A review of modern business cycle models

A critic’s perspective about mainstream assumptions in economics

Autores: FERRÁN GARCÍA, LUIS SANAGUSTÍN, DARIO CORTABITARTE, NÚRIA MASSANÉS, POL COMAS

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John Maynard Keynes’ General Theory changed the framework through which  macroeconomics was conceived, substituting the monetary theory (see Laidler, 1999, or Dimand, 2008).  Keynes’ aim in the book was to demonstrate the theoretical existence of involuntary unemployment, which he then argued resulted from a deficiency in aggregate demand, and therefore of insufficient investment. One year after the publication of General Theory, John Hicks (1937), by transforming Keynes’ verbal presentation into equations in order to compare it with classical economics, developed the first version of the IS-LM model, which would be key in the subsequent success of Keynesian macroeconomics.

In the 1970s, almost a decade of high inflation and high rates of unemployment, the basic Keynesian framework was revealed as not appropriate for explaining “what happens during a business cycle nor did it seem able to provide empirically correct answers to questions involving changes in economic environment or changes in monetary or fiscal policy ”(Plosser, 1989). Milton Friedman first, and Robert Lucas a decade later, published a paper demonstrating the «absence of a fundamental basis for the theoretical framework for the choice of microeconomics,» which would lead to misinterpretations of macroeconomic phenomena through a Keynesian lens.

From the critique of Keynesianism that Robert Lucas formulated (1972, 1973 and 1975) with the premise of rational expectations, the New Classical Macroeconomics (NCM) emerged. Other relevant authors of this school were Robert Barro, Edward Prescott, Thomas Sargent and Neil Wallace. NCM arose from the development of the principles of neoclassical economics such as the market equilibrium condition and the optimization of the behaviour of agents, linking it with monetarism. However, criticisms directed at Lucas’s islands model led to the abandonment of the neoclassical model with incomplete information, replacing it with the real cycle models or those with a New Keynesian root.

Table 1. Comparative analysis between economic cycle theories

CharacteristicsReal Business CycleClassical Monetary ModelsBasic New Keynesian Model
CompetitionPerfect competitionPerfect competition in goods and labour marketsMonopolistic competition
Monetary marketNot includedIncludedIncluded
PricesFlexible pricesFully flexible prices in all marketsSticky prices
Rationality of the agentsPerfect rationalityPerfect rationalityPerfect rationality
Central Authority interventionNoYes, although neutrality of monetary policy with respect to real variablesYes
InformationPerfect informationImperfect informationPerfect information
Exogenous shocksTechnological shocks (supply)Existence of exogenous shocksDemand shocks

INTRODUCTION TO THE REAL BUSINESS CYCLE THEORY

The Real Business Cycle is, jointly with the Keynesian approach, an accepted model studied in all the universities around the world. For this reason, it’s strongly necessary for the students to know the basic assumptions of the neoclassical perspective to understand correctly the limitations of the model and also to avoid unnecessary criticisms already contemplated by their theorists. The Real Business Cycle has been developed by important economists as Kydland, Prescott, King, Plosser and Hansen.

Main assumptions

Then, we will first list the assumptions of the Real Business Cycle Theory to later develop their main objections.

Perfect information available for all the agents in the economy: This assumption represents the economy as a game in which all the possible outcomes depending on the agent’s actions are known by all the participants. The representative individual of the model wants to maximize his utility which depends on his decision to consume or invest and decide between work or leisure activities. Moreover, the individual has to maximize this particularfunction taking into account technological constraints. Also, the model assumes individuals live forever (Plosser, 1989).

Perfect competition: The concept of perfect competition describes a market in which there exist many firms that produce an identical product. For this reason, firms are price-takers, they can’t fix a price individually. So, the model concludes that if the price is above the minimum of the unit average cost curve, and consequently, firms obtain a profit per unit sold, new firms enter the market since the price returns to a level in which firms don’t get benefit for selling marginal units in the long run.

Perfect rationality: This assumption means that agents maximize their utility without inconsistency in their preferences, also assuming that exists perfect information. This is the basic assumption of classical economists as John Stuart Mill and Adam Smith, indicating that self-interest will lead us to collective well-being.

General market equilibrium: This assumption refers to simultaneous equilibrium in all markets, but without assuming necessarily an efficient allocation of resources. Therefore, any deviation from them breaks the efficient allocation. However, monetary policy has no effect using this model, as we consider real variables.

