From: rob@KAMAN.COM (Rob Vienneau)
Newsgroups: sci.econ
Subject: RBCs again
Date: 8 Sep 92 17:14:34 GMT

I thought I'd reopen the thread on Real Business Cycles (RBCs) with my
two cents.

The theory of RBC is a development from a research program whose
leading light is Robert Lucas. He had a very good criticism of the
"Keynesian" alternative, which has been pretty much overthrown, as far
as I know. What few seem to realize is that that criticism is equally
applicable to his own program, including RBCs.

The Lucas argument goes like so. Suppose we want to construct
macroeconomic models to help us evaluate the broad consequences of
government policy decisions. We are given (time series) data generated
under a certain "policy regime." Now suppose we very sucessfully fit a
model to this data. Even more suppose this model works very well at
making predictions under the policy regime that generated the data.
Presumably, the model embeds decision rules economic agents use in
reacting to the environment.

Does any reason exist to assume that this model will help us in
evaluating policy outcomes? According to Lucas, not necessarily. For
under a different policy regime, agents will have a different set of
expectations about government actions and the results that will follow
from their actions. Consequently, they will vary their decision rules,
and the structure and parameters of the applicable model may be
completely different. According to Lucas, the "Keynesian" econometric
models others were using when he published this critique suffered from
these flaws. They emphasized disequilibrium behavior that is
particularly sensitive to changes in policy rules. Their structure and
parameters did not explictly show the decision rules assumed, or how
their predictions would vary if these rules vary.

Lucas then developed equilibrium models based on data he thought was
invariant to policy changes: tastes and technology. His models
explicitly showed how maximizing behavior and expectations led to the
predicted outcomes. Models of RBCs are just one set that grew out of
this research program.

But these models do not escape the Lucas criticism. Although it's hard
to formalize, presumably technology is influenced by the pace and
direction of investment. It's hard to imagine a variable that's more
sensitive to expectations than investment. So Lucas' fundamental
parameters for encoding technology may be just as sensitive to changes
in policy regimes as the "Keynesian" models he was critizing. And,
being a fan of Thorstein Veblen, I believe tastes will change with
changes in policy regimes.

How, then, should macroeconomics proceed? I hold the most promising
approach is to rediscover Keynes. The Lucas critique is just a
restatement and development of Keynes comments on econometric models
of his day. (Even though the formal structure of the General Theory
was developed first by Kalecki, the reliance to be placed on
econometrics was one area where Keynes and Kalecki differed.) Likewise
Keynes was well aware of the importance of policy rules. His
recommendations were not "fine tuning." These concerns can be seen in
some of his comments on the difficulty of using monetary policy to
reduce the long run rate of interest. So unlike "Keynesian" economics,
the economics of Keynes does not suffer from the defects attacked by
the Lucas critique and not transcended in RBC and rational
expectations models. Macroeconomic theory can be advanced by serious
interpretative work on Keynes.

(I leave to one side the question of how anybody that knows anything
can place any credence in a theory that relies on an aggregate
Cobb-Douglas production function. It was demonstrated long ago that
C-D functions can fit data that has nothing to do with the mechanisms
assumed by C-D functions. Did the battle between the Cambridges really
have this little effect?)
                                     Robert Vienneau
                                     rob@kaman.com

Reference: Alessandro Vercelli, _Methodological Foundations of
Macroeconomics - Keynes & Lucas_, Cambridge University Press, 1991.
Newsgroups: sci.econ