The transformation of macroeconomic policy and research prize Lecture, December 8, 2004 by

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6. SIGNIFICANCE OF BUSINESS CYCLE RESEARCH

We learned that business cycle fluctuations are the optimal response to real

shocks. The cost of a bad shock cannot be avoided, and policies that attempt

to do so will be counterproductive, particularly if they reduce production 

efficiency. During the 1981 and current oil crises, I was pleased that policies

were not instituted that adversely affected the economy by reducing produc-

tion efficiency. This is in sharp contrast to the oil crisis in 1974 when, rather

than letting the economy respond optimally to a bad shock so as to minimize

its cost, policies were instituted that adversely affected production efficiency

and depressed the economy much more than it would otherwise have been.

To summarize, concern has shifted away from business cycle fluctuations

toward more important things. One important thing is setting up a good tax

system. Finn’s and my work sheds light on the most important economic

parameter in the design of a tax system, the aggregate labor supply elasticity.

In finding that technology shocks are important for fluctuations, our research

program has been important in shifting the profession’s attention to how

economic institutions affect total factor productivity.

7. BEYOND BUSINESS CYCLE RESEARCH

The methodology that Finn and I developed and used to study business 

cycles is equally applicable to studying other phenomena. In this section I will

briefly review three successful applications of this methodology and one very

interesting open puzzle. While presenting evidence that the labor supply

elasticity is 3, I already effectively reviewed one highly successful application 

– namely, my study assessing the role of taxes in accounting for the huge 

differences in labor supply across the advanced industrial countries and the

huge fall in labor supply in Europe between the early 1970s and the mid-1990s.

Using the Methodology in the Stock Market Valuation Research

An interesting question is, why did the value of the stock market relative to

GDP vary by a factor of 2.5 in the United States and 3 in the United Kingdom

in the last half of the 20th century? Other variables display little secular vari-

ation relative to GDP, whether they are corporate after-tax profits or corporate

physical capital relative to GDP.

Clearly the single sector neoclassical growth model does not suffice for 

studying the market value of corporate equity. The model must have both a

corporate and noncorporate sector. Fortunately, the national accounts report

the components of value added for the corporate sector as well as for govern-

ment business, household business, and unincorporated business sectors.

Various adjustments must be made to the accounts to bring them into con-

formity with the model, such as using producer prices for both inputs and

outputs to the business sector.

An equilibrium relation develops when the market value of corporations is

equal to the value of their productive assets. The capital accounts of the 

national accounts provide measures of the cost of replacing tangible capital.

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But corporations also own large amounts of intangible capital, including 

organization capital, brand names, and patents, which also affect the market

value of corporations. These assets cannot be ignored when determining

what theory says the value of the stock market should be. This presents a 

problem for determining the fundamental value of the stock market – a problem

that McGrattan and I solve (see McGrattan and Prescott, 2005a).

We find that the secular behavior of the value of the U.S. stock market is as

theory predicts. What turns out to be important for the movement in the value

of corporations relative to GDP are changes in tax and regulatory policies. If

the tax rate on distributions by corporations is 50 percent rather than 0 percent,

the value of corporations will be only half as large given the resource cost of

their productive assets.

Our study uses a neoclassical growth model and connects the model to 

national income and product data, tax data, and sector balance sheet data.

We submitted the paper to the Review of Economic Studies, a British journal.

The editor rightfully insisted that we do the analysis for the U.K. stock market

as well as for the U.S. stock market. We were nervous as to what theory and

measurement would say and were happy when we found that the behavior of

the value of the U.K. stock market was also in conformity to theory. Here is an

example of the power of the macroeconomic methodology that Finn and I

developed.

The excessive volatility of stock prices remains. Indeed, our study strength-

ens this puzzle. Stocks of productive capital vary little from year to year, whe-

reas stock prices sometimes vary a lot. I am sure this volatility puzzle will, in

the not too distant future, be resolved by some imaginative neoclassical eco-

nomist. However, resolving the secular movement puzzle is progress.

This example illustrates how macroeconomics has changed as a result of

the methodology that Finn and I pioneered. It is now that branch of economics

in which applied dynamic equilibrium tools are used to study aggregate phe-

nomena. The study of each of these aggregate phenomena is unified under

one theory. This unification attests to the maturity of economic science when

it comes to studying dynamic aggregate phenomena.

Using the Methodology to Study the Great U.S. Depression

The welfare gains from eliminating business cycles are small or negative. The

welfare gains from eliminating depression and creating growth miracles are

large. Cole and Ohanian (1999) broke a taboo and used the neoclassical

growth model to study the Great U.S. Depression. One of their particularly

interesting findings is that labor supply on a per adult basis in the 1935–1939

period was 25 percent below what it was before the Depression. Recently,

Cole and Ohanian (2004) showed how New Deal cartelization could very well

have been the reason for the low labor supply using neoclassical economics.

The rapid recovery of the U.S. economy subsequent to the abandonment of

these cartelization policies supports their theory.

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