Modern Macroeconomics.pdf

The real business cycle school 303evolve as a statistical process known as a random walk. Equation (6.2) showsa random walk with drift for GNP:Yt = gt + Yt−1 + zt(6.2)In equation (6.2) g t reflects the ‘drift’ of output and, with Y t also beingdependent on Y t–1 , any shock to z t will raise output permanently. Suppose ashock raises the level of output at time t 1 in Figure 6.2. Since output in thenext period is determined by output in period t 1 , the rise in output persists inevery future period. In the case of a random walk with drift, output is said tohave a ‘unit root’; that is, the coefficient on the lagged output term in equation(6.2) is set equal to unity, b = 1. The identification of unit roots isassumed to be a manifestation of shocks to the production function.These findings of Nelson and Plosser have radical implications for businesscycle theory. If shocks to productivity growth due to technologicalchange are frequent and random, then the path of output following a randomwalk will exhibit features that resemble a business cycle. In this case, however,the observed fluctuations in GNP are fluctuations in the natural (trend)rate of output, not deviations of output from a smooth deterministic trend.What looks like output fluctuating around a smooth trend is in fact fluctuationsin the natural rate of output induced by a series of permanent shocks,with each permanent productivity shock determining a new growth path.Whereas, following Solow’s seminal work, economists have traditionallyseparated the analysis of growth from the analysis of fluctuations, the work ofNelson and Plosser suggests that the economic forces determining the trendare not different from those causing fluctuations. Since permanent changes inGNP cannot result from monetary shocks in a new classical world because ofthe neutrality proposition, the main forces causing instability must be realshocks. Nelson and Plosser interpret their findings as placing limits on theimportance of monetary theories of the business cycle and that real disturbancesare likely to be a much more important source of output fluctuations.If there are important interactions between the process of growth and businesscycles, the conventional practice of separating growth theory from theanalysis of fluctuations is illegitimate. By ending the distinction betweentrend and cycle, real business cycle theorists began to integrate the theory ofgrowth and fluctuations (see King et al., 1988a, 1988b; Plosser, 1989).6.5 Supply-side ShocksCyclical instability can arise because of shocks to aggregate demand orshocks to aggregate supply, or some combination of the two. On the demandside, the shocks may originate from instability in some component of the IS