Real Business Cycle Theory

Roger Farmer:

Real business cycle theory and the high school Olympics: I have lost count of the number of times I have heard students and faculty repeat the idea in seminars, that “all models are wrong”. This aphorism, attributed to George Box,  is the battle cry  of the Minnesota calibrator, a breed of macroeconomist, inspired by Ed Prescott, one of the most important and influential economists of the last century.

Of course all models are wrong. That is trivially true: it is the definition of a model. But the cry  has been used for three decades to poke fun at attempts to use serious econometric methods to analyze time series data. Time series methods were inconvenient to the nascent Real Business Cycle Program that Ed pioneered because the models that he favored were, and still are, overwhelmingly rejected by the facts. That is inconvenient. Ed’s response was pure genius. If the model and the data are in conflict, the data must be wrong. …

After explaining, he concludes:

We don’t have to play by Ed’s rules. We can use the methods developed by Rob Engle and Clive Granger as I have done here. Once we allow aggregate demand to influence permanently the unemployment rate, the data do not look kindly on either real business cycle models or on the new-Keynesian approach. It’s time to get serious about macroeconomic science…