55
Real Business Cycle Models: An Introduction
Mark Crosby and Glenn Otto*
Department of Economics
The University of New South Wales
Abstract
In this article we present a simple real business
cycle (RBC)model, in order to show that these
models capture many of the features of busi-
ness cycles in the real economy. While these
models are very abstract, we argue that they
are a useful way of thinking about the macro-
economy. RBC models have also been influen-
tial in refocusing attention on supply issues in
macroeconomics, after a long postwarfocus on
aggregate demand management in Australia
and most other western economies. Policies
such as structural reform and labour market
reform are clearly aimed at influencing the
supply side of the economy and productivity,
and can be understood within the framework of
RBC theory. RBC models have developed rap-
idly recently, yet there remains a good deal of
misunderstanding about the methods and aims
of these models. In this article we present a re-
view of the literature and examine a simple
model, using graphical techniques, to clarifjt
some issues. We also argue that these models,
while having limitations, have caused a fruitful
re-examination of supply issues in economics,
after the almost exclusive focus on aggregate
demand in macroeconomics until the late
1970s.
* We would like to thank two referees, and an editor, for
extensive and helpful suggestions. All remaining errors are
ours.
1. Introduction
Since 1959 the Australian economy has expe-
rienced approximately ten recessions, the
most recent in 1991-92. The irregular but
seemingly inevitable pattern of expansions and
contractions in gross domestic product (GDP)
is known as the business cycle. Theories of
business cycle fluctuations* are concerned
with determining the fundamental causes of
the fluctuations in GDP (possibly exogenous
changes in government policy, technology
shocks, oil shocks and so on) and also in de-
scribing the mechanisms by which these
shocks are transmitted (or propagated)
throughout the economy (both across sectors
and over time).
Prior to Keynes writing his General Theory
there was considerable interest in theories of
business cycles (for example, Mitchell 1927;
Hicks 1933). The Great Depression, along with
Keynes famous comment that in the long run
we are all dead led to a refocusing of macro-
economics away from long-run examination of
business cycles, toward the short-run static
analysis typical of current textbook Keynesian
macroeconomics.3 For example, standard mac-
roeconomics texts such as Dornbusch and
Fischer (1990) and Samuelson et al. (1992) rel-
egate the theory of growth to a chapter at the
end of their texts, while several chapters are de-
voted to static models. This is despite the fact
that there was a considerable amount of re-
search from the mid-1930s to the 1950s on
business cycle fluctuations (for example,
Goodwin 1951; Kalecki 1937; Kaldor 1940;
Samuelson 1939). Recently there has been re-
newed interest among academic economists in
56 The Australian Economic Review
explaining business cycle fluctuations. Initial
work by Lucas (1977, 1980) and others
followed the lead of Milton Friedman and at-
tributed the primary cause of business cycle
fluctuations to exogenous (policy induced)
changes in the money supply. The so-called
New- Classical economists differed from Fried-
man in assuming that prices are flexible and
that individuals have rational expectations.
These two assumptions, in combination with
conventional aggregate demand and supply
models, produced the prediction that only un-
anticipated (or unpredictable) changes in mon-
etary policy should have an affect on real out-
put.4
Money surprise models did not explain all of
the empirical facts however, and a seminal ar-
ticle by Kydland and Prescott (1982) (KP) led
business cycle theorists to focus attention on
technology (or productivity) shocks as the un-
derlying source of business cycle fluctuations.
This article initiated a research agenda which
has become known as real business cycle the-
ory. The real refers to the fact that until quite
recently money was not explicitly introduced
into these models. In fact KP were interested in
whether business cycle fluctuations in real out-
put (and other real variables) could be ex-
plained without reference to any nominal vari-
ables, such as money.
While the KP approach may seem a bit odd
to those familiar with Keynesian, monetarist or
even new classical economic theory, where
changes in nominal money can have at least
short-run real effects, it hardly seems highly
controversial. The most controversial aspect of
the KP article (and in our view the major meth-
odological contribution) was their use of an
explicit dynamic competitive equilibrium
model to explain business cycle fluctuations
for the postwar period in the United States.
The model was explicitly dynamic in that a
representative household is assumed to make
choices about how to balance current con-
sumption against future consumption, and cur-
rent work against work in the future subject to
the current and expected future environment
(which is summarised by an intertemporal
budget constraint). The solution to the model
is consistent with a competitive equilibrium in
3rd Quarter 1995
that all markets (for both current and future
goods) clear through changes in relative
prices.
In the KP model the only source of changes
in an agents environment is a common (econ-
omy wide) shock to the state of technology.
This shock has a direct effect on current output
and possibly an indirect effect on future output
since it leads firms and households to alter their
saving/investment choices and current and fu-
ture labour supply/demand choices. These are
the mechanisms by which the effects of a tech-
nology shock in one period are transferred or
propagated to another period. We examine
these propagation mechanisms in more detail
below.
Traditionally there has been a view that the
business cycle was a reflection of market, or
policy, failure and entailed large welfare
losses-that is, Okun Gaps. If we could get
policy settings right, we ought to be able to
eliminate, or at least mitigate, business cycle
fluctuations. The most challenging, and per-
haps surprising, result due to KP is that a well-
functioning competitive economy with sto-
chastic technology shocks produces move-
ments in GDP over time that look like business
cycle fluctuations. If the KP model is a good
representation of the workings of a modem
economy then business cycle fluctuations are
natural in a competitive economy subject to
technology shocks, and do not entail any wel-
fare losses5 In short, at least some of the
boom-bust cycle in output may be inevitable,
and desirable, and should not be a focus of pol-
icy concem6 To the extent that this is true,
government policy designed to reduce business
cycle fluctuations will be welfare reducing and
counterproductive.
In Section 2 of this article the empirical
properties of the business cycle in Australia are
presented and discussed. In Section 3 a simple
real business cycle (RBC) model is presented,
and it is shown that this model is consistent
with many of the facts presented in Section 2.
Section 4 offers a brief discussion of some crit-
icisms of this research, along with discussion
of some recent extensions to the basic RBC
model. The final section contains concluding
comments.
 Crosby & Otto: Real Business Cycle Models 57

