purchases leads to an increase in real output because the induced rise in the

real rate of interest encourages an increase in labour supply, thereby increas-

ing employment and real output.

Finally, we can use the Cd“Ys model to examine the impact of temporary

v. permanent technology shocks. In this case we simply reproduce the Cd“Ys

diagram on its own, but we also allow for possible wealth effects on the Cd

curve.

Figure 6.8 represents the basic market-clearing diagram which is central to

the modern new classical equilibrium approach to macroeconomic analysis.

Following Barro (1993), the market-clearing condition is given by (6.12):

Cd (r, ¦) = Ys(r, ¦) (6.12)

The real business cycle school 319

(b) (c)

Y = AF(K,L)

Y Y

b

Y2 Y2 b

a

Y1 Y1 a

45°

L 1 L2 L Y1 Y2 Y

(a) (d)

YS

r

(W/P)

SL1(r1)

SL2(r2)

r2 b

(W/P)1 a

r1 a

b

(W/P)2

Cd2

Cd1

DL

L 1 L2 L Y1 Y2 Y

Figure 6.7 The impact of a government expenditure shock

In equation (6.12) variables omitted and indicated by ¦ include the various

wealth and substitution effects which result from shocks to the production

function or government expenditure and so on. The response of Cd and Ys to

changes in the real rate of interest is illustrated by movements along the

aggregate demand and supply curves. The Cd and Ys curves will shift if any

of the other variables which in¬‚uence Cd and Ys change, as with a shock to

the production function or an increase in government expenditure.

To see how a technology shock will in¬‚uence aggregate output in this

model, consider Figure 6.8, where, starting from point a, we assume a bene¬-

cial technology change takes place of the type considered in Figure 6.3. Such

a shock will clearly shift the Ys curve to the right from Ys1 to Ys*. If the

technology shock is seen to be temporary, the impact on consumer demand of

the wealth effect is likely to be small and the resultant rightward shift of Cd

320 Modern macroeconomics

Figure 6.8 The impact of temporary and permanent technology shocks in

the real business cycle model

will be less than the shift of Ys: a movement from point a to b. Output rises

from Y1 to Y2 and the real interest rate falls to r2. If the technology shock is

seen to be permanent, then the wealth effect of the shock on consumption is

more powerful. In this case the rightward shifts of Ys and Cd are likely to be

of a similar magnitude, leading to a rise in output from Y1 to Y* but with the

real interest rate remaining at r1: a movement from point a to c. According to

Barro, this model does reasonably well in accounting for the stylized facts of

business ¬‚uctuations. For a detailed discussion of these issues, see Barro

(1993), especially pp. 232“41.

6.11 Calibrating the Model

It was Kydland and Prescott (1982) who ¬rst demonstrated that a general

equilibrium real business cycle model, driven by exogenous technological

shocks, was capable of generating time series data that possessed the statis-

tical properties of US business cycles over the period 1950“79. However,

real business cycle theorists have not generally attempted to provide mod-

els capable of conventional econometric testing but have instead tended to

focus on providing numerical examples of a more general theory of

¬‚uctuations. In order to examine the quantitative implications of their mod-

The real business cycle school 321

els, real business cycle theorists have developed a method known as ˜cali-

bration™ or ˜computational experiments™. Cooley (1997) de¬nes calibration

as ˜a strategy for ¬nding numerical values for the parameters of arti¬cial

economies™ and involves a ˜symbiotic relationship between theory and meas-

urement™. The calibration strategy consists of the following steps (see

Kydland and Prescott, 1982, 1991, 1996; Plosser, 1989; Backhouse, 1997b;

Abel and Bernanke, 2001):

1. Pose a question relating to a speci¬c issue of concern, for example an

important policy issue such as ˜What is the quantitative nature of

¬‚uctuations caused by technology shocks?™

2. Use a ˜well-tested™ theory, where ˜theory™ is interpreted as a speci¬c set

of instructions about how to build the imitation economy.

3. Construct a model economy and select functional forms. Kydland and

Prescott (1982) utilize the basic stochastic neoclassical growth model as

the cornerstone of their model.

4. Provide speci¬c algebraic forms of the functions used to represent pro-

duction and consumption decisions. For example, a speci¬c Cobb“Douglas

production function is used by Plosser (1989).

5. Calibrate the model economy using data from pre-existing microeconomic

studies and knowledge of the ˜stylized facts™. Where no information

exists select values for parameters so that the model is capable of mim-

icking the real-world behaviour of variables.

6. The calibration exercise then involves simulating the effect of subjecting

the model to a series of random technology shocks using a computer.

7. The impact that these shocks have on the key macroeconomic variables

is then traced out so that the results can be compared with the actual

behaviour of the main macroeconomic time series.

8. Run the experiment and compare the equilibrium path of the model

economy with the behaviour of the actual economy. Use these types of

simulations to answer questions relating to the important issues initially

identi¬ed under (1).

In their seminal 1982 paper Kydland and Prescott use the neoclassical growth

model and follow the calibration/simulation procedure to see if the model can

explain aggregate ¬‚uctuations when the model economy is subject to technol-

ogy shocks. As Prescott (1986) recalls, ˜the ¬nding that when uncertainty in

the rate of technological change is incorporated into the growth model it

displays business cycle phenomena was both dramatic and unanticipated™.

The simulations carried out by Kydland, Prescott and Plosser produced some

impressive results in that their models are able to mimic an actual economy

with respect to some important time series data. These simulations indicate

322 Modern macroeconomics

that a competitive economy hit by repeated technology shocks can exhibit the

kind of ¬‚uctuations that are actually observed.

On the negative side, one of the problems with calibration is that it cur-

rently does not provide a method that allows one to judge between the

performance of real and other (for example Keynesian) business cycle mod-

els. As Hoover (1995b) notes, ˜the calibration methodology, to date, lacks

any discipline as stern as that imposed by econometric methods ¦ Above all,

it is not clear on what standards competing, but contradictory, models are to

be compared and adjudicated.™ Nevertheless calibration has provided an im-

portant new contribution to the methodology of empirical macroeconomic

research. While initially the calibration methodology was focused on busi-

ness cycle research, more recently calibrated models have been used to