Must-Read: Roger Farmer (2014): Real Business Cycle Theory and the High School Olympics

Must-Read: I think that the subtle Roger Farmer is mostly right here, but gets one key crucial detail wrong. He states that there are “permanent long-run shifts in the equilibrium unemployment rate caused by changes in the animal spirits of participants in the asset markets”. I am not sure that that is correct. What I do think is correct is this: there are permanent long-run shifts in the employment-to-population ratio caused by changes in the animal spirits of participants in the asset markets. (There are also permanent long-run shifts in the employment-to-population ratio caused by demographic, sociological, and cultural factors.) By focusing on the unemployment rate–now back to 4.9%–Roger, I think, unnecessarily weakens his case:

Roger Farmer (2014): Real Business Cycle Theory and the High School Olympics:

[Prescott’s] argument was that business cycles… are caused by the substitution of labor effort of households between times of plenty and times of famine…

A recession, according to this theory, is… a ‘sudden attack of contagious laziness’…. Keynesians disagreed. They argued that whatever causes a recession, low employment persists because of ‘frictions’ that prevent wages and prices from adjusting to their correct levels. The Keynesian view was guided by Samuelson’s neoclassical synthesis which accepted the idea that business cycles are fluctuations around a unique classical steady state. By accepting the neo-classical synthesis, Keynesian economists had agreed to play by real business cycle rules… accepted that the economy is a self-stabilizing system…. [So] they hey filtered the data and set the bar at the high school level. [But] Keynesian economics is not about the wiggles. It is about permanent long-run shifts in the equilibrium unemployment rate caused by changes in the animal spirits of participants in the asset markets. By filtering the data, we remove [that] possibility… have given up the game before it starts by allowing the other side to shift the goal posts. We don’t have to play by Ed [Prescott]’s rules…. 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 and put back the Olympic bar…