2. Empirical Properties of Business of the trend itself. A detailed analysis of the

Cycles in Australia
RBC modellers follow in the tradition of earlier
work by Burns and Mitchell (1946) in seeking
to summarise various empirical regularities (or
stylised facts) about important macroecon-
omic variables. These stylised facts are estab-
lished by computing simple statistics (that is,
standard deviations, auto-correlations and
cross-correlations) from the data.
Business cycle fluctuations are commonly
defined as being the fluctuations of GDP
around a trend (or a long-run growth path). It is
common to assume that business cycle fluctua-
tions can be analysed separately from the long-
run growth component of a series. Exactly how
to separate a time series into its trend and busi-
ness cycle components is an open question.
One approach which is common in the RBC lit-
erature is to use the Hodrick-Prescott (HP) fil-
ter. This method estimates the trend component
of a series via the minimisation of an objective
function which is composed of two terms: the
first is the sum of squared deviations of the se-
ries around the trend and the second is the sum
of squared deviations of the second differences
statistical properties of the HP filter is provided
by King and Rebelo (1993).
The appropriateness of the HP filter for iden-
tifying business cycle fluctuations has been
questioned by a number of authors (see Canova
1991; Cogley & Nason 1992). At question is
the extent to which the HP filter can introduce
artificial or spurious variability in detrended
series and comovements between detrended se-
ries, so that the business cycle facts are actually
artifacts of the HP filter and not statistical prop-
erties of the original data. While a recent paper
by Baxter and King (1 995) contains a defence
of the HP filter, current best practice would
seem to entail ensuring that stylised facts about
business cycles are relatively robust to alterna-
tive methods of detrending. In the following we
have used the HP filter to detrend series, but
these caveats should be kept in mind. Fisher,
Otto and Voss (1994) explore correlations
among the growth rates of variables, and reach
similar conclusions to the following.
Chart A shows the results from applying this
filter to Australian GDP (that is, GDP(A)). The
trend path is non-linear and approximates what
might be obtained by drawing a free-hand

Chart A Actual and Trend GDP

(1989-90 prices, seasonally adjusted)

logarithm
11.6 3

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year
58 The Australian Economic Review 3rd Quarter 1995

