Questions: Technology Shocks and Propagation Mechanisms

Question 1

In an RBC model, a positive technology shock causes hours worked to rise. Which mechanism best explains this?

• A. Workers are forced to work more because firms hire aggressively during expansions
• B. Rational workers recognize their time is temporarily more valuable and substitute leisure from today into lower-productivity future periods
• C. Output prices fall due to higher productivity, causing workers to demand higher wages and work more
• D. Government automatically increases labor supply by cutting unemployment benefits during expansions

Answer: (B)

This is intertemporal substitution of labor: rational workers recognize that the technology shock has temporarily raised wages. They optimally shift leisure into the future, when productivity and wages will be relatively lower. This is not a forced or price-driven response — it is a rational intertemporal trade. The RBC framework interprets business cycle fluctuations in hours as optimal responses to changing incentives, not as market failures or deviations from equilibrium.

Question 2

Critics of RBC theory note that empirical evidence on whether positive technology shocks increase or decrease hours worked in the short run is mixed. What aspect of the model does this criticism most directly challenge?

• A. The assumption that capital depreciates over time
• B. The claim that technology shocks are the dominant source of business cycles
• C. The use of logarithmic utility functions in the model
• D. The autoregressive specification of the TFP process

Answer: (B)

If positive technology shocks actually decreased hours worked in the short run (as some structural VAR studies suggest), the co-movement predicted by the model — output, consumption, investment, and hours all rising together — breaks down. This challenges the core claim that technology shocks drive business cycles. The intertemporal substitution mechanism predicts hours rise with positive shocks; if data shows otherwise, technology shocks may not be the dominant driver even if the mechanism itself is valid.

Question 3

In RBC models, a technology shock has long-lasting effects on the economy primarily because the shock itself is assumed to be permanent.

• T. True
• F. False

Answer: False

RBC models typically assume technology follows an autoregressive (AR) process — the shock is persistent but not permanent; it decays slowly over time. The long-lasting effects arise from the model's propagation mechanism: rational agents invest heavily in capital in response to elevated productivity, and that capital stock remains elevated even after the original shock has largely dissipated. Capital accumulation is the internal amplifier that converts a transient productivity improvement into a prolonged expansion.

Question 4

A model that treats business cycles as equilibrium responses to technology shocks implies that monetary policy has no role in stabilizing the economy.

• T. True
• F. False

Answer: True

In a pure RBC model, business cycle fluctuations are optimal responses to real disturbances — there are no market failures to correct. If expansions reflect workers rationally working more when productivity is high, and recessions reflect optimal leisure, then policy intervention cannot improve welfare; it can only distort otherwise efficient choices. Monetary policy stabilization only makes sense when prices are sticky and monetary transmission affects real activity, which is why New Keynesian models that add price rigidity to the RBC core give monetary policy a stabilizing role.

Question 5

Why is the persistence of technology shocks — rather than their magnitude — considered the critical ingredient for explaining business cycle dynamics in RBC models?

Model answer: A one-period productivity improvement would cause output to spike and immediately return to trend, not generating the prolonged expansions and contractions characteristic of actual business cycles. Persistence means elevated productivity lasts multiple periods, giving agents time to respond dynamically: they invest more in capital (which takes time to install and produces returns over many periods) and smooth consumption over the expansion. The accumulating capital stock then propagates the effect forward even as the underlying productivity shock fades. Without persistence, there is no propagation mechanism and the model produces fluctuations far too brief to resemble real business cycles.

This connects the AR(1) assumption about TFP to the observable duration of business cycles. A shock decaying by only 5–10% per quarter will have effects visible 2–3 years later, matching typical expansion lengths. The investment response is also duration-dependent: firms invest in new capital only if they expect favorable conditions to persist long enough for the investment to pay off. Persistence is what makes rational-agent responses generate long-lived macroeconomic dynamics.