<p>If possible, clarifying what exactly you're most interested in might help answers be more on point and useful. Are you interested in the mechanisms that cause a one-period shock to last (and not just immediately dissipate)? Or are you interested in understanding some of the reasons that a shock to one variable (say technological progress) leads to changes in other variables (output, employment, wage, interest rates, etc.)?</p>

<p>In either case, the answer depends somewhat on what flavor of the model you're considering. The reasons that shocks tend to have persistent effects in the models comes from mechanically inserting persistence (by using an AR process for shocks) and/or the interplay between stocks and flows (the most common being capital accumulation and investment).</p>

<p>As for sources, I personally found that lecture notes from graduate macro classes were often some of the most useful resources for understanding internal mechanisms and reasoning (Eric Simms, for example, has a <a href="https://www3.nd.edu/~esims1/grad_macro_13.html" rel="nofollow noreferrer">wonderful series</a> of lecture notes that include <a href="https://www3.nd.edu/~esims1/stylized_facts_rbc_sp12.pdf" rel="nofollow noreferrer">some outlines of BC facts</a> that models try to explain (including persistence), <a href="https://www3.nd.edu/~esims1/rbc_model_2012.pdf" rel="nofollow noreferrer">basic RBC model notes</a>, <a href="https://www3.nd.edu/~esims1/rbc_extensions_sp12.pdf" rel="nofollow noreferrer">notes examining extensions to the RBC framework</a>, notes on <a href="https://www3.nd.edu/~esims1/investment_notes_sp12.pdf" rel="nofollow noreferrer">investment</a> in RBC models, in addition to <a href="https://www3.nd.edu/~esims1/new_keynesian.pdf" rel="nofollow noreferrer">NK notes</a> and some explaining <a href="https://www3.nd.edu/~esims1/monetary_policy.pdf" rel="nofollow noreferrer">optimal monetary policy</a> in NK models). In addition to Simms' resources, <a href="https://www.sas.upenn.edu/~ordonez/html/TeachingG.htm" rel="nofollow noreferrer">Ordonez</a> has created a <a href="https://www.sas.upenn.edu/~ordonez/pdfs/ECON%20510/RBC.pdf" rel="nofollow noreferrer">nice, simple set</a> that explain the derivation, which might provide some insight. Additionally, <a href="http://www.wifa.uni-leipzig.de/fileadmin/user_upload/itvwl-vwl/makro/Lehre/ss/am-ii/AM_II_RBC_Theory_3.pdf" rel="nofollow noreferrer">slide 15 in this set</a> describes one example of how propogation can work, though again, that's quite a limited example.</p>

<p>That said, there are several classic papers (such as <a href="http://www.kellogg.northwestern.edu/faculty/rebelo/htm/rbc2000.pdf" rel="nofollow noreferrer">Resuscitating Real Business Cycles</a> especially section 4) which are useful to keep in mind. As for how others generate persistence, you can look at habit formation in consumption (<a href="https://minneapolisfed.org/research/sr/sr280.pdf" rel="nofollow noreferrer">here</a>, though there are many others, of course), <a href="https://www.jstor.org/stable/1809141" rel="nofollow noreferrer">variable capital utilization</a>, or any of the other <a href="http://www.uio.no/studier/emner/sv/oekonomi/ECON4310/h12/undervisningsmateriale/lecture13.pdf" rel="nofollow noreferrer">listed methods on slides 40-46</a>.</p>

<p>Though again, more info on what exactly you're looking for could help me refocus a bit. I hope these at least provide a start to what you're interested in!</p>

<p>EDIT: Given your interest within a single period, I think the key is to keep in mind what the "engine" is behind the RBC model- ultimately, it's all about households maximizing utility. They do this by producing (through the firm side of the RBC model) and by enjoying leisure. The specific relationship between these objects leads households to respond to changes in any single value.</p>

<p>For example, take a technology shock (say a positive one, so now more output can be generated from the same levels of input). There are two competing forces:</p>