curve through the data. The difference between
the actual GDP and the trend is defined as re-
flecting business cycle fluctuations. Chart B
shows the detrended GDP data. This method of
identifying business cycle fluctuations in the
data produces results which tend to accord rea-
sonably well with the conventional wisdom
about the timing of recessions and booms in
Australia. The recessions of 1991-92 and
1981-82 are clearly evident in the detrended
data, as is the slower growth in output experi-
enced during the mid-1970s.
A second aspect of business cycle fluctua-
tions concerns the question of how various se-
ries are related over the business cycle. Using
GDP as the reference series we can ask whether
a series is more or less variable (volatile) than
GDP over the business cycle, and also whether
each series is correlated with GDP over the
business cycle. A series which co-varies posi-
tively with GDP is said to be procyclical while
one that co-varies negatively is said to be coun-
tercyclical. We can also examine whether a se-
ries tends to lead or lag GDP over the cycle.
By way of an example, we compute some
stylised facts for Australia using quarterly data
for the period 1959:3 to 1994:2. We examine
the following series: GDP, non-durable con-
sumption, durable consumption, private invest-
ment, government (or public) consumption,
public investment, employment and real wages
(see Table 1 for the exact definitions). All se-
ries are in logarithms, seasonally adjusted, and
detrended using the HP filter. Charts C to I
present plots of each (detrended) series along
with GDP. Notice that non-durable consump-
tion is less variable than GDP while durable
consumption and private investment are both
more volatile. All three series are procyclical.
Public consumption is about as variable as
GDP while public investment is more volatile.
Neither of these two series displays a particu-
larly systematic pattern of correlation with
GDP over the business cycle. Employment
tends to by procyclical. This is particularly ev-
ident in the 1980s where employment has
tended to move closely with GDP, albeit with a
slight lag. Finally while the real wage displays
considerable variability over the business cy-
cle, it has no obvious cyclical correlation with
GDP.
To examine more carefully the stylised facts
we present in Table 1 a number of statistics;
that is, standard deviation of each series, four
autocorrelations, and cross-correlations up to
four leads and lags. The results in Table 1 con-
firm the impressions obtained from the charts.
From the estimated standard deviations we see
that non-durable consumption is smoother than
aggregate output. This is broadly consistent

Chart B Detrended GDP

(1989-90 prices, seasonally adjusted)

logarithm
0.036 --t

0.024

0.012

-0.024
V' y\( V " V V
-0.036

-0.048

-0.06 ' I I
I I l 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 l I I I
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year
 Crosby & Otto: Real Business Cycle Models 59

Table 1 Australian Business Cycle Facts

Variables
Y C D I G P E W
Standard deviation 1 .58 0.80 5.1 1 6.41 2.04 5.40 1.13 1.29
Autocorrelation
coefficients 0.70 0.61 0.76 0.7 1 0.38 0.38 0.88 0.4 1

Cross-correlation coeficients
Corr(Y,, x,+ k)
k
4 4.11 -0.10 -0.10 0.02 4.28 4.26 -0.20
-3 0.08 0.11 0.1 1 0.03 4.24 -0.09 -0.27
-2 0.24 0.29 0.38 4.08 4.21 0.13 -0.27
-1 0.41 0.50 0.54 4.13 -0.18 0.38 -0.16
0 0.56 0.59 0.72 -0.06 4.06 0.57 0.03
1 0.44 0.48 0.63 -0.08 0.00 0.62 0.01
2 0.28 0.32 0.47 4.01 0.03 0.62 0.03
3 0.17 0.15 0.31 0.01 0.15 0.53 0.14
4 - 0.11 -0.07 0.11 0.02 0.27 0.40 0.06
Notes: Sample 1959:3-1994:2.
Y = GDP(A)
C total consumption - D
=
D motor vehicles + other durables
I = non-dwelling construction + equipment
G = government consumption
P = government investment
E = non-farm employment
W = average weekly earnings of non-farm wage and salary earners divided by the implicit price deflator for non-farm GDP.
Source: DX database.

Chart C Detrended GDP and Non-Durable Consumption

(1 989-90 prices, seasonally adjusted)

logarithm
0.036 7

0.024

0.012

-0.012

-0.024

-0.036
- GDP
-0.048
- non-durable consumption
- 0 . 0 6 1 1 , 1 1 , 1 1 1 1 1 1 , 1 1 1 1 1 1 1 1 , 1 1 1 1 1 1 1 1 1 1 1 1
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year
60 The Australian Economic Review 3rd Quarter 1995

with a permanent income or life-cycle model of
consumption, in which households borrow and
lend in order to smooth their consumption
paths. Expenditure on durables and private in-
vestment expenditure are both more variable
than output. This ranking of relative variability
for consumption, output and investment is con-
sistent with evidence from other OECD econo-
mies (see Backus & Kehoe 1992). Government
consumption and investment expenditure are
both more variable than output, however public
investment is the more volatile of the two se-
ries. Employment and real wages are both less
variable than GDP.
The cross-correlations tell us about how, on
average, the various series move with output
over the business cycle. Note that both the con-
sumption series and private investment are
strongly procyclical. Private investment is the
most procyclical of all of the series. Looking at

Chart D Detrended GDP and Durable Consumption

(1989-90prices, seasonally adjusted)

logarithm

0.1 -I 1
0.05

-0.05

-0.1
-
-031 v
GDP

- durable consumption
-0.2 I I I l 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Ye=

