Download Real Business Cycle Theory

Equation Chapter 1 Section 1Real Business Cycle
Theory
Real Business Cycle (RBC) models follow the classical monetarist tradition.
Generally they come to the same conclusions but by a different methods.
Recall that the classical and monetarists schools had very similar conclusions
about fiscal policy and the stability of the economy. They did differ about the use
of monetary policy, at least in the short run.
Real Business cycles
1. Economy not susceptible to aggregate demand shocks (Keynesian view),
but is susceptible to shocks that affect output.
2. Government aggregate demand management policies are not useful in
curing recessions. Recessions are caused on the supply side not on the
demand side.
Assumptions
 1. Agents optimize
 2. Markets clear
These are essentially classical assumptions.
From assumption 1, C0 , I 0 fluctuations don’t occur with the frequency that
Keynesians would suggest. Agents don’t behave in chaotic fashion.
From assumption 2., Keynesians tend to believe that markets are very slow to
clear.
Figure 1. A wage rigidity in the Keynesian model
Figure 2 A the effects of a decline in aggregate demand with a Keynesian rigid
(sticky, fixed) wage model
In the Keynesian rigid wage model a decline in the price level (caused by a
leftward shift in the aggregate demand curve) will shift the labor demand curve to
the left so that N 2 hours of labor are employed rather than N1 the amount used
prior to the shift. We might call the initial position the full employment level of
employment. This is a market that does not clear.
By market clearing we mean prices adjust so that demand equals supply. In this
case workers would be willing to sell N1 hours of labor at wage rate W but that
employers are only willing to hire N 2 hours of labor at price P2 . An increase in
the price level will reduce the real cost of labor and shift the aggregate demand
curve to the right. Full employment will only be established if the price level rises
to P1 . In the Keynesian view wages don’t adjust to bring supply in line with
demand in the labor market.
The RBC theorists believe that wages do adjust to clear the labor market.
The RBC economists believe that agents have the following utility function
Ut  U  ct , lt 
(1)
where U t is the utility at time t that an agent would receive from a level of
consumption ct and lt worth of leisure. RBC assumes that agents choose
combinations of consumption and leisure that maximize utility over the agents
lifetime. Note that a decrease in consumption now increases savings and the
increased savings will increase consumption later on. This is a departure from
the Keynesian models that we have discussed so far. The Keynesian models we
have discussed view agents as determining how much to consume at the
moment out of a household current income. The future was not considered in
the Keynesian view we have considered.
Also note that we are looking here at the behavior of an individual not from and
economy wide consumption function.
Figure 3. The effect of a 1 period negative shock on output
The RBC economists view an individuals production function to be
yt  zt F ( Nt , Kt )
(2)
where zt represents a shock to the economy. A negative shock is shown in
Figure 3 and it is clear that this represents a decline in output. A negative shock
causes a decrease in output. While it does not appear in Figure 3 (to keep things
from getting messier), the number of hours of labor input will also decline. The
downward shift in the production function lowers the MPN. Firms will hire less
labor to bring MPN in line with the real wage rate. Note that we can have a
fluctuation in income and output, but the fluctuation is caused on the supply side.
Recall that the Keynesian model had fluctuations originating on the demand side.
The sort of shocks that might affect the economy are changes in technology,
changes in environmental conditions, changes in the relative price of imported
raw materials (OPEC – this represents a change in real prices), changes in tax
rates, changes in other laws that might affect the economy. The classical
economists would have agreed that things affected aggregate supply in the long
run but largely ignored them in the short run.
yt  ct  st
(3)
Part of the agents optimization problem is to determine how much to consume
and how much to save. An increase in savings now means more consumption in
the future.
The point here is that consumers won’t tend to change their current consumption
as Keynes suggested. The consumption decision is made considering a long
planning horizon. In the Keynesian view only immediate factors determine
current consumption.
Kt 1  st  Kt   Kt  st  1    Kt
(4)
where  represents the proportion of capital used up in the current production
period.
450
400
350
300
250
200
150
100
50
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Figure 4. The time path of an economy with no shocks
450
400
350
300
250
200
150
100
50
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Figure 5. The effect of a 1 period shock extends over several time periods