Only real variables explain the business cycle: Firstly, it’s important to point out that RBC holds that business cycles start after a random shock or large fluctuations in the technological rate (Kydland & Prescott, 1982). These shocks are external from the economy, so the causes that lead to instability are changes in the supply-side. This model supports the idea that real variables can better explain the changes than can happen in a real economy. This is based on supply shocks. With the help of the real variables, studies the fluctuations that occur in an economy with no intervention of the state in the short run and letting the market be efficient by itself. This equilibrium will be optimal at that point unless a shock occurs, but the market will adjust without any help.

Prices and wages are flexible, so the aggregate demand is independent of the price level: This assumption holds the idea that the reduction of the working hours when there is a recession is completely a worker’s decision. So, as it is optional and not compulsory, it increases their welfare. It is necessary to point out that aggregate demand is the sum of consumption, investment made by firms and government spending (in a closed economy). The aggregate demand depends on which real interest rate is applied. Also, we know that in the equilibrium, both total demand and total income are equal to aggregate demand. The more income people have, the more they are going to consume. However, if the interest rates are high, consumption will decrease and saving will go up.

A QUICK VIEW ON CLASSICAL MONETARY MODELS

So far, we have seen that RBC models had no role for money and no predictions for nominal variables. However, in 1989, Thomas Cooley and Gary Hansen incorporated money into an articulated, dynamic, general equilibrium structure, assuming that all goods were subject to a cash-in-advance constraint. In other words, they add a monetary sector to the RBC model, which will later result in the classical monetary model. These shared some references from past monetary concepts such as Friedman’s rule (1969), that is, setting the rate of monetary growth such as the nominal interest is zero for those holding money (representative household) do not bear any opportunity cost from holding money.

In the basic form of these models it is characterized by perfect competition and fully flexible prices. Also, in the baseline monetary policy does not affect real variables, but does affect nominal variables like prices.

However, these models were not used for so long. Because of criticism against the classical model being incomplete as it “cannot explain the observed real effects of monetary policy on real variables (Gali, J., 2008), and its «predictions regarding the response of the price level, the nominal rate, and the money supply to exogenous monetary policy shocks [being] in conflict with the empirical evidence», it led to the introduction of nominal frictions and the Basic New Keynesian Model.

INTRODUCTION TO THE BASIC NEW KEYNESIAN MODEL

The New Keynesian economics is a school of thought that was born in the 70-80’s as an evolution of the classical Keynesian economics theory developed in 1936 by John Maynard Keynes (after the great depression) together with some ideas from the previous neoclassical theories. It was born in order to provide microeconomic foundations to the Keynesian theories.

The two main new aspects they introduced that significantly affected the macroeconomy, were the rigidity (stickiness) of prices and wages and the imperfect competition. Another important basis of the New Keynesian school is that both households and firms have rational expectations and behave as perfect rational agents.

Finally, it is important to mention as a small homage the most important economists that developed this model; Gregory Mankiw, that did an important work on developing the idea of Menu Costs (1985, see also 1989) and large business cycles; J.Taylor and S.Fischer, who worked with the rational expectations hypothesis along with long-term contracts on nominal terms leading to rigid prices and wages, and for Taylor’s rule (1993) and Fischer’s sticky information model (1977) ; and Jordi Galí, that contributed on the analysis of the causes on the economic cycles and the optimal monetary policies (with R.Clarida and M.Gertler); among others such as O. Blanchard, D. Romer, etc.

Main assumptions

Sticky prices: wage and price stickiness are important features of the economy, and that this implies a positive role for countercyclical policy. By and large, they maintain the position that stabilization policy can improve economic outcomes. New Keynesians differ from “old Keynesians” in that rather than simply asserting that prices or wages are sticky, they seek a microeconomic framework in which the maximizing decisions of rational agents lead to stickiness.

In relation to wages, the coordination argument can be mentioned. It aims to prove that even if economic agents were willing to reduce their wage during recessions (as long as others do the same) a market based economy could hardly apply such a plan of coordinated similar reductions. Other economists argue that frequent wage cuts/rises might hurt worker’s morale and productivity as the subjective valuation of changes is steeper for losses than for gains. (Tversky and Kahneman,1991). Based on this idea, aiming to explain why market clearing mechanisms may fail, New Keynesian economists propose that firms set efficiency wages, wages above the level of wage in the labour market equilibrium in order to boost productivity or reduce rotation costs for example.

