Business cycles can be viewed as equilibrium phenomena, because cycles are the
result of agents optimally adjusting their labour-leisure choice in response to
exogenous and persistent technology shocks.
•Welfare can not be improved by the intervention of a policy maker – there is no
role for stabilization policy in the macro-economy in RBC model
• Households choose an optimal consumption path s.t. their intertemporal budget
constraint, - savings are used to increase future consumption. The three ingredients in
their consumption decision are: permanent income, real i.r and subjective discount
rate. The RBC also adds in the consumption/ leisure choice -> workers can freely
alter their hours of work in response to an economic shock.
• RBC assumes consumption and output volatility are very similar, whereas investment
is much more volatile. However, data shows that hours per worker are less responsive
to changes in output than employment. Data is not consistent with RBC propagation
mechanism
