Federal Reserve Bank of Minneapolis
Quarterly Review Fall 1986
Response to a Skeptic
Edward C. Prescott
Federal Reserve Bank of Minneapolis and Professor of Economics
University of Minnesota
New findings in science are always subject to skepticism and challenge. This is an important part of the scientific process. Only if new results successfully withstand the attacks do they become part of accepted scientific wisdom. Summers (in this issue) is within this tradition when he attacks the finding I describe (in this issue) that business cycles are precisely what economic theory predicts given the best measures of people’s willingness and ability to substitute consumption and leisure, both between and within time periods. I welcome this opportunity to respond to Summers’ challenges to the parameter values and the business cycle facts that I and other real business cycle analysts have used. In challenging the existing quality of measurement and not providing measurement inconsistent with existing theory, Summers has conceded the point that theory is ahead of business cycle measurement.
Before responding to Summers’ challenges to the measurements used in real business cycle analyses, I will respond briefly to his other attacks and, in the process, try to clarify some methodological issues in business cycle theory as well as in aggregate economic theory more generally.
Summers asks, Where are the prices? This question is puzzling. The mechanism real business cycle analysts use is the one he and other leading people in the field of aggregate public finance use: competitive equilibrium. Competitive equilibria have relative prices. As stated in the introduction of “Theory Ahead of Business Cycle Measurement” (in this issue), the business cycle puzzle is, Why are there large movements in the time allocated to market activities and little associated movements in the real wage, the price of people’s time? Along with that price, Kydland and I (1982, 1984) examine the rental price of capital. An infinity of other relative prices can be studied, but these are the ones needed to construct national income and product accounts. The behavior of these prices in our models conforms with that observed.
In competitive theory, an economic environment is needed. For that, real business cycle analysts have used the neoclassical growth model. It is the preeminent model in aggregate economics. It was developed to account for the growth facts and has been widely used for predicting the aggregate effects of alternative tax schemes as well. With the labor/leisure decision endogenized, it is the appropriate model to study the aggregate implications of technology change uncertainty. Indeed, in 1977 Lucas, the person responsible for making business cycles again a central focus in economics, defined them (p. 23) as deviations from the neoclassical growth model—that is, fluctuations in hours allocated to market activity that are too large to be accounted for by changing marginal productivities of labor as reflected in real wages. Lucas, like me and