<p>The substitution effect, which leads households to "realize" that, by increasing the number of labor hours they commit to, they can get even more output (some of which can be used for consumption, since "output" in this model isn't differentiated, and can therefore be used either for consumption or investment).</p>

<p>The income effect, which dictates that, since leisure is a normal good (as defined by the utility function exogenously plugged in to the model), higher consumption should lead to higher leisure as well.</p>

<p>Generally, models are "calibrated" such that hours worked and output both rise. So this suggests that households value the additional consumption enough so they choose to work more.</p>

<p>In RBC models with investment, positive technology shocks also mean that capital is more productive, which means interest rates rise.</p>

<p>I can write a more thorough overview from my grad macro notes later in the day, but until then, I'd review <a href="https://www3.nd.edu/~esims1/rbc_model_2012.pdf" rel="nofollow noreferrer">this set</a> of Simms' notes, which do a decent job explaining where everything comes from, and why variables move the way they do. Alternatively, as <a href="https://mpra.ub.uni-muenchen.de/17932/1/Real_Business_Cycle_Theory-A_Systematic_Review.pdf" rel="nofollow noreferrer">this source</a> notes: "Proposed by Kydland and Prescott, the RBC theory rests on the neoclassical concept of rational expectations and constructs on the basis of expected utility maximization. Therefore, it is important to understand the central assumption in the RBC theory: individuals and firms respond to economic events optimally all
the time." Additionally <a href="https://zdoc.site/7-stochastic-growth-models-and-real-business-cycles.html" rel="nofollow noreferrer">pages 10 onwards</a> might be useful in understanding where this comes from, and <a href="http://www.sfu.ca/~bkrauth/econ808/808_lec5.pdf" rel="nofollow noreferrer">this set of notes</a> also takes more time detailing where things come from, and what they mean.</p>

<p>Let me know if those additional resources are helpful at all!</p>

CC BY-SA 4.0
2018-05-25T14:21:34.847Z
"Are you interested in the mechanisms that cause a one-period shock to last (and not just immediately dissipate)? Or are you interested in understanding some of the reasons that a shock to one variable (say technological progress) leads to changes in other variables (output, employment, wage, interest rates, etc.)?" My question is intended about the latter (though I'm also somewhat interested in the former, but this is not what my question is about). In summary: I am interested in understanding all the internal mechanisms **primarily within a single time period**.
user56834
CC BY-SA 4.0
2018-05-25T15:10:09.623Z
@Programmer2134 just added a bit more to focus on what you're really interested in. I can try to go into more detail later, but hopefully those resources can be a start!
AndrewC
CC BY-SA 4.0
2018-05-26T18:47:01.160Z
Note that in the NK model, agents ALSO always act rationally, though while being constrained by price stickiness.
user56834
CC BY-SA 4.0
2018-05-26T18:48:47.573Z
But do you have a resource that purely explains the intuition behind the propagation mechanisms of a shock to 1 variable, to various other variables in the time period? Just a very lucid explanation of the mechanims. By the way your edit was only on RBC models, not NK models
user56834
CC BY-SA 4.0
2018-05-26T23:00:51.900Z
@Programmer2134 sorry for the delay there. Regarding RBC vs. NK models- yes, that's exactly right- both are "powered" by agents acting to maximize their discounted sum of future utility, and "firms" maximizing their profits. The difference is that the RBC model framework assumes that firms are able to freely change prices and wages every period, and are therefore better able to accommodate certain types of shocks. The NK model framework assumes that they cannot, and it imposes (by assumption) some restrictions on their ability to change prices. Because of these restrictions, firms are (cont.)
AndrewC
CC BY-SA 4.0
2018-05-26T23:04:56.860Z
forced to adjust prices and/or wages assuming there is some probability that they won't be able to do so in the next period, causing some internal frictions about what is optimal currently, and what is the expected optimum, given the probability their prices will be stuck. (Similarly, in some NK model flavors, wages are sticky, meaning individuals make decisions knowing that the future stream of wages might not be perfectly smoothed.) But I'm having trouble thinking of a different way of explaining the propagation mechanisms. It's really just a setting where a bunch of identical agents (cont2.
AndrewC
CC BY-SA 4.0
2018-05-26T23:08:40.550Z
are mechanically maximizing the expected sum of discounted utility. Shocks to the economy change the marginal calculus so that levels that were previously maximizing utility are no longer optimal. How agents respond is dictated by the specific nature of their utility function. If their work suddenly becomes more productive, and they value both leisure and consuming goods, they might realize that working a little bit less per period not provides a higher utility. Because of this, there are fewer work hours, which leads firms to need different amounts of capital so that they're still (cont.3)
AndrewC
CC BY-SA 4.0
2018-05-26T23:12:42.090Z
producing at the profit maximizing level, with the proper mix of inputs, which leads to changes in investment and output. At the same time, these shifts cause labor market fluctuations- the increase in labor efficiency means that firms are willing to pay higher wages. If you're working in a NK framework, firms are also considering the fact that they're not perfectly competitive, but monopolistically competitive. This gives them price setting power, so they'll make decisions not only for this period, but into the uncertain future. [Is this more what you were looking for?]
AndrewC
CC BY-SA 4.0
2018-05-25T13:39:16.613Z
2018-05-25T15:09:30.627Z
2018-05-25T15:09:30.627Z
AndrewC
<p>I have read technical books about the (baseline) RBC and New Keynesian models. </p>

