Money, Credit, and Prices in a Real Business Cycle By robert G. KING AND CHARLES I PLOSSER* An important recent strain of macroeco- the analysis is on the banking system, build- nomic theory views business cycles as arising ing on the earlier work of James Tobin(1963) from variations in the real opportunities of and Eugene Fama(1980). In our real busi the private economy, which may include ness cycle model, monetary services are shifts in government purchases or tax rates privately produced intermediate goods whose as well as technical and environmental con- quantities rise and fall with real economic ditions. These models are often viewed as developments incomplete or wrong because they do not In the absence of central bank policy re generate the widely emphasized, but not sponse, the model predicts that movemen easily explained, correlation between the in external money measures should be uncor quantity of money and real activity related with real activity. Some preliminary This paper integrates money and banking empirical analysis (using annual data from into real business cycle theory. The result is a 1953 to 1978) provides general support for class of models that can account for the our focus on the banking system since the correlation between money and business correlation between monetary measures and cycles in terms that most economists would real activity is primarily with inside money. label reverse causation. The main focus of Our proposed explanation of the corre lation between money and business fluctua- Department of Economics and Graduate School of tions stands in sharp contrast to traditional theories that stress market failure as the ke Rochester, NY 14627. A preliminary version of this to understanding the relation and interpret paper was presented at the Seminar on Monetary The- monetary movements as a primary source of ory and Monetary Policy, Konstanz, West Germany, impulses to real activity. Given the con- Robert barro, Herschel Grossman, John Long, benne troversies surrounding the main contending McCallum, anonymous referees, and participants of hypotheses concerning money and busines cycles-the incomplete information frame- Pennsylvania, Harvard, and Princeton. The National work of Robert Lucas( 1973)and Keynesian Government Policy and Business of the University of Sticky wage models as revitalized by Stanley Rochester have supported this research. The above indi- Fischer(1977)-it seems worthwhile to con viduals and institutions should not be regarded as neces- sider alternative hypotheses. 3 sarily endorsing the views expressed in this Robert Lucas(1980)provides an ov general equilibrium approach to business cycles work by Fynn Kydland and Edward Prescott (1982 )and tions in money demand including those arising from g and Plosser(1983)illustrate ns in real activity = an mimic key elements of business cycles. in In our view, there are good reasons for dissatisfac tterns of persisten with existing macro c ea that monetary quantities are endogenous is ities, from the textbook reliance on exogenous values to models typically rely on implausible wage or price rigid old one. but has received little the recent more sophisticated effort of Fischer (197 find it useful to categorize earlier stories into two broad that relies on existing nominal contracts. As Barro(1977) points out, a key feature of the explanations that stress central bank policy odel is that agents select contracts that do not I fully or example, James Tobin (1970) provides an ploit potential gains from trade. In addition, Costas em shasizes central bank policy response. Tobins determin- ment contract perceived monetary dis- tic treatment involves the turbances do not Recent analyses of monetary nonneutrality that stress ence-aggregate demand. In Fischer Black's(1972) expectation errors based on "imperfect information analysis, external money passively responds to all varia- ( Lucas, 1977, provides a summary of this viewpoint 363