Chart E Detrended GDP and Private Investment

(1989-90prices, seasonally adjusted)

logarithm

o'2
0.15 1
0.1

0.05

-0.05

-0.1
- GDP
-0.15 - private investment
-0.2 I
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 l 1 l I I I I I I I I I I I l I I I I
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year
 Crosby & Otto: Real Business Cycle Models 61

the cross-correlations at various leads and lags
we observe that private consumption and pri-
vate investment tend to move symmetrically
with output. The cross-correlations between
output and the two government variables are
much weaker than for the private variables.
There is some weak evidence that government
consumption expenditure is countercyclical al-
though the contemporaneous correlation is
only -0.06. These statistics do not provide any
strong evidence to suggest that either public
consumption or public investment has been
systematically used to pursue countercyclical
fiscal policy.
As suggested by Chart H employment is pro-
cyclical, but tends to lag output by about 1-2
quarters. The real wage displays virtually zero
contemporaneous correlation with GDP, rather
the data suggest that real wages tend to lead the
cycle. In fact movements in the real wage tend

Chart F Detrended GDP and Public Consumption

(1989-90 prices, seasonally adjusted)
logarithm
0.08

0.06

0.04

0.02

-0.02

-0.04
- GDP
-0.06
public consumption
-0.08
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year

Chart G Detrended GDP and Public Investment

(1989-90 prices, seasonally adjusted)

logarithm
0.15
0.1
0.0s
0
-0.0s
-0.1
-0.15
-0.2 - GDP

-0.25
-0.3
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year
62 The Australian Economic Review 3rd Quarter I995

to be negatively correlated with future move-
ments in output. This finding for Australian
real wages is at odds with results for the United
States and the United Kingdom, where there is
stronger evidence of a procyclical real wage,
which is contemporaneously correlated with
output (see Blackburn & Ravn 1992). We re-
turn to this issue in a later section.
We have calculated statistics for a number of
key macroeconomic variables, using a com-
mon detrending method. A more detailed
analysis of business cycle facts for Australia
can be found in Fisher, Otto and Voss (1994),
while Blackburn and Ravn (1992) present re-
sults for the United Kingdom and Backus and
Kehoe (1992) examine historical facts for a
number of countries. In the following section
we outline a simple RBC model and see if it can
predict similar comovements, to those which
exist in the data, among particular variables.

Chart H Detrended GDP and Employment

(1989-90 prices, seasonally adjusted)

logarithm

- 0 . 0 6 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 , 1 1 1 1 1 , 1 1 1 1 1 1 1 1 1 1 1 ,
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year

Chart I Detrended GDP and Real Wage

(1989-90 prices, seasonally adjusted)

