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The Solow Residual & Austrian Business Cycle Theory

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krazy kaju posted on Sat, Dec 17 2011 12:52 AM

Question to you guys who know a bit about both mainstream macroeconomics and Austrian school economics…

Does the Solow residual explain the ABCT?

Here’s my reasoning:
The short-run fluctuations of the Solow residual match the short-run fluctuations in real GDP, and thus seem to indicate that business cycles aren’t caused by changing aggregate demand thereby refuting Keynesian economics. Instead, the fluctuations of the Solow residual reaffirm Say’s law and form the basis for the neoclassical “real” business cycle theory. Of course, the neoclassicals then seek to explain this fluctuation as the result in technological change – which is absurd on the face of it, which is why this RBCT has been rejected by mainstream Keynesians.

That said, do Austrians have a better explanation to provide for the short-run fluctuations of the Solow residual? You can’t say it’s because of a change in the capital level, since the Solow residual is supposed to represent labor productivity after already accounting for capital. So could this varying change in labor productivity be somehow due to the changing profitability of different kinds of capital, which would affirm ABCT?

Any thoughts on this?

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I may have posted this question too soon... I believe I have found an answer using my superior google-fu:

The real business cycle model regards fluctuations in factor productivity
as the major source of fluctuations in economic activity. These fluctuations in
total factor productivity, “the effectiveness with which workers and machinery
generate value-added” (Chatterjee 1999, p. 19), are usually identified with the
“Solow residual.” The Solow residual is developed by modeling an economy
with competitive markets and constant returns to scale, using an aggregate
production function of the form Q = Af(K,N), where A, the Solow residual, is
a shift parameter representing exogenous technical progress or a productivity
shock, K is a measure of the capital stock, and N is a measure of labor input
(Lewin 1999, p. 76).4 Proponents conclude that the model can account for
about 70 percent of the postwar business cycle phenomenon (Kyland and
Prescott 1991). But critics contend there is “no independent corroborating evidence
for the large technology shocks that are assumed to drive business
cycles” (Stadler 1994, p. 1751).
While one should not deny that fluctuations in key aggregates may be the
result of agents’ responses to exogenous shocks, one should expect historical
studies would be able to identify the shocks. A capital-based macroeconomic
model provides some possible answers. What is identified as a technology
shock in the highly aggregated production function model may be better modeled
in an Austrian capital framework as a change in the structure of production.
The explanation relies on a lower level of aggregation (pp. 224–29). If the
above specified production function is incomplete, if it fails to identify all relevant
inputs, then the shift factor A picks up the effects of the unidentified or
omitted inputs. “Identifying and talking about them renders them “endogenous”
(Lewin 1999, p. 76). Clearly, from an Austrian perspective, such a production
function is incomplete. If capital is viewed as a structure, there is at
any point in time not just one technology known by all and used by all, but a
multiple of technologies either in use or available for use. Time preference and
available saving limits not only the amount of investment, but also the type of
capital goods and technologies invested in.5 With high time preferences and
limited saving, investments are, in general, production plans to meet more
immediate needs. Investment projects are shorter, less labor-saving, and less
durable. The complex combination of resources that makes up the structure
of production is less productive. With lower time preferences, production
plans provide for greater future provision. Investment projects are, on average,
longer, more labor-saving, and more durable. In broad aggregate measures the
results of such investment choices should show up as increased total factor
productivity, the “shock factor” in the real business cycle literature.
At a lower level of aggregation, what looks like an economy’s response to
a “positive technology” shock may be in fact an economy’s response to credit
creation. The productivity increase is, in reality, endogenous. Or it could be a
combined response; the economy is subjected to a truly exogenous productivity
shock in new knowledge or improved production techniques. The greater
potential productivity of new investment projects of all types increases the
demand for credit, but the higher demand for credit is partially accommodated
by credit creation. In either case, the economy-wide response will be a
combination of sustainable and unsustainable growth. Part of the expansion
of investment during the response period will be malinvestment. As the malinvestments
are discovered and corrected, the production structure will shorten,
productivity will decline, and the aggregate data picks up a negative productivity
shock. The money and credit creation during the expansion, rather
than being a harmless endogenous response of banks to changing market conditions,
sets the stage for the boom-bust pattern of the cycle.

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