Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday, 24 September 2016

What is so bad about the RBC model?

This post has its genesis in a short twitter exchange storified by Brad DeLong

DSGE models, the models that mainstream macroeconomists use to model the business cycle, are built on the foundations of the Real Business Cycle (RBC) model. We (almost) all know that the RBC project failed. So how can anything built on these foundations be acceptable? As Donald Trump might say, what is going on here?

The basic RBC model contains a production function relating output to capital (owned by individuals) and labour plus a stochastic element representing technical progress, an identity relating investment and capital, a national income identity giving output as the sum of consumption and investment, marginal productivity conditions (from profit maximisation by perfectly competitive representative firms) giving the real wage and real interest rate, and the representative consumer’s optimisation problem for consumption, labour supply and capital. (See here, for example.)

What is the really big problem with this model? Not problems along the lines of ‘I would want to add this’, but more problems like I would not even start from here. Let’s ignore capital, because in the bare bones New Keynesian model capital does not appear. If you were to say giving primacy to shocks to technical progress I would agree that is a big problem: all the behavioural equations should contain stochastic elements which can also shock this economy, but New Keynesian models do this to varying degrees. If you were to say the assumption of labour market clearing I would also agree that is a big problem.

However none of the above is the biggest problem in my view. The biggest problem is the assumption of continuous goods market clearing aka fully flexible prices. That is the assumption that tells you monetary policy has no impact on real variables. Now an RBC modeller might say in response how do you know that? Surely it makes sense to see whether a model that does assume price flexibility could generate something like business cycles?

The answer to that question is no, it does not. It does not because we know it cannot for a simple reason: unemployment in recessions is involuntary, and this model cannot generate involuntary unemployment, but only voluntary variations in labour supply as a result of short term movements in the real wage. Once you accept that higher unemployment in recessions is involuntary (and the evidence for that is very strong), the RBC project was never going to work.

So how did RBC models ever get off the ground? Because the New Classical revolution said everything we knew before that revolution should be discounted because it did not use the right methodology. And also because the right methodology - the microfoundations methodology - allowed the researcher to select what evidence (micro or macro) was admissible. That, in turn, is why the microfoundations methodology has to be central to any critique of modern macro. Why RBC modellers chose to dismiss the evidence on involuntary unemployment I will leave as an exercise for the reader.

The New Keynesian (NK) model, although it may have just added one equation to the RBC model, did something which corrected its central failure: the failure to acknowledge the pre-revolution wisdom about what causes business cycles and what you had to do to combat them. In that sense its break from its RBC heritage was profound. Is New Keynesian analysis still hampered by its RBC parentage? The answer is complex (see here), but can be summarised as no and yes. But once again, I would argue that what holds back modern macro much more is its reliance on its particular methodology.

One final point. Many people outside mainstream macro feel happy to describe DSGE modelling as a degenerative research strategy. I think that is a very difficult claim to substantiate, and is hardly going to convince mainstream macroeconomists. The claim I want to make is much weaker, and that is that there is no good reason why microfoundations modelling should be the only research strategy employed by academic economists. I challenge anyone to argue against my claim.




14 comments:

  1. Reading this debate over the last few weeks, I've started wondering how much of the "problem" is actually a result of DSGE modelling itself.

    The bigger problem I see is a lack of consensus about what should be included in a standard model. There are obviously some who think the New Keynesian monopolistic competition/sticky prices additions to RBC shouldn't have been added, and those are really the only additions to the "standard" macro model in the last 30 years or so.

    But if we can't decide what features are important, to me this seems more of a problem with how the profession tackles empirical macro. Wouldn't we just be having the same discussion about, for example, agent based macro if that was the standard approach?

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    1. The "modelling" is indeed a big part of the problem, because DSGE doesn't model. Models have empirically derived parameters and realistic, empirically verifiable iteration formulas.

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  2. I've harbored a theory about the New Classicals for a while: it's all about biography. Specifically, it's no coincidence that Robert Lucas, the eldest of the New Classicals, was born in 1937. Bob Solow, on the other hand, was born in 1924; Samuelson in 1915; and Milton Friedman in 1912. For economists (Keynesian and otherwise) with first-hand experience of the Great Depression, the notion that the labor market always cleared would have been so ridiculous as to be beneath serious response. To those of Lucas's generation, for whom bread lines and soup kitchens were something you read about in books, the realities of mass involuntary unemployment were a lot easier to overlook. (Just to be clear: of course many economists born after the Depression take the Depression seriously; the point is merely that *only* an economist born after the Depression could pretend, even to themselves, that it never really happened.)

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    1. I was born in 1937 and the idea that there is no involuntary unemployment is so ludicrous to me that I think any person who holds it should be restrained from going anywhere without adult supervision. Of course I have two advantages. I am not an economist, and I spent my high school years in a suburb of Detroit where the teachers maintained some of the oral history of the labor movement.

