M.A.

Program in Economics
International School of Economics
at Tbilisi State University (ISET)

MACRO V

Lecture Notes - I

Instructor: Maksym Obrizan

(Kyiv School of Economics)

1
THIS LECTURE: REAL BUSINESS CYCLES
The following discussion is based on Economic Growth and
Business Cycles by Cooley and Prescott (1995)

The infinite horizon Ramsey model is the working horse of

modern macroeconomics

For example, we can easily turn it into exogenous growth model

Yt = At Ktα L1−α
t (1)

where At is the Total Factor Productivity growing at a constant

rate At+1 = (1 + γ)At

Similar models (with properly chosen preferences and

production) will converge to a balanced growth path and
replicate Kaldor’s stylized growth facts

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Re-consider Solow exercise

Moreover, we can use this new model to study the

determinants of long run growth similar to Solow

After taking logs we obtain the econometric specification

ln Yt = ln At + α ln Kt + (1 − α)Lt (2)

Solow ran a similar regression for 1909-1949 to show that

productivity change accounted for 87.5% of growth in real
output per worker

Later studies, however, found a smaller effect after controlling

for the quality of inputs (i.e. health and education of workers)

3
Growth vs Business Cycles

After repeating Solow exercise with recent data one can obtain
the following results for the US economy:

1. Changes in capital are responsible for about 1/3 of growth in

output per worker but are not related to business cycles

2. Changes in labor do not affect growth but explain about 2/3

of business cycle fluctuations

3. Productivity changes account for 2/3 of growth in output per

worker and for 1/3 of business cycle dynamics

Notice that economic growth and business cycles are not

distinct phenomena

4
Real Business Cycle (RBC)
Any realistic model economy should demonstrate both growth
and business cycle which characterize most economies

Real (because there is no money) Business Cycle models

address this goal in a very simple perfectly competitive setup
(just three equations in the most basic model)

New-Keynesian Models is an alternative class of Dynamic

Stochastic General Equilibrium (DSGE) models in which money
is not neutral

In New-Keynesian models increases in money supply have real

effects on the economy due to price or wage stickiness (i.e.
imperfect competition)

However, these models are typically very complicated with tens

of equations describing many imperfect markets
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New features

How should we modify the growth model so that it generates

business cycles?

Integrating both growth and fluctuations requires some features

not present in deterministic growth model:

1. Introduce mechanism causing productivity changes at

business cycle frequency

2. Introduce labor supply consistent with large movements in

labor

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A stochastic growth economy with labor
Households’ utility is defined over stochastic sequences of
consumption and leisure
∞
X
E β t u(ct , 1 − ht ), (3)
t=0

where ht is labor supply (percent of time in productive activities)

Utility function u is continuously differentiable in both

arguments, strictly increasing and concave

Notice the expectation sign E in front of the infinite sum of

discounted utilities

Question: Where does the uncertainty come from?

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Production

The production is characterized by

Yt = ezt F (Kt , Ht ) (4)

where zt is a random productivity shock

Productivity zt evolves according to

zt+1 = ρzt + εt+1 (5)

where 0 < ρ < 1 and εt is normally distributed with mean zero

and variance σε2

Question: Why can’t we use Yt = zt F (Kt , Ht )?

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Firm’s problem

Aggregate capital stock evolves according to

Kt+1 = (1 − δ)Kt + Xt (6)

With CRS - constant returns to scale - we can consider a single

firm choosing Kt and Ht to maximize profits

pt ezt F (Kt , Ht ) − rt Kt − wt Ht (7)

By Walras law we can normalize pt = 1 without loss of

generality (only N − 1 relative prices are determined when
there are N goods)

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Firms FOCs

After taking the first order conditions we obtain the usual

condition that each factor is paid its marginal product

rt = ezt FK (Kt , Ht ) (8)

zt
wt = e FH (Kt , Ht ) (9)

where FK (Kt , Ht ) is the derivative with respect to the first

argument

Question: What is firm’s profit given CRS production function?

Question: Is the firm’s problem intertemporal?

Introducing population growth

Suppose that Ht+1 = (1 + η)Ht and At+1 = (1 + γ)At where η

and γ are population and TFP growth rates correspondingly

We can express all variables in per efficient unit of labor terms

once again by dividing each term by At Lt

For example, equation for the aggregate capital can be

re-defined as
Kt+1 At+1 Ht+1 (1 − δ)Kt Xt
= + (10)
At Ht At+1 Ht+1 At Ht At Ht
(1 + η)(1 + γ)kt+1 = (1 − δ)kt + xt (11)

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A specific model economy

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Quiz

Take a piece of paper and solve this quiz by hand.

You may work in teams but each student must submit

individual solution.

Please show derivations (even if they are simple) and explain in

5-15 words.

Take a picture and upload it to Dropbox using the link provided

in the email.

You will get 50% of the score (10 points) for submitting your
solution and up to 50% for correct answer (or up to 20 points in
total).

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Quiz

Use a specific model economy described on the previous slide

to answer the following questions:

1. Set up the infinite horizon Lagrangian.

2. List all the choice variables.

3. Take the corresponding first-order conditions.

4. Obtain and interpret the Euler equation

5. Obtain and interpret the condition linking consumption and

labor choice.

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The idea behind ’calibration’

In the specific model economy there are parameters (such as θ,

α etc) that have corresponding counterparts in the real
economy

For example, θ is the capital share in output which you can

approximate as the sum of rental income, corporate profits, net
interest and depreciation in the properly defined measure of
output

This process of assigning specific values from real economy to

theoretical parameters is called calibration
Defining business cycles

In most industrialized countries output tends to fluctuate about

a long-term growth path - this is what we mean by the
"business cycle"

These fluctuations may be of varying amplitude and duration

We would like our artificial economy to replicate these

fluctuations

How can we divide time series of output yt into the growth and
the cyclical components if we observe them in one series
(income)?

Hodrick-Prescott filter is often used for this purpose

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HP Filter

Specifically, we can characterize the observed time series yt as

g
the sum of cyclical component ytc and growth component yt

Define λ as a parameter reflecting the relative variance of the

growth component to the cyclical component
g
Then HP filter chooses the growth component yt to minimize
the loss function
T T
g g g g
X X
(ytc )2 + λ [(yt+1 − yt ) − (yt − yt−1 )]2 (12)
t=1 t=1

The tradeoff in this optimization problem is between how

closely the growth component tracks the actual series (i.e.
smaller ytc ) against smoothness of the trend

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Practical considerations

When λ = 0 the growth component is simply the series

When λ approaches infinity the growth component approaches

a linear trend

For quarterly data λ is usually set to 1600

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Successes and failures of the RBC model
How can we judge about the quality of the model?

Cooley and Prescott simulate the model economy 100 times for
150 quarters and apply HP filter to characterize cyclical
behaviour of the model economy

They compare standard deviation of the simulated economy

with the actual US data (also HP filtered at the same frequency)

While the simulated model captures some features of the US

data it still misses many others

However, this is probably not surprising given the simplicity of

the model which calls for more realistic (hence, more complex)
models to be considered

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