A Macroeconomics Reader

By Brian Snowdon; Howard R. Vane | Go to book overview

16

Some skeptical observations on real business cycle theory

Lawrence H. Summers

Federal Reserve Bank of Minneapolis Quarterly Review (1986) Fall, pp. 23-7

The increasing ascendancy of real business cycle theories of various stripes, with their common view that the economy is best modeled as a floating Walrasian equilibrium, buffeted by productivity shocks, is indicative of the depths of the divisions separating academic macroeconomists. These theories deny propositions thought self-evident by many academic macroeconomists and all of those involved in forecasting and controlling the economy on a day-to-day basis. They assert that monetary policies have no effect on real activity, that fiscal policies influence the economy only through their incentive effects, and that economic fluctuations are caused entirely by supply rather than demand shocks.

If these theories are correct, they imply that the macroeconomics developed in the wake of the Keynesian Revolution is well confined to the ashbin of history. And they suggest that most of the work of contemporary macroeconomists is worth little more than that of those pursuing astrological science. According to the views espoused by enthusiastic proponents of real business cycle theories, astrology and Keynesian economics are in many ways similar: both lack scientific support, both are premised on the relevance of variables that are in fact irrelevant, both are built on a superstructure of nonoperational and ill-defined concepts, and both are harmless only when they are ineffectual.

The appearance of Ed Prescott’s stimulating paper, Theory Ahead of Business Cycle Measurement’, affords an opportunity to assess the current state of real business cycle theory and to consider its prospects as a foundation for macroeconomic analysis. Prescott’s paper is brilliant in highlighting the appeal of real business cycle theories and making clear the assumptions they require. But he does not make much effort at caution in judging the potential of the real business cycle paradigm. He writes that ‘if the economy did not display the business cycle phenomena, there would be a puzzle’, characterizes without qualification economic fluctuations as ‘optimal responses to uncertainty in the rate of technological change’, and offers the policy advice that ‘costly efforts at stabilization are likely to be counter productive’.

Prescott’s interpretation of his title is revealing of his commitment to his theory. He does not interpret the phrase theory ahead of measurement to

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