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

379

be the mechanism by which monetary shocks gave rise to persistent real 

effects on output and employment. Another conjectured mechanism of that

era is the cost of changing nominal prices. In that era about the only people

who argued that real shocks were the factor were Long and Plosser (1983). 

I say “in that era” because earlier, Wicksell (1907), Pigou (1927), and others

held the view that real shocks were an important contribution to business 

cycles. My prior at the time we did the research for our “Time to Build” paper,

and I think Finn’s prior as well, was that business cycle fluctuations were 

induced by nominal and not real shocks.

3.3 Macroeconomics and growth theory before the “Time to Build” paper

Macroeconomics of the 1970s largely ignored capital accumulation. Growth

theory was concerned with the long-term movements in the economic aggre-

gates, whereas macroeconomics was concerned with the short-term move-

ments. Virtually no connection was made between the then-dormant growth

theory and the dynamic equilibrium theories of business cycles. Probably the

reason was that short-term movements in output are accounted for in large

part by movements in the labor input, whereas long-term growth in living

standards is accounted for by increases in the capital service input and in total

factor productivity. All these variables are per working-age person.

Kydland and I decided to use the neoclassical growth model to study business

cycle fluctuations in the summer of 1980. The basic theoretical framework we

developed came to be called the real business cycle model. The term real does

not mean that the framework can be used only to answer questions concerning

the consequences of real shocks. The real business cycle model is equally 

applicable to addressing the consequences of monetary shocks. I will not be

discussing these monetary applications in this address because Kydland will

in his address. This is appropriate given that he and his collaborators, and

not I, are leaders in the study of the consequences of monetary policy for 

business cycles.

3.4 The methodology

This model builds on the contributions of many economists, many of whom

have been awarded the Nobel Prize. The importance of the contributions of

Simon Kuznets and Richard Stone in developing the national income and

product accounts cannot be overstated. These accounts reveal a set of growth

facts, which led to Solow’s (1956) classical growth model, which Solow (1970)

calibrated to the growth facts. This simple but elegant model accounts well

for the secular behavior of the principal economic aggregates. With this mod-

el, however, labor supply is supplied inelastically and savings is behaviorally

determined. There are people in the classical growth model economy, but

they make no decisions. This is why I, motivated by Frisch’s Nobel address de-

livered here in 1969, refer to this model as the classical growth model.

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The steps in Finn’s and my methodology are as follows.

Step 1: Start with the Neoclassical Growth Model

Central to the neoclassical growth model is the Solow–Swan aggregate 

production function. As explained in Solow (1956, n. 7), the theory underlying

the aggregate production function is a theory of the income side of the 

national accounts.

3

With competitive factor and product markets and entry

and exit of production units, factor claims against product exhaust product.

In addition, output is maximized given the quantities of the factor inputs

supplied.

The function F

t

is the period t aggregate production function that specifies

the output that is produced as a function of the inputs

(1)

c

t 

+ x

t

= y

t

= F

t

(k

t

,l

t

),

where c is consumption, x is investment, y is output, k is the capital service input,

and l is the labor service input. One unit of capital provides one unit of capital

services, and capital depreciates geometrically at rate 

␦. Thus,

(2)

k

t+1

= (1– 

␦)k

t

+ x

t

.

We also introduced a multi-period requirement for building new capacity be-

cause we thought it might be an important shock propagation mechanism.

4

For the growth model to be neoclassical, the savings-investment and labor-

leisure decisions must be decisions of the households. Finn and I introduced

an aggregate or stand-in household with preferences ordered by the expected

discounted value of utility flows from consumption and leisure; that is, the

household maximizes the expected value of

(3)

u(c

t

,1–h

t

),

where c is consumption and 1– h is leisure. The aggregation theory underlying

this aggregate household is based in part on the first welfare theory, namely,

that a competitive equilibrium maximized some weighted average of individual

utilities.

380

3 

For partial equilibrium models, this was recognized by Marshall and Wicksell at the end of the

19th century, but Solow saw it in the general equilibrium context.

4 

Hansen (1985) shows that this feature of reality is not central to understanding business cycle fluc-

tuations and is best abstracted from.

0

t

t

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