CAN A REAL BUSINESS-CYCLE MODEL PASS THE WATSON TEST

Watson (1993) [Measures of fit for calibrated models. Journal of Polit ical Economy 101 (6), 1011-1041] proposes a procedure for evaluating t he fit of a dynamic equilibrium business cycle model. Under Watson's c riterion, the standard real business cycle (RBC) model fails dramatica lly in reconciling the dynamics of the model with the data. This inabi lity to account for the dynamics of US aggregate data remains a major challenge to RBC theory. This paper demonstrates that reasonable modif ications can bring RBC theory into closer conformity with the data. Th e empirical results indicate that when habit formation on leisure choi ce and employment externality are incorporated into the analysis, the striking spectral density differentials documented by Watson virtually vanish at business cycle frequencies. (C) 1998 Elsevier Science B.V. All rights reserved.