A Defense of RBC: Understanding the Puzzling E¤ects of Technology Shocks

The research led by Gali (AER 1999) and Basu et al. (AER 2006) raises two important questions regarding the validity of the RBC theory: (i) How important are technology shocks in explaining the business cycle? (ii) Do impulse responses to technology shocks found in the data reject the assumption of ‡exible prices? This paper argues that the conditional impulse responses of the U.S. economy to technology shocks are not grounds to reject the notion that technology shocks are the main driving force of the business cycle and the assumption of ‡exible prices, in contrary to the conclusions reached by the literature. Our paper also provides a new approach to deriving aggregate production functions and TFP.