A significant modification that is added to the standard core of the RBC cycle by the NKM is nominal rigidities. This assumption based on Calvo (1983) can be explained as follows: At least some firms -a randomly drawn proportion- are subject to constraints on the frequency with which they can adjust prices of the goods and services they sell. Alternatively, firms face some costs of adjusting those prices. The most known is the one we refer to as menu cost. Evidence shows it is possible for aggregate demand to affect output; aggregate demand externalities mean that when there is an aggregate demand shock, it is possible that the firm’s gain in profit associated with adjusting its price is small. As long as this gain is smaller than the menu costs associated with changing the price, the firm will keep its price fixed. Therefore, even if there is a big reduction in aggregate demand, the firm’s incentive to change its price could be small resulting in intermittent rather than continuous price adjustment.  Generally, New Keynesian economists emphasize the fact that the profit/losses of a small shift in prices to an individual firm is minor whenever compared to the cost of transmitting this new information to the public.  

Sceptics point out that menu costs are likely to be small, but the main point of Mankiw and Akerlof-Yellen is that small menu costs may be sufficient, since the private gains from adjusting the price may be small too.

Monopolistic competition: New Keynesian models have incorporated the concept of imperfect competition as a fundamental basis to justify the existence of sticky prices. They state that in the goods market there is a large number of sellers of differentiated products with low barriers to entry. Due to the heterogeneity of the goods, the suppliers do not take part in a competitive economy but in a monopolistic one. Because of that the goods in the market are not perfect substitutes, firms have fewer limitations to set its prices above its MC (to maximize profits). Moreover, each firm faces a demand constraint.

Monetary policy: the terminology “Neutrality of the money” was introduced by Friedrich A. Hayek in 1931. New Keynesian Models agree with classical theories when they state that in the long run, changes in money supply are neutral, this means, only affect nominal variables such as prices, wages, exchange rates…

Whereas in the short run, they demonstrate the non-neutrality of the money so by increasing/decreasing the interest rates, the Central Bank can have an effect in the real variables. Based on the nominal rigidities, an expansionary policy (increase the money supply) is going to increase output and decrease unemployment rate (real variables). As this method would increase inflationary expectations, it is used only as a tool to respond to exogenous shocks to balance out the effects. Moreover, it also assumes that agents are perfectly rational and behave according to rational expectations. When an economy is close to the zero lower bound, the incentives from the Central Bank to deviate from the initial promise of keeping the nominal interest rates low are high, so agents do not perceive them as credible and the economy may fall into a bigger recession. That is why when a country is close to the zero lower bound the effect of low credibility is bigger than in a country with positive interest rates.

Stabilization policy: This school of thought also states that the Central Bankand the Government must use monetary and fiscal policies as tools to reduce the deadweight loss that appear due to the existence of imperfect competition. In other words, there is less production than the social optimal amount in the market that provokes a loss of the consumer’s welfare.  This refers to the idea of the Welfare losses criterion. Due to the stickiness of the prices and the wages, the demand/supply are not able to be flexible enough in the short term to respond to the fluctuations in the Business Cycles. As a consequence, the market cannot be immediately stabilized, and it can not reach a social optimum amount of production, so there is a loss of welfare by the consumer. 

ANALYSIS OF THE MODELS

At this point of the article, we would like to dedicate a section to reflect on the evolution of the models and its respective assumptions and analyse in a critical and objective way its main implications.

Both models studied in this article assume that the agents in the economy are perfectly rational. This assumption reflects that agents maximize their utility without inconsistency in their preferences, also assuming that exists perfect information. This is the basic assumption of classical economists as John Stuart Mill and Adam Smith, indicating that self-interest will lead us to collective well-being. Nevertheless, the modern behavioural economics shows this assumption, far from serving as a useful simplification, could bias our model by not including a truly representative individual. A sample of this fact is the existence of the asymmetric value function (Kahneman and Tversky, 1979) and other psychological bias demonstrated by empirical evidence as the sunk cost bias (Thaler, 1980). Even today the definition of a truly representative rational agent for the study of the economy is a complete line of research, and for this the student has to show a critical perspective and not assume the neoclassical perspective as a definitive point of view.

