WHAT DO INTEREST-RATES REVEAL ABOUT THE FUNCTIONING OF REAL BUSINESS-CYCLE MODELS

This paper begins by documenting the extent to which the predictions o f standard Real Business Cycle (RBC) models are incompatible with obse rved movements in real interest rates. The main finding of the paper i s that extending the baseline model to include habit persistence in co nsumption and adjustment costs to capital significantly improves the m odel's empirical performance, In our evaluation of the model's perform ance, we take special care of estimating and testing predictions of th e model using both moments drawn directly from the data and moments ca lculated after identifying shocks to the stochastic trend.