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RBC model study notes for better understanding, Study notes of Economics

Notes on Real Business Cycle model

Typology: Study notes

2017/2018

Uploaded on 10/03/2018

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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
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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 𝐼𝑆𝑃𝐶 − M 𝑅 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
  • It tells us that RBC modellers did not work backwards from real world facts in making their modelling decisions, instead they began with a simple model & evaluated how well it matches facts about the business cycle (deductive approach)

Assumptions of RBC model:

  • Large number of identical agents who are assumed to live forever
  • When savings increase, it is invested and results in larger capital stock following period
  • Perfect competition and perfect information
  • Expectations are formed rationally
  • Full flexibility of nominal wages and prices so RBC looks at real wages
  • There are random, persistent technological shocks which disturb the economy via shifting the production function

NK:

  • First stage is to derive NK PC, which states that current inflation depends on the entire future path of expected output gaps – which is different than adaptive expectations (backward looking) in 3-eq model
  • Cycles are also equilibrium cycles but presence of imperfections in the economy (sticky prices) means that welfare can be improved by the presence of an inflation- targeting central bank