logarithm
0.04

0.02

-0.02

-0.04 - GDP

-0.06
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
year
 Crosby & Otto: Real Business Cycle Models
3. A Simple Real Business Cycle Model
In this section we examine a simple RBC
model similar to that found in Kydland and
Prescott (1982). While this model contains
some obviously counterfactual simplifications,
this model has been used as a basis for more
complicated recent research. In an RBC world
the economy is always assumed to be in a mar-
ket clearing equilibrium. It is assumed that
there is a representative household which di-
vides its time between leisure and work in
order to maximise utility. Since the model is a
representative agent model (or alternatively a
model in which all households are identical)
there can be no desired trade in equilibrium.
Households own all of the shares in the econ-
omys firms, and make consumption and sav-
ings decisions to maximise the (discounted)
sum of utilities over all periods. If we assume
that the household lives for two periods then
the households first period decision problem
becomes one of choosing leisure and con-
sumption to maximise utility intrutemporally
(within the period), as well as choosing the op-
timal amount of savings to maximise the utility
from consumption over the two periods (the in-
tertemporal problem). We will first consider
the decision problem of the household, before
moving on to examine the behaviour of a firm.
Figure 1
consumption
I I w
L leisure
63
The solution to the intratemporal problem
will be:
MRS, = w (1)
where MRS, is the marginal rate of substitution
between consumption and leisure, and w is the
real wage rate. The model determines real vari-
ables only, and it is assumed that nominal vari-
ables are separately determined, as in the clas-
sical dichotomy of, for example, Patinkin.
Equation (1) can be represented diagrammati-
cally as in Figure 1, where it can be seen that
(1) simply is the solution to the usual utility
maximising problem subject to the households
budget constraint. The budget constraint re-
flects the fact that when one hour of leisure is
given up, and spent working, the households
income rises by the amount of the real wage.
The slope of the budget constraint is thus -w.It
is usual to assume that both leisure and con-
sumption are normal goods, so that indiffer-
ence curves have the usual convex to the origin
shape. A utility maximising household will
choose consumption and leisure so that the in-
difference curve is tangent to the budget con-
straint, or MRS,, = w. Since time that is not
spent pursuing leisure is time spent working we
can use Figure 1 (and equation (1)) to find how
much labour the household will wish to supply,
given any real wage.
Two features of the RBC model are the ex-
plicit use of optimising behaviour, and the in-
tertemporal nature of household and firm deci-
sion problems. The two-period RBC model
preserves most of the features of multi-period
models which are usually utilised, but is easier
to solve. In a two-period model households
smooth consumption to maximise the dis-
counted sum of utilities over the two periods.
When $1 of current consumption is given up,
$( 1 + r) of future consumption will be available
next period, where r is the rate of interest. If the
household is behaving optimally, the marginal
utility lost from the $1 reduction in current con-
sumption should exactly equal the marginal
utility in the next period from the $(I + r) of
consumption in period 2, or:
64 The Australian Economic Review
where ? is consumption in period 2. This is il-
lustrated diagrammatically in Figure 2, where
the cost of future consumption today is re-
flected in the slope of the budget constraint,
and the slope of the indifference curves reflects
the marginal rate of substitution between cur-
rent and future consumption.
The usual treatment of firms in RBC models
is the same as found in standard micro-theory,
except for the fact that firms are assumed to be
buffeted by stochastic (random) productivity
shocks, so that their supply curve, and their de-
mand curve for labour, are also stochastic.
Firms have available to them a production
technology represented by:
where Y is the output of the firm, 8 is a (sto-
chastic) productivity term, k is the firms
stock of productive capital (carried forward
from last period), and n is labour utilised by
the firm. The firm maximises the present
value of profits over the two periods, given
the costs of labour and the rental price of capi-
tal, r, that it faces, as in standard micro-
theory. Profit maximising behaviour by firms
implies that:
MPn = w (4)
Figure 2
future
consumption
consumption
3rd Quarter 1995
MPz(1 - 6 ) = 1 +r (5)
where MP, is the marginal product of labour,
MP,- is the marginal product of next periods
capital stock (or the marginal product of invest-
ment), and 6 is the rate of depreciation of the
capital stock. Equation (4) is the familiar profit
maximising condition for a firm, defining a
firms demand for labour. Equation (4) can be
represented graphically as the point on the pro-
duction function where the production func-
tions slope equals the real wage, W , as in Fig-
ure 3. Equation (5) is an optimising condition
for investment. If $1 is borrowed today to pur-
chase capital, then the return to this investment
will be the marginal product of capital tomor-
row ( M P F ) ,applied to the amount of the capi-
tal purchased which still exists tomorrow (1 -
6). The return to the marginal investment un-
dertaken, given by the left-hand side of ( 5 ) ,
must just be sufficient to repay the cost of the
$ I borrowed-that is, $( 1 + r).
In equilibrium the labour market and the
goods market clear. Labour market clearing
requires that labour supply, implicitly defined
by (1) and Figure 1 , equals labour demand,
given by (4). There is a unique real wage
which clears the labour market, so that (1) and
(4) are satisfied. Goods market clearing re-
quires that the supply of output is equal to the
Figure 3
output
-
employment
 Crosby & Otto: Real Business Cycle Models
demand for output. Note that once the wage
