The Real Business Cycle Model

Ester Faia

Goethe University Frankfurt

Fundamentals of Macro, WS 2021/22

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 Introduction

The RBC model explains the co-movements in the fluctuations of

aggregate economic variables around their trend
It is a competitive model with perfect markets:
No externalities
Symmetric information
Complete markets
No other imperfections
The real business cycle model ”builds up” on the Solow growth
model, which generates an economy which converges to a ”balanced
growth path” and then grows smoothly

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 Introduction

We modify this model in order to generate:

Fluctuations of aggregate output around trend
Co-movements of output and other aggregate economic variables
around their respective trends
The two ingredients used are:
1 Shocks to the economy’s technology (changes in the production
function from period to period. Another possible source of shocks is
the unexpected changes in government purchases).
2 An optimizing household that decide how much to consume and to
work. The cost of work is the loss in leisure time.
Therefore we follow the Brock and Mirman ’72 idea that Growth and
Fluctuations are not distinct phenomena, to be studied with separate
data and different analytical tools.

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 Introduction

Note 1: since markets are perfect, there are no market failures, and
fluctuations are the optimal responses of agents to the exogenous
shocks. Therefore:
There is no deterministic cycle (as in the Mitchell sense).
There is no scope for government intervention.
Note 2: here we consider a walrasian model of the aggregate
economy where fluctuations are generated by real shocks.
The current debate in the economic theory is about the fact that
walrasian models with real shocks are insufficient in explaining
aggregate economic fluctuations.
Later we will consider non-walrasian models of aggregate economic
activity where fluctuations are generated by nominal shocks.
Other strands of macroeconomics consider models with real shocks and
with non walrasian imperfections.

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 The Baseline RBC Model

The economy is populated by:

A large number of identical, price-taking firms
A large number of identical, price-taking households
A government which each period purchases an amount of goods Gt
and finances itself using lump sum taxes
Since all agents are identical and price taking, we can aggregate and
consider an economy with one representative firm and one
representative household.
The Ricardian equivalence holds
Note: The government is only a source of real shocks in this model.

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 The Baseline RBC Model
The Firm

In each period the firm produces output Yt using capital Kt and

labour Lt
The units of labour Lt are multiplied by At , the labour augmenting
technology
Therefore At Lt is the effective labour input
The production function is a CRTS Cobb Douglas function:

Yt = Ktα (At Lt )1−α (1)

0<α<1
Capital depreciates at the rate δ:

K t + 1 = ( 1 − δ ) K t + It + 1 (2)

where It +1 is investment.
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 The Baseline RBC Model
The Firm (con’t)

The technology At is determined by the following equation:

ln At = Āt + gt + Ãt (3)

Ā and g are positive constants. Therefore without the last term we

would have an economy growing smoothly along the trend.
The last term is the random disturbance:

Ãt = ρÃt −1 + ε t (4)

−1 < ρ < 1
ε t is a white noise:
E (ε t ) = 0 (5)
cov (ε t , ε s ) = 0 for any t 6= s (6)

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 The Baseline RBC Model
The Firm (con’t)

The binomial process we considered in the example last week is an

example of a stochastic process that satisfies (5) and (6).
If ρ = 0 then At = ε t . The technological shock is a white noise.
If ρ > 0, it means that the shock in technology disappears gradually
over time. Ãt is persistent.
In the case when ρ ∼ 1, At is so persistent that it seem to have a
cyclical pattern.
This is the shock that determines the business cycle fluctuations.

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 The Baseline RBC Model
The Firm (con’t)

The firm observes At and chooses Kt and Lt in order to maximize the

profits at time t.
Labour Lt is paid with the wage wt , while the opportunity cost of
capital is (rt + δ), where rt is the real interest rate.

max Πt = max [Yt − wt Lt − (rt + δ) Kt ] (7a)

Kt ,Lt Kt ,Lt

We use (1) to substitute Yt = Yt = Ktα (At Lt )1−α in (7a). The First

Order Conditions (FOC):

∂Πt
= αKtα−1 (At Lt )1−α − (rt + δ) = 0 (8)
∂Kt

Ktα (At Lt )1−α

⇒ rt = α −δ (9)
Kt
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 The Baseline RBC Model
The Firm (con’t)

∂Πt
= (1 − α) At Ktα (At Lt )−α − wt = 0 (10)
∂Lt
Ktα (At Lt )1−α
⇒ wt = (1 − α) (11)
Lt
The firm solves (8) and (10) with respect to Kt and Lt .
We can substitute Yt back in (8) and (10) and derive the equilibrium
interest rates and wages:
Yt
rt = α −δ (12)
Kt
Yt
wt = ( 1 − α ) (13)
Lt