<p>However, these books tend not to explain very intuitively the propagation mechanisms of shocks between the two models, or the difference between them. I am referring to the mechanisms by which a shock to one variable affects the other variables. Since the baseline NK model does not contain any endogenous persistence, I'm primarily interested in how these effects play out <strong>within one time period</strong>. That is: what are all the mechanisms through which a shock propagates through the system and determines a new equilibrium $E^*$ (as opposed to the equilibrium $E$ that <em>would have</em> happened in that time period without the shock.)</p>

<p>So I'm looking for an intuitive paper/article on the internal (propagation) mechanisms in RBC and New Keynesian models. </p>

<p>Note again, that I am interested in a <strong>primarily intuitive/economic explanation</strong> of these mechanisms, <strong>rather than an overly mathematical one</strong> since the latter I have already found in textbooks. </p>

CC BY-SA 4.0
2018-05-25T09:15:21.817Z
I didn't read the paper at this link but it looks relevant possibly. http://www.nber.org/papers/w22422. if you're talking about pure cyclic time series in general, then all the slutsky and yule material isa good places to start. but, if you're talking specifically about business cycles, I'm not sure.
mark leeds
<new-keynesian-economics><dsge><rbc>
Good paper/article on the mechanisms in RBC vs New Keynesian models
user56834
# Good paper/article on the mechanisms in RBC vs New Keynesian models

(Asked by: username_0 on 2018-05-09)

I have read technical books about the (baseline) RBC and New Keynesian models.

However, these books tend not to explain very intuitively the propagation mechanisms of shocks between the two models, or the difference between them. I am referring to the mechanisms by which a shock to one variable affects the other variables. Since the baseline NK model does not contain any endogenous persistence, I'm primarily interested in how these effects play out **within one time period**. That is: what are all the mechanisms through which a shock propagates through the system and determines a new equilibrium $E^\*$ (as opposed to the equilibrium $E$ that *would have* happened in that time period without the shock.)

So I'm looking for an intuitive paper/article on the internal (propagation) mechanisms in RBC and New Keynesian models.

Note again, that I am interested in a **primarily intuitive/economic explanation** of these mechanisms, **rather than an overly mathematical one** since the latter I have already found in textbooks.

**Tags:** new-keynesian-economics, dsge, rbc

> **Comments:**
> **username_1**: I didn't read the paper at this link but it looks relevant possibly. http://www.nber.org/papers/w22422. if you're talking about pure cyclic time series in general, then all the slutsky and yule material isa good places to start. but, if you're talking specifically about business cycles, I'm not sure.  