rate is determined, and given the capital stock
in the first period, the supply of output is deter-
mined by 0 and the production function, (3).
Alternatively, note that labour market clearing
determines n, and k is given in the first period,
so that for any 0 equation (3) uniquely deter-
mines the supply of output. The demand for
output arises from consumption demand, in-
vestment demand, and the demands of govern-
ment. It is assumed that the government pur-
chases some output from firms, and finances
these purchases by lump-sum taxes on house-
holds. It is easiest to consider the case where
government purchases do not affect the utility
of households.
Goods market clearing thus requires that:
where i is investment demand (which deter-
mines the size of the capital stock in period 2 )
and g is spending by the government. Recall
that the right-hand side of (6) is fixed, once the
labour market has cleared. Also, consumption
and investment depend negatively on the rate
of interest. A higher interest rate raises the
cost of current consumption relative to future
consumption, causing households to postpone
consumption until the future. A higher interest
rate also makes current investment more
costly, causing investment to fall. The interest
rate is thus the variable which equates the de-
mand for output to the supply of output in (6).
Since y - c - g equals savings, we can alterna-
tively say that the equilibrium interest rate is
the interest rate at which savings equals invest-
ment.
Equilibrium in the markets for goods and for
labour determine the real interest rate and the
real wage rate. We can then use these variables
to determine the levels of consumption, invest-
ment, employment, and output in the model.
We can also conduct experiments with the
model, and show the effects of changes in gov-
ernment spending, and 0 (demand and sup-
ply shocks), on the equilibrium levels of the
variables in the model. This is analogous to
conventional comparative static exercises in
the AD-AS model, the only difference being
65
that we are here assuming that the supply curve
for output is stochastic (0 is variable).
3.I A Government Spending Shock
The first experiment we will perform on the
model above is to examine the effects of a gov-
ernment spending shock on all of the variables
in the model. Note that the first effect of an in-
crease in g is to increase demand in the model.
If this increase in demand is not met with any
increase in output supply, consumption and in-
vestment must fall one-for-one with the rise in
government spending. That is, since y = c + i +
g, if the rise in g is not accompanied by a rise
in output then consumption and investment
must fall. Diagrammatically, a rise in govern-
ment spending shifts the households con-
sumption opportunities locus inward (Figure 4)
in the same manner as a lump-sum tax. If (as is
usually the case) consumption and leisure are
both normal goods, then the household will re-
duce both consumption and leisure (diagram-
matically this is the move from A to B ) . Since
the reduction in leisure is equivalent to a rise in
labour supply, the real wage falls, and employ-
ment rises.
Note that since employment has risen, so too
must have output (from the production func-
tion). With the fixed capital stock there are now
more hours worked (and hence lower marginal
Figure 4
consumption
t
66 The Australian Economic Review
product and wages), and more output must be
produced. In effect households take part of the
income shock due to the rise in government
spending as a fall in consumption, but also in-
crease hours worked to partly offset this fall in
income. Thus the overall effect of the increase
in government spending is to increase output
and employment, but to reduce consumption
and real wages. Note also that savings will fall,
causing the interest rate to rise and investment
to fall. The increase in government spending
has caused a full in consumption and invest-
ment. This is not consistent with the business
cycle facts outlined in Section 2, and led RBC
theorists to examine supply shocks as a source
of business cycle fluctuations.
3.2 A Productivity Shock
A productivity shock is represented by a
change in 0, usually assumed to be Solow re-
siduals from conventional growth accounting;
that is, that part of economic growth not ex-
plained by (the factor share weighted) growth
in factors of production. Consider an increase
in the Solow residual in period 1, and its effects
on the variables in the model. Firstly, an in-
crease in 8 will push up the production function
in Figure 1, causing output and labour demand
to increase (since there is an increase in the
marginal product of labour). The increase in la-
bour demand increases the real wage, inducing
households to work more (note that there is an
income and a substitution effect from the in-
crease in income, and we have made the con-
ventional assumption that the substitution
effect dominates). There is an increase in con-
sumption, and also an increase in savings as
households attempt to smooth consumption
across periods. The increase in the supply of
savings causes interest rates to fall and invest-
ment to rise. This will cause output to be higher
next period also (since the capital stock is
higher due to the investment), so that the pro-
ductivity shock has persistent effects on out-
put-productivity shocks generate cycles.
The positive productivity shock has caused
output, consumption, real wages, and invest-
ment to rise, and interest rates to fall. These
facts seem to be consistent with the basic busi-
3rd Quarter I995
ness cycle phenomena discussed in Section 2.
All of the comovements between the variables
are in the same direction as in the data, with the
notable exception of the real wage." This very
simple model of intratemporal and intertempo-
ral substitution by households and firms is able
to capture the basic cyclical features of the real
economy. Kydland and Prescott (1 982) claim
that this model was a first step in building a full
model, which would include money and other
realistic features of the economy. However
