Modern Macroeconomics.pdf

The real business cycle school 321els, real business cycle theorists have developed a method known as ‘calibration’or ‘computational experiments’. Cooley (1997) defines calibrationas ‘a strategy for finding numerical values for the parameters of artificialeconomies’ and involves a ‘symbiotic relationship between theory and measurement’.The calibration strategy consists of the following steps (seeKydland and Prescott, 1982, 1991, 1996; Plosser, 1989; Backhouse, 1997b;Abel and Bernanke, 2001):1. Pose a question relating to a specific issue of concern, for example animportant policy issue such as ‘What is the quantitative nature offluctuations caused by technology shocks?’2. Use a ‘well-tested’ theory, where ‘theory’ is interpreted as a specific setof instructions about how to build the imitation economy.3. Construct a model economy and select functional forms. Kydland andPrescott (1982) utilize the basic stochastic neoclassical growth model asthe cornerstone of their model.4. Provide specific algebraic forms of the functions used to represent productionand consumption decisions. For example, a specific Cobb–Douglasproduction function is used by Plosser (1989).5. Calibrate the model economy using data from pre-existing microeconomicstudies and knowledge of the ‘stylized facts’. Where no informationexists select values for parameters so that the model is capable of mimickingthe real-world behaviour of variables.6. The calibration exercise then involves simulating the effect of subjectingthe model to a series of random technology shocks using a computer.7. The impact that these shocks have on the key macroeconomic variablesis then traced out so that the results can be compared with the actualbehaviour of the main macroeconomic time series.8. Run the experiment and compare the equilibrium path of the modeleconomy with the behaviour of the actual economy. Use these types ofsimulations to answer questions relating to the important issues initiallyidentified under (1).In their seminal 1982 paper Kydland and Prescott use the neoclassical growthmodel and follow the calibration/simulation procedure to see if the model canexplain aggregate fluctuations when the model economy is subject to technologyshocks. As Prescott (1986) recalls, ‘the finding that when uncertainty inthe rate of technological change is incorporated into the growth model itdisplays business cycle phenomena was both dramatic and unanticipated’.The simulations carried out by Kydland, Prescott and Plosser produced someimpressive results in that their models are able to mimic an actual economywith respect to some important time series data. These simulations indicate