Eli Dourado

Why RBC is awesome

Paul Krugman disses RBC theory and those who study it as unscientific. I’m not an RBC theorist, but I’ll stick up for freshwater macro. Here are some reasons why RBC theory deserves more respect than Krugman gives it.

  1. Suppose monetary policy is conducted so that all nominal shocks are perfectly offset. Zero percent of net shocks, shocks adjusted for changes in the quantity of money, are nominal; 100% of net shocks are real. Therefore as monetary policy improves it is the policy conclusions of the RBC literature, not the New Keynesian literature, that are relevant.

  2. Empirically, I agree with Krugman and others contra pure RBC theory that money appears to be non-neutral. But why is money non-neutral? Saltwater macro offers answers to this question that are frankly absurd. Menu cost arguments rely on a fallacy of composition. Even if all businesses face costs of changing prices, unless they synchronize their price changes, there is no reason to believe that the price level as a whole is sticky; see Caplin and Spulber. If the nominal price level is not sticky, there is no reason to believe that real stickiness—efficiency wages and so on—can be the source of monetary non-neutrality. Freshwater macro has advanced the much more plausible idea that money is non-neutral because of legal restrictions on financial intermediation. Under laissez-faire, money would be neutral, and RBC would be correct.

  3. Critics of RBC argue that it is hard to find shocks to real factors such as technology, particularly negative shocks, to account for recessions. However, they overlook shocks to credit, which is—wait for it—a real not a nominal factor.

  4. Critics of RBC ridicule the theory by saying that according to freshwater economists, the Great Depression was the Great Vacation. But their own theory is no less ridiculous. According to saltwater economists, unemployment of over 20 percent persisted for almost a decade because people were too stubborn to accept wage cuts. Sorry, not plausible.

  5. RBC makes strong assumptions, but it should be appreciated for what it is, which is an attempt to do macro as pure economics without post hoc additions to make the theory fit with measurement (which is, after all, imperfect). In contrast, other approaches exhibit a tendency toward, to coin a phrase, Macro of the Gaps. The models don’t always make this clear, but a lot of the features that do the work in saltwater theory are residuals. I am not aware, for instance, of a serious effort to give a theoretical account of the value of the fiscal multiplier. Instead, the fiscal multiplier is whatever regressions say it is. I am not against empirical work, but how convenient that regressions set the multiplier to whatever level is necessary to make the theory work. In fairness, some RBC papers empirically calibrate models, but there is more honesty about the fact that they are calibrating, not independently estimating results.

  6. As Tyler used to say in Macro I, 98 percent or more of business cycles in human history were indisputably real business cycles. There was no central bank and no fiscal authority in caveman days. “My theory explains 98 percent of business cycles” seems like pretty good justification to me.

As I said before, I’m not an RBC theorist, but not everything has to be about petty tribalism. RBC is both scientific and worth studying.