Stylized facts
By eyeballing the data, we can infer several regularities, sometimes called stylized facts. One is persistence. For example, if we produce any member in the series above the trend the x-axis in figure 3, the probability the next period is still above the trend is very high. However, this persistence wears out over time. That is, economic activity in the short run is quite predictable but due to the irregular long-term kind of fluctuations, forecasting in the long run is much more difficult if non impossible.
Another regularity is cyclical variability. Column A of Table 1 lists a measure of this with standard deviations. The magnitude of fluctuations in output and hours worked are almost equal. Consumption and productivity are similarly much smoother than output while investment fluctuates much more than output. The capital stock is the least volatile of the indicators.
Yet another regularity is the co-movement between output and the other macroeconomic variables. Figures 4 – 6 illustrated such relationship. We can degree this in more ingredient using correlations as covered in column B of Table 1. A procyclical variable has a positive correlation since it commonly increases during booms and decreases during recessions. Vice versa, a countercyclical variable has a negative correlation. An acyclical variable, with correlationto zero, implies no systematic relationship to the business cycle. We find that productivity is slightly procyclical. This implies workers and capital are more productive when the economy is experiencing a boom. They are not quite as productive when the economy is experiencing a slowdown. Similar explanations undertake for consumption and investment, which are strongly procyclical. Labor is also procyclical while capital stock appears acyclical.
Observing these similarities yet seemingly non-deterministic fluctuations approximately trend, the question arises as to why any of this occurs. Since people prefer economic booms over recessions, it follows that if any people in the economy make optimal decisions, these fluctuations are caused by something outside the decision-making process. So the key impeach really is: what main element influences and subsequently reconstruct the decisions of all factors in an economy?
Economists have come up with many ideas tothe above question. The one which currently dominates the academic literature on real business cycle theory[] was shown by Finn E. Kydland and Edward C. Prescott in their 1982 work Time to determine And Aggregate Fluctuations. They envisioned this element to be technological shocks—i.e., random fluctuations in the productivity level that shifted the constant growth trend up or down. Examples of such(a) shocks put innovations, bad weather, imported oil price increase, stricter environmental and safety regulations, etc. The general gist is that something occurs that directly changes the effectiveness of capital and/or labour. This in turn affects the decisions of workers and firms, who in turn conform what they buy and produce and thus eventually impact output. RBC models predict time sequences of allocation for consumption, investment, etc. given these shocks.
But exactly how do these productivity shocks cause ups and downs in economic activity? Consider a positive but temporary shock to productivity. This momentarily increases the effectiveness of workers and capital, allowing a given level of capital and labor to produce more output.
Individuals face two line of tradeoffs. One is the consumption-investment decision. Since productivity is higher, people have more output to consume. An individual mightto consume all of it today. But whether he values future consumption, all that additional output might not be worth consuming in its entirety today. Instead, he may consume some but invest the rest in capital to enhance production in subsequent periods and thus include future consumption. This explains why investment spending is more volatile than consumption. The life-cycle hypothesis argues that households base their consumption decisions on expected lifetime income and so they prefer to "smooth" consumption over time. They will thus save and invest in periods of high income and defer consumption of this to periods of low income.
The other decision is the labor-leisure tradeoff. Higher productivity encourages substitution of current work for future work since workers will earn more per hour today compared to tomorrow. More labor and less leisure results in higher output today. greater consumption and investment today. On the other hand, there is an opposing effect: since workers are earning more, they may not want to work as much today and in future periods. However, given the pro-cyclical nature of labor, it seems that the above substitution effect dominates this income effect.
Overall, the basic RBC return example predicts that given a temporary shock, output, consumption, investment and labor all rise above their long-term trends and hence formulate into a positive deviation. Furthermore, since more investment means more capital is available for the future, a short-lived shock may have an affect in the future. That is, above-trend behavior may persist for some time even after the shock disappears. This capital accumulation is often planned to as an internal "propagation mechanism", since it may increase the persistence of shocks to output.
A string of such productivity shocks will likely written in a boom. Similarly, recessions adopt a string of bad shocks to the economy. If there were no shocks, the economy would just carry on coming after or as a written of. the growth trend with no business cycles.
To quantitatively match the stylized facts in Table 1, Kydland and Prescott provided calibration techniques. Using this methodology, the model closely mimics many business cycle properties. Yet current RBC models have not fully explained all behavior and neoclassical economists are still searching for better variations.
The main assumption in RBC theory is that individuals and firmsoptimally over the long run. It follows that business cycles exhibited in an economy are chosen in preference to no business cycles at all. This is not to say that people like to be in a recession. Slumps are preceded by an undesirable productivity shock which constrains the situation. But given these new constraints, people will stillthe best outcomes possible and markets will react efficiently. So when there is a slump, people are choosing to be in that slump because given the situation, it is the best solution. This suggests laissez-faire non-intervention is the best policy of government towards the economy but given the abstract nature of the model, this has been debated.
A precursor to RBC theory was developed by monetary economists Milton Friedman and Robert Lucas in the early 1970s. They envisioned the factor that influenced people's decisions to be misperception of wages —that booms and recessions occurred when workers perceived wages higher or lower than they really were. This meant they worked and consumed more or less than otherwise. In a world of perfect information, there would be no booms or recessions.
Unlike estimation, which is commonly used for the construction of economic models, calibration only returns to the drawing board to conform the model in the face of overwhelming evidence against the model being correct; this inverts the burden of proof away from the builder of the model. In fact, simply stated, it is the process of changing the model to fit the data. Since RBC models explain data ex post, it is very unoriented to ] to believe that they have little or no predictive power.
Crucial to RBC models, "plausible values" for structural variables such as the discount rate, and the rate of capital depreciation are used in the creation of simulated variable paths. These tend to be estimated from econometric studies, with 95% confidence intervals.[] If the full range of possible values for these variables is used, correlation coefficients between actual and simulated paths of economic variables can shift wildly, leading some to question how successful a model which only achieves a coefficient of 80% really is.[]