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  3. Simon,

    First, am interested to know what you consider to be "the" RBC project? Am curious to know whether you would classify (say) the Diamond-Mortensen-Pissarides model part of the project. Also, as you know, the TFP shock has a broader interpretation than "technical progress." Is RBC necessarily wedded with the notion of TFP = tech progress and, if so, why would you want to characterize the project so narrowly?

    Second, you seem to imply a *necessary* connection between "involuntary unemployment" and "inflexible prices." RBC modelers (those that replaced the auction with decentralized search) did not choose to dismiss "involuntary" unemployment.

    Third, how does the NK model correct the "central failure" of the RBC model? Which "pre-revolution" wisdom is presently embedded in the NK model? Not the 'beta-shock,' I hope! :)

    Thanks, David

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    1. Not to answer for Simon, but I'd say that Diamond-Mortenson-Pissarides is either a model of *frictional* unemployment, in which case it's a microeconomic model, or it's a model of *all* unemployment, in which case it is (a) a macroeconomic model; (b) part of the RBC program; and (c) plainly false.

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  4. "The answer to that question is no, it does not. It does not because we know it cannot for a simple reason: unemployment in recessions is involuntary, and this model cannot generate involuntary unemployment, but only voluntary variations in labour supply as a result of short term movements in the real wage. Once you accept that higher unemployment in recessions is involuntary (and the evidence for that is very strong), the RBC project was never going to work."

    It's nice to see some recognition that involuntary unemployment is what distinguishes good theory from bad.

    I've got a model that shows how involuntary unemployment follows as a matter of course by just making one change: showing that the general shape of the demand curve is a rectangular hyperbola.

    See http://www.philipji.com/involuntary-unemployment/

    What is even more important, from an analysis of the Marshallian demand curve, it is possible to show that General Equilibrium theory (which is of course the parent of RBC) is no more general than Marshallian demand analysis. See http://www.philipji.com/holes-in-general-equilibrium (this is work in progress)

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  5. You state that you don't want to discuss problems with the RBC model which can be solved by adding features, but are fundamental to the methodology.

    But introducing involuntary unemployment into a RBC framework is easy - you just add sticky wages or matching frictions. I agree that the microfoundations project has problems, but I'm not sure that this one is as fundamental as you claim.

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  6. Fully flexible prices do not imply that monetary policy has no effect on real variables. Changes in monetary policy create changes in expectations. Unless expectations are rational (and monetary policy changes may create a situation in which rational expectations are impossible to apply) the changes in expectations will have real effects whether or not prices are flexible. NC and NK both assume that flexible prices would lead to more stability in real variables, the only difference between them are whether prices really are flexible. Hence the 'freshwater/saltwater' storm-in-a-teacup.

    As for DSGE not being degenerative, a sign of a degenerative research programme is that is forever spinning ad hoc epicycles to deal with empirical reality and forever getting more complicated as a result. In his textbook for graduate students, Advanced Macroeconomics, David Romer just gives up, saying that recent DSGE models are too complex to explain even to graduate students. Surely this vindicates your correct contention ('I would not start from here') that these people are starting in the wrong place.

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  7. Excellent

    There is a useless confusion here

    The struggle Within the academy over ideology and modeling

    Versus

    The struggle over instruments and assignments in actual macro management


    Of course interests influence macro policy choices
    And discussion

    I'd venture to say
    The death of fine tuning even before the new classical counter revolution
    Proves policy choices will face struggling interests even without model wars

    Fiscal activism was effectively relegated to crisis time
    Because powerful interests for convincing reasons
    Opposed perpetually tight job markets

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  8. The New Keynesian (NK) model, although it may have just added one equation to the RBC model, did something which corrected its central failure: the failure to acknowledge the pre-revolution wisdom about what causes business cycles and what you had to do to combat them.

    Speaking as a lay person, up to this point I found this post remarkably didactic and useful.

    The passage above, however, raises a couple of questions.

    First.
    "New Keynesian (NK) model ... added one equation to the RBC model"

    As a lay person, ignorant of those things, it would be of great help to me to see that equation, at least to complement what The Basic RBC model with Dynare shows.

    Second.
    "the pre-revolution wisdom about what causes business cycles"

    Again, what is that "pre-revolution wisdom"?

    I'm sure those two things are perfectly obvious to economists, but they are obscure to the non-initiated.

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  9. A few days ago you wrote about the problems associated with the media using household allegories to draw conclusions about macroeconomic policy. How do you think microfounded models are any different in this regard?

    In both cases they ignore the many macroeconomic paradoxes ( thrift, costs etc...) that have been known of for almost 100 years.

    Instead new Keynesians use imperfectly flexible prices to replicate the ills caused by the above.

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  10. "Surely it makes sense to see whether a model that does assume price flexibility could generate something like business cycles?"

    another response to that question could be that a model with flexible prices can trivially generate business cycles by, for example, assuming Godzilla periodically rampages through the economy destroying the capital stock. So we need a higher bar than can you model recessions with flexible prices.

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  11. One of the best discussions I have seen on this

    https://uneasymoney.com/2016/09/23/paul-romer-on-modern-macroeconomics-or-the-all-models-are-false-dodge/

    NK.

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