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 The Baseline RBC Model
The Household

The representative household is infinitely lived

He is endowed with a certain amount of time each period (normalized
to one unit), which can be used either to work or as leisure time.
Therefore with respect to the optimal consumption problem analyzed
before, here labour supply is endogenous.
The household maximizes the expected value of the intertemporal
utility function:
∞
" #
U0 = max E0
Ct ,Lt
∑ βt u (Ct , 1 − Lt ) (14)
t =0

0<β≤1 (15)
Ct is the level of consumption; Lt is the amount of time worked;
(1 − Lt ) is the amount of leisure time; β is the intertemporal discount
factor;
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 The Baseline RBC Model
The Household (con’t)

The lower is β, the less future consumption and leisure are valued
with respect to present ones.
The utility function is assumed to be strictly concave in both
arguments:

u1 > 0, u11 < 0, u2 > 0, u22 < 0

The household maximizes the intertemporal utility function subject to

the budget constraint (we introduce, as before, the stock of net
asset):
Bt +1 = (1 + rt +1 ) (Bt + wt Lt − Ct ) (16)
wt Lt is the labor income of the household
Note 1: now we consume Ct at the beginning of period t
Note 2: the household can consume more than his salary: if
Ct > wt Lt then net wealth is reduced.
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 The Baseline RBC Model
The Household (con’t)

If Ct > wt Lt ⇒ Bt +1 can become negative, but the household

cannot borrow infinitely (transversality condition):

Bt
lim t
≥0 (17)
t →∞
∏ (1 + rj )
j =0

We can once again use the Lagrangian solution method:

∑t∞=0 βt (u (Ct , 1 − Lt )
 
L = E0 (18)
−λt +1 [(1 + rt +1 ) (Bt + wt Lt − Ct ) − Bt +1 ])

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 The Baseline RBC Model
The Household: Optimal household choices with certainty

In this case the Lagrangian is without the expectation term:

∑t∞=0 βt (u (Ct , 1 − Lt )
 
L= (19)
+λt +1 [(1 + rt +1 ) (Bt + wt Lt − Ct ) − Bt +1 ])
F.O.C. w.r.t. Ct :
∂L
= βt [u1,t − (1 + rt +1 ) λt +1 ] = 0 (20)
∂Ct
F.O.C. w.r.t. Lt :
∂L
= βt [−u2,t + wt (1 + rt +1 ) λt +1 ] = 0 (21)
∂Lt
F.O.C. w.r.t. Bt :
∂L
= βt λt +1 (1 + rt +1 ) − βt −1 λt = 0 (22)
∂Bt
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 The Baseline RBC Model
The Household: Intertemporal substitution in consumption

We consider (20) and (22):

u1,t = (1 + rt +1 ) λt +1 (23)

λt = β (1 + rt +1 ) λt +1 (24)
First we substitute (23) in (24):

λt = βu1,t (25)

Then we forward by one period:

λt +1 = βu1,t +1 (26)

Finally, we substitute (26) and (25) back in (24):

u1,t = β (1 + rt +1 ) u1,t +1 (27)

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 The Baseline RBC Model
The Household: Intertemporal substitution in consumption (con’t)

(27) is the Euler equation for consumption, which has also the
following interpretation:
u1,t
= 1 + rt +1 (28)
βu1,t +1

Subjective value of present consumption with respect to future

consumption:
u1,t
(29)
βu1,t +1
Market price of present consumption with respect to future
consumption:
1 + rt +1 (30)

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 The Baseline RBC Model
The Household: Intertemporal substitution in labor supply

We consider now equations (21) and (22):

u2,t = wt (1 + rt +1 ) λt +1 (31)

λt = β (1 + rt +1 ) λt +1 (32)
First we substitute (31) in (32):
u2,t
λt = β (33)
wt
Update one period:
u2,t +1
λ t +1 = β (34)
wt + 1
Finally, substitute (33) and (34) back in (32):
u2,t u2,t +1
= β (1 + rt +1 ) (35)
wt wt + 1
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 The Baseline RBC Model
The Household: Intertemporal substitution in labor supply

(35) has the following interpretation:

u2,t wt
= (36)
βu2,t +1 wt +1 / (1 + rt +1 )

Subjective value of present leisure with respect to the one of future

leisure:
u2,t
βu2,t +1
Opportunity cost of present leisure with respect to the one of future
leisure:
wt
wt +1 / (1 + rt +1 )