---

## 1 answers

### Answer by username_2 on 2018-05-25. Score: 2

If possible, clarifying what exactly you're most interested in might help answers be more on point and useful. Are you interested in the mechanisms that cause a one-period shock to last (and not just immediately dissipate)? Or are you interested in understanding some of the reasons that a shock to one variable (say technological progress) leads to changes in other variables (output, employment, wage, interest rates, etc.)?

In either case, the answer depends somewhat on what flavor of the model you're considering. The reasons that shocks tend to have persistent effects in the models comes from mechanically inserting persistence (by using an AR process for shocks) and/or the interplay between stocks and flows (the most common being capital accumulation and investment).

As for sources, I personally found that lecture notes from graduate macro classes were often some of the most useful resources for understanding internal mechanisms and reasoning (Eric Simms, for example, has a [wonderful series](https://www3.nd.edu/~esims1/grad_macro_13.html) of lecture notes that include [some outlines of BC facts](https://www3.nd.edu/~esims1/stylized_facts_rbc_sp12.pdf) that models try to explain (including persistence), [basic RBC model notes](https://www3.nd.edu/~esims1/rbc_model_2012.pdf), [notes examining extensions to the RBC framework](https://www3.nd.edu/~esims1/rbc_extensions_sp12.pdf), notes on [investment](https://www3.nd.edu/~esims1/investment_notes_sp12.pdf) in RBC models, in addition to [NK notes](https://www3.nd.edu/~esims1/new_keynesian.pdf) and some explaining [optimal monetary policy](https://www3.nd.edu/~esims1/monetary_policy.pdf) in NK models). In addition to Simms' resources, [Ordonez](https://www.sas.upenn.edu/~ordonez/html/TeachingG.htm) has created a [nice, simple set](https://www.sas.upenn.edu/~ordonez/pdfs/ECON%20510/RBC.pdf) that explain the derivation, which might provide some insight. Additionally, [slide 15 in this set](http://www.wifa.uni-leipzig.de/fileadmin/user_upload/itvwl-vwl/makro/Lehre/ss/am-ii/AM_II_RBC_Theory_3.pdf) describes one example of how propogation can work, though again, that's quite a limited example.

That said, there are several classic papers (such as [Resuscitating Real Business Cycles](http://www.kellogg.northwestern.edu/faculty/rebelo/htm/rbc2000.pdf) especially section 4) which are useful to keep in mind. As for how others generate persistence, you can look at habit formation in consumption ([here](https://minneapolisfed.org/research/sr/sr280.pdf), though there are many others, of course), [variable capital utilization](https://www.jstor.org/stable/1809141), or any of the other [listed methods on slides 40-46](http://www.uio.no/studier/emner/sv/oekonomi/ECON4310/h12/undervisningsmateriale/lecture13.pdf).

Though again, more info on what exactly you're looking for could help me refocus a bit. I hope these at least provide a start to what you're interested in!

EDIT: Given your interest within a single period, I think the key is to keep in mind what the "engine" is behind the RBC model- ultimately, it's all about households maximizing utility. They do this by producing (through the firm side of the RBC model) and by enjoying leisure. The specific relationship between these objects leads households to respond to changes in any single value.

For example, take a technology shock (say a positive one, so now more output can be generated from the same levels of input). There are two competing forces:

The substitution effect, which leads households to "realize" that, by increasing the number of labor hours they commit to, they can get even more output (some of which can be used for consumption, since "output" in this model isn't differentiated, and can therefore be used either for consumption or investment).

The income effect, which dictates that, since leisure is a normal good (as defined by the utility function exogenously plugged in to the model), higher consumption should lead to higher leisure as well.

Generally, models are "calibrated" such that hours worked and output both rise. So this suggests that households value the additional consumption enough so they choose to work more.