Prescott (1986) found that a calibrated'* ver-
sion of this model (with more than two periods)
was able to replicate the features of the econ-
omy quite well (there is a problem with what
'quite well' means here, since Prescott pro-
vides no statistical metric to judge whether a
correlation in the model is 'close' to the corre-
lations in the economy or not).
It can be seen that this very simple model,
with no nominal variables, can generate realis-
tic fluctuations in real variables with only
productivity shocks as the sources of these
fluctuations. These productivity shocks are
propagated through the economy through
households adjusting consumption and leisure
within periods, as well as smoothing consump-
tion across periods. However this simple ver-
sion of the RBC model is not without its prob-
lems and in the following section we outline
some criticisms of the basic model and some
extensions designed to overcome the criti-
cisms.
4. Evaluating the RBC Model
As a number of critics, including McCallum
(1989), have noted, in the RBC model which
relies entirely on productivity shocks as the
source of business cycle fluctuations we obtain
the prediction that the real wage should be
strongly procyclical. The model also implies
that employment and the real wage should be
positively correlated. Intuitively we can think
of productivity shocks as shifting the demand
for labour schedule, while the labour supply
schedule remains fixed. These predictions are
essentially at odds with the empirical facts.
Empirical evidence for the United States and
the United Kingdom suggest that at best the
 Crosby & Otto: Real Business Cycle Models
real wage is mildly procyclical, while the Aus-
tralian data point to an acyclical or countercy-
clical real wage.I3
The absence of any systematic relationship
between real wages and employment in the
data has long been recognised (see Dunlop
1938; Tarshis 1939). In fact it provided an
early criticism of the version of the IS-LM
model which assumes sticky nominal wages
(but flexible prices). In this model workers are
on their labour demand schedules so real wages
must fall to induce firms to increase employ-
ment. The absence of any strong systematic
correlation between the real wage and employ-
ment is confirmed by the Australian data. The
contemporaneous correlation between the de-
trended series is only -0.1 1.
One means of improving the predictions of
the RBC with regard to these labour market
facts has been suggested by Christian0 and
Eichenbaum (1992). They develop an RBC
model which includes both supply (productiv-
ity) shocks and demand (government spend-
ing) shocks. They find that this simple modifi-
cation to the basic model is capable of
generating business cycle fluctuations without
relying on procyclical movements in real
wages. Essentially the government expenditure
shocks produce shifts in the labour supply
curve, so that any pattern of covariation be-
tween the real wage and employment and be-
tween the real wage and output is possible.
Although not directly apparent from our sim-
ple examples, the basic RBC model suffers
from two other problems related to its labour
market predictions. One of these concerns the
variability of employment (or hours worked)
over the business cycle. In the productivity
shock model fluctuations in employment arise
from movements along a given labour supply
schedule. This implies that all employment
fluctuations over the business cycle are volun-
tary. Moreover in order to obtain the level of
employment variability observed in the data,
the willingness of workers to substitute be-
tween work and leisure in a particular period
and to substitute work effort between different
periods (that is, intertemporal substitution)
must be quite large. Empirical studies using
micro-data suggest that atemporal and inter-
67
temporal labour supply elasticities are rela-
tively small.
A related issue concerns the fact that in the
data for the United States (see Prescott 1986)
and Australia (see Fisher, Otto & Voss 1994)
most of the variation in total hours worked
arises from variations in the level of employ-
ment and not from variations in hours per
worker. Surprisingly this is not the case for the
United Kingdom where the standard deviation
of employment and hours per worker are ap-
proximately equal.
Hansen (1985) has suggested one way in
which the basic RBC model might be extended
to account for the above two anomalies. Like
Rogerson (1988), he uses a model with non-
convexities in labour supply to confront this is-
sue. The model has households wishing to
work either full-time, or not at all, because of
transactions costs in getting to work and the
existence of unemployment benefits. Hence
when there is a negative productivity shock
some households will, in equilibrium, not
work. This model tends to generate employ-
ment fluctuations without large fluctuations in
real wages, and will also feature positive levels
of unemployment.'4
There have been other more general criti-
cisms of the RBC models (see Summers 1986).
These criticisms have generally been of two
forms. Firstly, is a model which predicts well
necessarily a good model? Secondly, the as-
sumption of market clearing is not realistic.
Summers argues that RBC models are like
Lamarckian biology and Ptolemaic astronomy.
The former is able to predict much of what is
observed in the study of plants and animals,
and the latter guided ships for centuries, yet
both theories are now viewed as having fatal
flaws. In short, bad theories can sometimes pre-
dict well. This debate is an old one in econ-
omics, originating with the positivism of Mil-
ton Friedman. This is also a debate which is
unlikely to be resolved. The response of the
RBC theorists to this criticism is that it is im-
possible for a model to capture all of the fea-
tures of the real economy, and abstraction is
therefore essential. The RBC model is abstract,
but it is logical and has strong theoretical foun-
dations in microeconomics. Judgments on the
68 The Australian Economic Review
performance of the model should be based on
the predictive ability of the model. RBC theo-
