In previous chapters, we studied the long-run evolution of output and consumption, real interest rates and real wages, and the long-run evolution of the price level and inflation.

To focus on long-term trends, we made the assumption that all markets are competitive and in continuous equilibrium through the full adjustment of prices, wages, and interest rates.

However, as noted in chapter 1, economies are characterized by fluctuations in relation to their long-term trends. In some periods, output, consumption, investment, and employment grow at high rates, while at other times, they grow at low or even negative rates. In some periods, unemployment is low and in others it is quite high. Economies experience recessions and upswings. Inflation displays significant fluctuations as well.

Understanding the determinants of aggregate fluctuations is the second main objective of macroeconomics. This chapter and the ones that follow present the main theories regarding the nature of aggregate fluctuations.

This chapter introduces competitive equilibrium models of aggregate fluctuations. These are dynamic stochastic general equilibrium (DSGE) models based on optimizing households and firms, flexible wages and prices, and fully competitive markets. Fluctuations in these models are caused by real shocks (mainly exogenous shocks to productivity). The effects of these shocks are propagated through endogenous dynamic processes, such as consumption, investment, and labor supply.

We start with the stochastic growth model, which is an extended stochastic version of the Ramsey model. The utility function of a representative household depends on both consumption of goods and services and leisure, while random disturbances to real factors, such as productivity, cause aggregate fluctuations.

To be able to arrive at a tractable model, we first make simplifying assumptions regarding production and utility functions. Without such assumptions, the stochastic growth model becomes extremely complicated. The dynamic analysis is conducted in discrete rather than continuous time. Following the analysis of a simplified version of the stochastic growth model, in section 13.4, we analyze the full version of the stochastic growth model.

As the main impulses that generate aggregate fluctuations in the stochastic growth model are real, this model belongs to a class of models often referred to as real business cycle (RBC) models. In many ways, the stochastic growth model is the modern equivalent of the classical approach to aggregate fluctuations. Hence it is sometimes also labeled as the “new classical” model. Monetary shocks have no real effects on output, employment, and capital accumulation in this class of models; they only affect real money balances and nominal variables, such as the price level, inflation, and nominal wages and interest rates. We postpone the analysis of the impact of monetary shocks in new classical competitive equilibrium models to chapter 14, where we examine a simplified version of the model without capital.

13.1