In RBC models with investment, positive technology shocks also mean that capital is more productive, which means interest rates rise.

I can write a more thorough overview from my grad macro notes later in the day, but until then, I'd review [this set](https://www3.nd.edu/~esims1/rbc_model_2012.pdf) of Simms' notes, which do a decent job explaining where everything comes from, and why variables move the way they do. Alternatively, as [this source](https://mpra.ub.uni-muenchen.de/17932/1/Real_Business_Cycle_Theory-A_Systematic_Review.pdf) notes: "Proposed by Kydland and Prescott, the RBC theory rests on the neoclassical concept of rational expectations and constructs on the basis of expected utility maximization. Therefore, it is important to understand the central assumption in the RBC theory: individuals and firms respond to economic events optimally all
the time." Additionally [pages 10 onwards](https://zdoc.site/7-stochastic-growth-models-and-real-business-cycles.html) might be useful in understanding where this comes from, and [this set of notes](http://www.sfu.ca/~bkrauth/econ808/808_lec5.pdf) also takes more time detailing where things come from, and what they mean.

Let me know if those additional resources are helpful at all!

> **Comments:**
> **username_0**: "Are you interested in the mechanisms that cause a one-period shock to last (and not just immediately dissipate)? Or are you interested in understanding some of the reasons that a shock to one variable (say technological progress) leads to changes in other variables (output, employment, wage, interest rates, etc.)?" My question is intended about the latter (though I'm also somewhat interested in the former, but this is not what my question is about). In summary: I am interested in understanding all the internal mechanisms **primarily within a single time period**.  
> **username_2**: @Programmer2134 just added a bit more to focus on what you're really interested in. I can try to go into more detail later, but hopefully those resources can be a start!  
> **username_0**: Note that in the NK model, agents ALSO always act rationally, though while being constrained by price stickiness.  
> **username_0**: But do you have a resource that purely explains the intuition behind the propagation mechanisms of a shock to 1 variable, to various other variables in the time period? Just a very lucid explanation of the mechanims. By the way your edit was only on RBC models, not NK models  
> **username_2**: @Programmer2134 sorry for the delay there. Regarding RBC vs. NK models- yes, that's exactly right- both are "powered" by agents acting to maximize their discounted sum of future utility, and "firms" maximizing their profits. The difference is that the RBC model framework assumes that firms are able to freely change prices and wages every period, and are therefore better able to accommodate certain types of shocks. The NK model framework assumes that they cannot, and it imposes (by assumption) some restrictions on their ability to change prices. Because of these restrictions, firms are (cont.)  
> **username_2**: forced to adjust prices and/or wages assuming there is some probability that they won't be able to do so in the next period, causing some internal frictions about what is optimal currently, and what is the expected optimum, given the probability their prices will be stuck. (Similarly, in some NK model flavors, wages are sticky, meaning individuals make decisions knowing that the future stream of wages might not be perfectly smoothed.) But I'm having trouble thinking of a different way of explaining the propagation mechanisms. It's really just a setting where a bunch of identical agents (cont2.  
> **username_2**: are mechanically maximizing the expected sum of discounted utility. Shocks to the economy change the marginal calculus so that levels that were previously maximizing utility are no longer optimal. How agents respond is dictated by the specific nature of their utility function. If their work suddenly becomes more productive, and they value both leisure and consuming goods, they might realize that working a little bit less per period not provides a higher utility. Because of this, there are fewer work hours, which leads firms to need different amounts of capital so that they're still (cont.3)  
> **username_2**: producing at the profit maximizing level, with the proper mix of inputs, which leads to changes in investment and output. At the same time, these shifts cause labor market fluctuations- the increase in labor efficiency means that firms are willing to pay higher wages. If you're working in a NK framework, firms are also considering the fact that they're not perfectly competitive, but monopolistically competitive. This gives them price setting power, so they'll make decisions not only for this period, but into the uncertain future. [Is this more what you were looking for?]  

---