rists also argue that the arbitrary nature of the
model is limited by choosing the parameters of
their models using other empirical studies.
The assumption of market clearing most
clearly divides RBC model advocates from
their opponents. Fluctuations in the simple
RBC model arise from productivity shocks,
and the response of consumption, employment,
and investment are all optimal responses to
these shocks. Given the current state of the sys-
tem (that is, the current level of productivity),
all variables are at their optimal levels. This
runs counter to the arguments of most of post-
war macroeconomics, that the role of macro-
policy was to dampen fluctuations in output,
since these fluctuations were not optimal. This
is currently an area of much debate in macro-
economics, and is likely to remain so for some
time. It should also be noted that it is market
clearing that is the crucial feature of these mod-
els, and not perfect competition. Current real
business cycle research includes RBC models
which allow for imperfect competition, and in-
cludes government spending and productivity
shocks (see McGrattan 1994).
5. Conclusions
In this article we have presented a simple RBC
model, in order to show that these models cap-
ture many of the features of business cycles in
the real economy. While these models are very
abstract, we argue that they are a useful way of
thinking about the macroeconomy. These mod-
els have also been influential in refocusing at-
tention on supply issues in macroeconomics,
after a long postwar focus on aggregate demand
management in Australia and most other west-
ern economies. Policies such as structural re-
form and labour market reform are clearly
aimed at influencing the supply side of the
economy and productivity. While we would not
argue that supply factors are the whole story, it
would not seem likely that demand factors tell
the whole story either, as is implicitly assumed
in simple IS-LM type models. In addition, these
models suggest that at least some of the boom-
bust cycle in macroeconomic variables might
3rd Quarter 1995
be due to natural fluctuations in these variables,
and not due to policy failures. To the extent that
this is true, attempts to dampen aggregate fluc-
tuations will be counterproductive.
First version received October 1994;
final version accepted June 1995 (Eds).
Endnotes
1. The definition of a recession is contentious,
but is here assumed to be successive quarters of
negative GDP growth.
2. We follow Plosser (1 989) in using the termi-
nology business cycle fluctuations rather than
the business cycle. Earlier models of the busi-
ness cycle often included a deterministic cycle,
which gives a models predictions a regularity
which is not evident in the data.
3. See Zarnowitz (1985) for an exhaustive sur-
vey of pre-RBC business cycle theory.
4. This model is now integrated into most intro-
ductory macroeconomics textbooks, for exam-
ple Dornbusch and Fischer (1990).
5. The KP model does not, however, include
market failures or externalities which may lead
us to modify this conclusion. However, it could
be argued that if market failures cause an econ-
omy to suffer from business cycles, the market
failure ought to be addressed directly, rather
than indirectly through dampening fluctuations
in the cycle.
6. There is at present much debate about the ex-
tent to which fluctuations in output represent
demand shocks, and the extent to which they
reflect supply shocks. Eichenbaum ( 199 1 ) sug-
gested that supply shocks could explain all, or
none, of the movements in output, while others
have suggested that the fraction of movements
in output explained by supply shocks is be-
tween 45 per cent and 98 per cent (Aiyagari
1994), or indeterminate (Ingram, Kocherlakota
& Savin 1994). Our point is that it seems likely
that at least some of the movements in output
are due to supply shocks.
 Crosby & Otto: Real Business Cycle Models
7. Formally, letting { y , } , t = 1, . . . T be the se-
ries of interest, the trend component T~ is ob-
tained by choosing { T ~ } t, = I , . . . T to mini-
mise:
T
c
I= I
(Y,-T,)*
T erson approach is unlikely to satisfy economists
+ c
/= 1
KT/ + 1 - T/)- (T/- T/-])I2
where h is a weight which penalises accelera-
tion in the trend component. Setting h = 0 re-
sults in the trend being equal to first differ-
ences, while h = w results in a linear trend.
8. See McCallum (1989) for a simple multi-
period algebraic version of the model. Barro
(1990) presents a similar model in his textbook,
while Koenig (1993a, 1993b) shows that this
model can be analysed in a framework very
similar to textbook IS-LM analysis.
9. We have made the usual assumption that the
substitution effect of a change in income on
consumption is greater than the income effect.
10. See Barro and King (1 984) for a discussion
of the effect of government spending shocks in
the type of model we are considering here.
11. This is not a minor point, and is taken up in
the next section.
12. Calibration involves choosing functional
forms for the production function, utility func-
tion and other parameters of the model (usually
based on other econometric estimates) and
simulating the model given the statistical prop-
erties of the Solow residuals. This generates
correlations between variables which can then
be compared with the correlations in the actual
data.
13. Evidence in Fisher, Otto and Voss (1994)
suggests that the real wage for Australia was
moderately procyclical in the 1960s but coun-
tercyclical in the 1970s and 1980s.
14. Of course this is still an equilibrium model
and the unemployment is voluntary, in the sense
69
that workers choose to live in a world with little
real wage variability and large employment
variability, rather than the converse. Arguably,
this may be a reasonable description of Aus-
tralia under centralised wage bargaining, which
has kept real wage variability small in relation
to other variables. However, the HansedRog-
who feel that unemployment is a disequilibrium
(or an off the labour supply curve) phenomena.
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