Wednesday, October 29, 2014
That which is not dead doth sleeping lie (RBC edition)
The other day I had dinner with two prominent New Keynesian macroeconomists (whose names shall not herein be revealed). Both of them told me that the idea of technology shocks as the main driver of business cycles is effectively dead. At the same time, a number of Twitter people (Josh Hendrickson, Tony Yates, Ryan Decker, and Pedro Serodio) asserted that NK is the dominant school of macro. Other macroeconomists, like Chris House, have made the same claim.
I just don't think this is true at all.
Now, it is true - to my knowledge, anyway - that central banks use NK-style models (like Smets-Wouters), and don't use models where tech shocks are the main driver.
Also, I've recently seen people like Patrick Kehoe, Mark Bils and Peter Klenow - who had been known for their skepticism of the sticky-price mechanism - writing some papers giving more credence to the idea of sticky prices.
But in terms of academic publishing, the hot areas in macro seem to be A) labor search models, and B) financial-friction models. In both of those, you often see tech shocks as being the main driver.
The Diamond-Mortensen-Pissarides model, when it includes business cycles, includes them by adding TFP shocks. In other words, once you leave the steady state, DMP is just RBC with a matching friction. By my count, that makes two Nobel Prizes for RBC models and zero for NK. Actually, the vast majority of labor-search models I've seen, if they try to match business cycle facts, use the RBC mechanism to produce the cycles. The big exception I've seen is Christiano, Eichenbaum and Trabandt.
For financial-friction macro it's more even, as you definitely do have models that augment New Keynesian models with financial frictions - e.g. this one by Christiano et al., or this one by Curdia and Woodford. And of course there is Bernanke-Gertler, one of the original financial-friction models. But Kiyotaki-Moore, the other canonical financial-friction macro model I know of, uses RBC-style tech shocks as the single shock. And Brunnermeier-Sannikov uses what is basically a TFP-news-shock model. So here, the literature is pretty split, but RBC is alive and well.
But there are other macro-ish areas of research besides macro! There's international finance, where the models I've seen are all RBC-type models (caveat: my teacher for the international finance field class in grad school did her PhD at Minnesota). And when macro-finance asset pricing models bother to model production, they usually - though not always - use RBC-style tech shocks to make dividends and consumption move around.
So it seems pretty clear to me that RBC - defined loosely as "models where fluctuating TFP is the main driver of the business cycle" - ain't dead by any means. What's more, it seems unlikely that it will die for a good long while. Why? At least two reasons - A) ease of use, and B) familiarity.
First of all, productivity fluctuations are just plain easy to use. You can have constant returns to scale. You don't have to think about money or the aggregate price level. If you want to focus on other hard stuff, like labor search or banks, the easiest thing to do is just to use the simplest possible mechanism for the aggregate shock.
Second of all, everyone is really familiar with RBC, because everyone learns it before they learn any other type of shock mechanism (like NK). This is because RBC came first historically, because it's relatively easy to learn and understand, and maybe because of the enormous respect still given to the original RBC guys. So everyone knows how to use tech shocks, so they're the first go-to mechanism for many people.
So I think that all the people who pronounce RBC dead should think again. And NK's dominance is far from complete. If you don't believe me, just ask the Nobel committee!