Evolution of Modern Business Cycle Models

Accounting for the Great Recession

Bibliographic Data

ID14855534
AuthorsPatrick J Kehoe (0000-0001-5738-1236, Patrick Kehoe is a Professor of Economics at Stanford University, Stanford, California; Professor of Economics, University College London, London, United Kingdom; and a consultant at the Federal Reserve Bank of Minneapolis, Minneapolis, Minnesota.), Virgiliu Midrigan (Virgiliu Midrigan is a Professor of Economics at New York University, New York, New York.), Elena Pastorino (Elena Pastorino is a Research Fellow at the Hoover Institution, Stanford University, a Faculty Research Fellow at the Economics Department, Stanford University, and a Research Fellow at the Stanford Institute for Economic Policy Research, all in Stanford, California.)
Year2018
Volume32
Issue3
Pages141-166
Publication date2018-08-01
Open AccessYes
TypeARTICLE
VenueThe Journal of Economic Perspectives (JOURNAL)
Journal identifiersISSN: 0895-3309 • E-ISSN: 1944-7965
PublisherAmerican Economic Association (PUBLISHER • US)
DOI10.1257/jep.32.3.141
OpenAlexW2883451599
LanguageEN
Citations received7
References cited27

Modern business cycle theory focuses on the study of dynamic stochastic general equilibrium (DSGE) models that generate aggregate fluctuations similar to those experienced by actual economies. We discuss how these modern business cycle models have evolved across three generations, from their roots in the early real business cycle models of the late 1970s through the turmoil of the Great Recession four decades later. The first generation models were real (that is, without a monetary sector) business cycle models that primarily explored whether a small number of shocks, often one or two, could generate fluctuations similar to those observed in aggregate variables such as output, consumption, investment, and hours. These basic models disciplined their key parameters with micro evidence and were remarkably successful in matching these aggregate variables. A second generation of these models incorporated frictions such as sticky prices and wages; these models were primarily developed to be used in central banks for short-term forecasting purposes and for performing counterfactual policy experiments. A third generation of business cycle models incorporate the rich heterogeneity of patterns from the micro data. A defining characteristic of these models is not the heterogeneity among model agents they accommodate nor the micro-level evidence they rely on (although both are common), but rather the insistence that any new parameters or feature included be explicitly disciplined by direct evidence. We show how two versions of this latest generation of modern business cycle models, which are real business cycle models with frictions in labor and financial markets, can account, respectively, for the aggregate and the cross-regional fluctuations observed in the United States during the Great Recession

Business cycle · Counterfactual thinking · Dynamic stochastic general equilibrium · Econometrics · Economics · Macroeconomics · Monetary economics · Monetary policy · Recession · Economic theories and models · Economic Theory and Policy · Monetary Policy and Economic Impact

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