Is Real Business Cycle Theory Dead?

[alex_tabarrok]

Originally posted on October 5, 2009.

No. Real business cycle theory is alive and kicking.  If we write Y=a*F(K,L) and call "a" technology then an RBC theory is mostly about how fluctuations in "a" change output.  Amusingly, Brad DeLong calls this the great forgetting theory of recessions and indeed it is hard to see how we could forget about technology, thus reducing output in some periods.  But this view takes the term technology too literally.

I am in my office every day (L=1), my computer is here every day (K=1) but my output and thus my productivity fluctuates.  Why?  It's not that I forget how to use STATA.  Some days, however, a reporter calls and distracts, another day I need to tidy my office, on other days creativity just doesn't strike.  In short, everyone recognizes that at a micro-economic level productivity fluctuates a lot so why should macro productivity follow a smooth process?

In fact, there is a standard answer to that question which is the law of large numbers--spread idiosyncratic productivity shocks across many firms and in the aggregate volatility will be low.  In an important paper, The Granular Origins of Aggregate Fluctuations, Xavier Gabaix takes on this answer with a simple but important point: large firms matter.

In the United States, for example, sales of the top 100 firms account for about 30% of GDP.  (The share is even larger in most other developed economies.)  In fact, we know from my GMU colleague, Robert Axtell, that firm size follows Zipf's law.  As a result, large firms get larger in larger economies so that firm-level productivity shocks do not disappear in the aggregate even in large economies.

Gabaix shows theoretically that combining idiosyncratic shocks and Zipf's law for firm size can produce significant fluctuations in GDP.  Empirically the difficulty is to distinguish aggregate shocks from firm-specific or sectoral shocks.  Using one plausible, but no doubt debatable decomposition, Gabaix shows that idiosyncratic shocks to the top 100 firms can explain about one-third of aggregate volatility.

The bottom line is that Gabaix has opened the way for a much richer real business cycle theory in which real shocks can be identified and tied to specific firms and through transmission mechanisms these real shocks can affect the aggregate economy.