As we have said, the RBC model believes that prices and wages are flexible. However, nowadays is mostly agreed by the economists that the prices and wages do not adjust as fast as it was believed to get back to the equilibrium after a shock. Assuming that, we cannot conclude that the non-intervention policies are effective. If prices were totally flexible would react fast after a demand shock, but it has been proved that this only takes place in the long run, not in the short term. Thus, the new keynesian stickiness of prices and wages would be a more realistic assumption. Also, the number of voluntary quits is reduced in times of recession because of the risk of not getting another job, and because workers have less bargaining power to modify their working hours. Nonetheless, if the shocks are from the supply side and we take the idea that high interest rates do not affect unemployment, and this doesn’t apply to a reaction of the workers, we can see that actually it does.

About the debate of the nature of market competition, it is clear that the New Keynessian monopolistic competition view is more accepted nowadays. It is true that we could see competitive markets in the sectors that produce homogenous products, but we cannot generalize this assumption to all the economies as the heterogeneity of the products is the norm and not the exception. This model can be representative for describing some basic markets in which goods are homogenous, for example the demand of some convenience goods (regularly purchased by consumers) in less developed markets.  Also, when the product life cycle is in the decline stage it is typical that the goods are substitutes and perfect competition holds (Kotler, 1967). However, brands definitely destroy the concept of perfect competition and, in this manner, this model is suitable to describe how the market competition dynamics works starting from a very simplified model for didactic reasons. Therefore, the market paradigm is generally defined by monopolistic competition. There are multiple factors that influence the profitability of the market, such as  threat of entry barriers, bargaining power of suppliers and buyers and threat of substitutes (Porter, 1979).

One criticism about the general equilibrium assumption is that It’s more adjusted to a logical or mathematical model than a complex reality. Beyond the model,  there are three  characteristics of the post-walrassian perspective: multiple equilibriums, bounded rationality and the impact of the institutions in the price system (Colander, 2000).

The Real Business Cycle also assumes a very limited influence on the money market saying that only real variables cause the business cycle. The main historic criticism can be supported by the Austrian school of economics, saying that the manipulation of the interest rate due to the monetary monopoly of central banks can lead to an increase in the investments not supported by the savings of the population, this being the origin of economic cycles, because prices differ from their natural levels (Hayek, 1941).

Finally, while the RBC model bases its theory on the idea of perfect information, the NKM model disagrees with it. They conclude that this assumption, although it could be useful, is not so realistic. Currently, in the study of the economy it is more common to consider individuals as agents suffering information asymmetries. If this is not true, information wouldn’t be an economic good (Arruñada, 2013, p.28) and a simple observation of the human interactions reveals it can not be the case, we are constantly searching for the most appropriate information available to take actions that maximize our wishes. This is, information costs exist. In NKM, the information about economic conditions is distributed and acquired slowly through the population. This slow diffusion could arise because of either costs of acquiring information or costs of reoptimization (Mankiw&Reis, 2002). It derives into the fact that members of the economy make decisions with lagged information. Also, some economists object to the static conception of the knowledge, as if it were already given and the only problem was to distribute it, while the information is continually being created by agents, making it impossible to dispose of it as it is even exclusive (Hayek, 1945).

To conclude the analysis and comparison of the models, a consideration about the nature of the business cycle should be made. Regarding the implications of choosing each model,it is derived from the role – or its absence – of a central authority. The RBC model, based on the Walsarian Equilibrium in which market clearing happens instantaneously, leads to a series of equilibriums where all variables are perfectly adjusted and therefore Pareto efficient. Since economic fluctuations are a continuously changing Walrasian equilibrium these fluctuations will always be efficient. On the contrary, NKM proposes not just studying economic intricacies of general equilibrium but also facing the possibility that a generalized market failure is leading to inefficient equilibriums and therefore inefficient assignment of resources. In NK models the economy oscillates around efficient equilibrium allowing some gains to go unrealized in a recession. In contrast, RBC theory does not allow unrealized gains from trade (Mankiw, 1989). In both cases a reduction of welfare takes place but due to different reasons: mainly coordination problems -NKM- or decliment of technological capabilities -in RBC-. According to these facts, if we use the RBC model, any attempts by a central authority to implement either monetary or fiscal policy will have no effect, or they may misallocate resources from the optimal -Pareto efficient- equilibrium. Alternatively, when using NKM, monetary and fiscal policy implemented are susceptible to reduce the gap produced during economic booms or recessions smoothing the business cycle so that the welfare loss is minimized. 

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