Federal Reserve Bank of Minneapolis
Quarterly Review Fall 1986
Some Skeptical Observations on Real Business Cycle Theory *
Lawrence H. Summers
Professor of Economics
Harvard University and Research Associate
National Bureau of Economic Research
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 mean that we lack the data or measurements necessary to test his theory. Rather, he means that measurement techniques have not yet progressed to the point where they fully corroborate his theory. Thus, Prescott speaks of the key deviation of observation from theory as follows: “An important part of this deviation could very well disappear if the economic variables were measured more in conformity with theory. That is why I argue that theory is now ahead of business cycle measurement…. ”
The claims of real business cycle theorists deserve
* An earlier version of these remarks was presented at the July 25, 1986, meeting of the National Bureau of Economic Research Economic Fluctuations Group.