Edward C. Prescott
Theory Ahead of Measurement
Theory Ahead of Business Cycle Measurement*
Edward C. Prescott
Federal Reserve Bank of Minneapolis and Professor of Economics
University of Minnesota
Economists have long been puzzled by the observations that during peacetime industrial market economies display recurrent, large fluctuations in output and employment over relatively short time periods. Not uncommon are changes as large as 10 percent within only a couple of years. These observations are considered puzzling because the associated movements in labor’s marginal product are small.
These observations should not be puzzling, for they are what standard economic theory predicts. For the United States, in fact, given people’s ability and willingness to intertemporally and intratemporally substitute consumption and leisure and given the nature of the changing production possibility set, it would be puzzling if the economy did not display these large fluctuations in output and employment with little associated fluctuations in the marginal product of labor. Moreover, standard theory also correctly predicts the amplitude of these fluctuations, their serial correlation properties, and the fact that the investment component of output is about six times as volatile as the consumption component.
This perhaps surprising conclusion is the principal finding of a research program initiated by Kydland and me (1982) and extended by Kydland and me (1984), Hansen (1985a), and Bain (1985). We have computed the competitive equilibrium stochastic process for variants of the constant elasticity, stochastic growth model. The elasticities of substitution and the share parameters of the production and utility functions are restricted to those that generate the growth observations. The process governing the technology parameter is selected to be consistent with the measured technology changes for the American economy since the Korean War. We ask whether these artificial economies display fluctuations with statistical properties similar to those which the American economy has displayed in that period. They do. 1
I view the growth model as a paradigm for macro analysis—analogous to the supply and demand construct of price theory. The elasticities of substitution and the share parameters of the growth model are analogous to the price and income elasticities of price theory. Whether or not this paradigm dominates, as I expect it will, is still an open question. But the early results indicate its power to organize our knowledge. The finding that when uncertainty in the rate of technological change is incorporated into the growth model it
* This paper was presented at a Carnegie-Rochester Conference on Public Policy and will appear in a volume of the conference proceedings. It appears here with the kind permission of Allan H. Meltzer, editor of that volume. The author thanks Finn E. Kydland for helpful discussions of the issues reviewed here, Gary D. Hansen for data series and some additional results for his growth economy, Lars G. M. Ljungqvist for expert research assistance, Bruce D. Smith and Allan H. Meltzer for comments on a preliminary draft, and the National Science Foundation and the Minneapolis Federal Reserve Bank for financial support. The views expressed herein are those of the author alone.
1 Others [Barro (1981) and Long and Plosser (1983), for example] have argued that these fluctuations are not inconsistent with competitive theory that abstracts from monetary factors. Our finding is much stronger: standard theory predicts that the economy will display the business cycle phenomena.