Wednesday, March 5, 2014

Two Problems with Real Business Cycle Theory

Here are two simple but devastating problems with real business cycle theory:
(1) Bewley (1999), a major empirical study of wages and labour markets, found no evidence of the real business cycle theory idea that real exogenous productivity shocks cause recessions.

Bewley states:
I mention in passing that I found no support for real business cycle theory. During hundreds of hours of contact with businesspeople, I never heard one description of an exogenous productivity decline. Rather, I heard of decline in product demand and of successful efforts to increase productivity.” (Bewley 1999: 239).
That is, demand shocks in terms of quantity of output demanded are the major cause of reductions in employment and production, according to empirical evidence.

(2) in the real business cycle theory models, the normal market economy is assumed to have wages and prices that are perfectly or near perfectly flexible, so that markets have a strong tendency to clear.

Imperfections in price and wage flexibility, then, are attributed to government and union distortions (as in Ohanian’s [2009] explanation of the Great Depression).

But the very prior assumption that real world market economies have a normal or “default” tendency to rapid wage and price clearing is utterly untrue, and the empirical evidence is clear on this (here for prices and Bewley [1999] for wages).
It is no surprise that real business cycle theory models are something of a joke even amongst some mainstream neoclassicals.

Another datum is that there appear to be no real business cycle theory models proposed to explain pre-1914 businesses cycles, a task which seems hopeless given how the empirical evidence contradicts these models (Hanes 2013: 128).

Bewley, T. F. 1999. Why Wages Don’t Fall During a Recession. Harvard University Press, Cambridge, MA.

Hanes, Christopher. 2013. “Business Cycles,” in Robert Whaples and Randall E. Parker (eds.), Routledge Handbook of Modern Economic History. Routledge, Abingdon, Oxon and New York. 116–135.

Ohanian, Lee E. 2009. “What – or Who – Started the Great Depression?,” Journal of Economic Theory 144.6: 2310–2335.

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