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 Intra-temporal substitution between consumption and
leisure
We consider now (20) and (21), the F.O.C.’s w.r.t. consumption and
leisure:
u1,t = (1 + rt +1 ) λt +1 (37)
u2.t = wt (1 + rt +1 ) λt +1 (38)
Interpretation of 37: λt +1 is the increase in the value function
(intertemporal utility) if we increase the net assets by one unit
(postpone consumption to the next period)
(38) means that the loss in utility when decreasing leisure by one unit
is equal to the gain we have by:
working and gaining wt
saving and increasing our net assets by wt (1 + rt +1 )
Therefore the trade off between consumption and leisure is the
following:
u2,t
= wt (39)
u1,t
wt is the relative price of leisure with respect to consumption
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 The Baseline RBC Model: An example

We consider the logarithmic utility function:

u (Ct , 1 − Lt ) = ln Ct − b ln (1 − Lt ) (40)

b>0
Therefore:
1 b
u1,t = ; u2,t = (41)
Ct 1 − Lt
The Euler equation for consumption:
u1,t Ct + 1
= = 1 + rt +1 (42)
βu1,t +1 βCt

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 The Baseline RBC Model: An example

The Euler equation for labour becomes:

βu2,t +1 1 − Lt 1 wt +1
= = (43)
u2,t 1 − Lt +1 β (1 + rt +1 ) wt

If 11−−LLt +t 1 ↓ it follows that LLt +t 1 ↑ . We decrease our leisure at time t

and increase our labor supply at time t (relatively to the next period).
This corresponds to an increase in salary today (relatively to next
period)→ β(1+1rt +1 ) wwt +t 1 ↓
Two effects: income and substitution. If wt increases by substitution
you wish to increase labour supply today. By income effect the
opposite. The second prevail.

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 The Baseline RBC Model: An example (con’t)

We now examine the substitution effect between consumption and

leisure. There are both income and substitution effects: depending on
the parameters one of the two prevails.
This is clear from the intra-temporal optimal condition:
u2,t
= wt (44)
u1,t

which becomes:
Ct wt
= (45)
1 − Lt b
When the salary goes up: income increases and the household can
consume more (income effect). On the others side it is more costly to
increase leisure as the opportunity cost, wt , has increased (hence to
reduce labour)

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 The Baseline RBC Model: Optimal Household choices
with uncertainty

In this case the Lagrangian is with the expectation term:

∑t∞=0 βt (u (Ct , 1 − Lt )
 
L = E0 (46)
+λt +1 [(1 + rt +1 ) (Bt + wt Lt − Ct ) − Bt +1 ])

The first order conditions are similar to before:

∂L
= βt Et [u1,t − (1 + rt +1 ) λt +1 ] = 0 (47)
∂Ct
∂L
= βt Et [−u2,t + wt (1 + rt +1 ) λt +1 ] = 0 (48)
∂Lt
∂L
= Et βt λt +1 (1 + rt +1 ) − βt −1 λt = 0
 
(49)
∂Bt

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 The Baseline RBC Model: Optimal Household choices
with uncertainty

Equations (47), (48), and (49) can be rewritten as:

u1,t = Et [(1 + rt +1 ) λt +1 ] (50)

λt = βEt [(1 + rt +1 ) λt +1 ] (51)

u2,t = wt Et [(1 + rt +1 ) λt +1 ] (52)
Now we can derive the intertemporal optimal conditions in the same
way as before.

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 The Baseline RBC Model: Optimal Household choices
with uncertainty
Consider for example the Euler equation for consumption:

u1,t = βEt [(1 + rt +1 ) u1,t +1 ] (53)

Using again the logarithmic utility function we have:

 
1 1
= βEt (1 + rt +1 ) (54)
Ct Ct + 1
From this point onwards things are different with respect to the
certainty case, because we have that:
   
1 1
E t ( 1 + rt + 1 ) = Et (1 + rt +1 ) Et (55)
Ct + 1 Ct + 1
 
1
+cov 1 + rt +1 , (56)
Ct + 1

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 The Baseline RBC Model: Optimal Household choices
with uncertainty

Using (55) in (54):

 

Ct
 1 − Ct βcov 1 + rt +1 , Ct1+1
E = (57)
Ct +1 βEt (1 + rt +1 )
 
If cov 1 + rt +1, Ct1+1 = 0, then we have the same result as in the
certainty case:
 
Ct 1
Et = (58)
Ct + 1 βEt +1 (1 + rt +1 )

The ratio of current to expected consumption is equal to the relative

prices

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 The Baseline RBC Model: Optimal Household choices
with uncertainty

 
Now suppose that cov 1 + rt +1, Ct1+1 < 0

→ This means that marginal utility of consumption Ct1+1 tends to be

lower when the interest rate is higher. In this case the household has
less incentive to save for future consumption
 
In fact from (57) it follows that if cov 1 + rt +1, Ct1+1 decreases (or
 
becomes negative) then Et CCt +t 1 increases. This implies that future
consumption decreases vis-a-vis current consumption

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