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Macroeconomics Chamberlin and Yueh Chapter 9 Lecture slides Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Business Cycles and Stabilisation Policy • Economic Cycles • Real Business Cycles • New Keynesian Theories of Fluctuations Wage Rigidities Price Rigidities • Stabilisation Policy Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Learning Objectives • Recognise the existence of business cycles • Understand the two main theories of business cycles: Real Business Cycles and new Keynesian economics • Analyse new Keynesian theories of short-run fluctuations in output • Identify sources of wage and price rigidities in the Keynesian frameworks • Consider the welfare effects of short-run fluctuations • Evaluate stabilisation policies Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Business Cycles • Although output tends to rise over time, this upward march is not smooth but punctuated by alternating periods of high and low (including negative) growth. • These are known as booms and recessions. • There are two main approaches to understanding these cycles: real business cycle (RBC) theory and New Keynesian approach to cycles. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real business cycle (RBC) theory • This suggests that output movements are driven by productivity shocks, which hit an economy and lead to shifts in its production function. • Although these shocks are considered to be both quick and temporary, they can lead to persistent movements in output. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning New Keynesian approach to cycles • Cyclical output movements here are predominately the result of demand shocks which have a long lasting although temporary effect on output. In this way, booms and recessions are seen as periods of excess demand or supply. • However, to generate cycles in output, it has to be the case that these disequilibria are not quickly corrected by movements in wages or prices. Therefore, persistent output movements are explained by slow market clearing. New Keynesian theory is then all about accounting for why wages and prices move only sluggishly – meaning that in the short run, demand shocks will have significant effects on output. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation policy • Whether or not we feel we should be worried about business cycles, it is certainly true that governments and policy makers over the years have made substantial efforts to control them. • The government can use monetary and fiscal policies in order to offset the cycle; this is known as stabilisation policy. Traditionally, it has also been referred to as demand management. The reason for this is because fluctuations were deemed to be caused by changes in aggregate demand. • The use of stabilisation policy though is not uniformly welcomed. Those against the use of active policy have proposed a two pronged attack. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation policy • The first questions the need for stabilisation policy, arguing that economies will self-correct. This is really a market clearing issue, booms and recessions are just the outcome of excess demand or supply in an economy, so changes in prices will ultimately correct the disequilibrium. • The second forms the policy inadequacy debate. Although the case for active stabilisation policy is recognised, in essence it is very difficult to implement the correct policies. Therefore, it is argued that active policy, if inappropriate, may do more harm than good and is best not implemented. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Economic Cycles • A simple way of looking at the path of output is to divide it up into a trend and cycle component. Output = Trend + Cycle. – The trend component represents the long run rate of economic growth for an economy. However, the actual path the economy takes fluctuates considerably around this trend. These cyclical components are short run temporary fluctuations in output, described as the business cycle. – The cycle is driven by short-term fluctuations in the rate of economic growth. The goal of business cycle theory is to account for these persistent fluctuations in growth. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Actual and Trend GDP, U.S. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Actual and Trend GDP, UK Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Annual growth rates, U.S. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Annual growth rates, UK Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • Real business cycle theory (RBC) emphasises the importance of ‘real’ factors in determining cycles. This is simply because RBC theorists have a strong belief that markets clear and that information is close to perfect. In this case, the source of output fluctuations will come from ‘real’ factors which alter an economy’s production function – these are predominately technology or productivity shocks. • Nominal factors, which include price and money shocks, have no impact on the real economy when information is complete and prices are flexible. They are not considered to play an important role in generating cycles. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • A key part of explaining cycles is to account for how a given shock can then generate a sustained movement in output. If we look at the cycle dynamics in the UK and U.S. GDP figures, we are certainly made aware that cycles have a duration of at least several quarters, and typically several years. • Therefore, a key part of the theory must be to explain how very short and temporary shocks generate these sustained movements in output. • The response of RBC theory is to consider cycles being generated through the combination of two parts: impulse and propagation. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • The impulse is the initial productivity or technological shock. This is a sudden and very short lived innovation. • The propagation mechanism then describes how the shock generates a persistent movement in output. • Without the propagation mechanism, there would be no real explanation of the business cycle. A temporary productivity shock would lead to a change in the equilibrium level of output and a shift in the long run aggregate supply curve, but once the shock disappeared or was reversed, the economy would jump back to where it started. As productivity shocks are largely seen as very short lived innovations, it would be hard to see how they can account for cycles of several years in duration. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Propagation mechanism • The propagation mechanism is therefore central to the understanding of real business cycles. • One approach, following the seminal models of Ramsey (1928) and Diamond (1965), argues that the persistence in output movements results from a sustained increase in capital investment following a productivity shock. • The propagation mechanism at work here is consumption smoothing. A positive productivity shock would increase current income, but if households are permanent income consumers, they will rationally attempt to spread this gain over time so as to maximise their life-time utility. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • The two period optimal consumption model aims to account for the pattern of consumption undertaken by a household to maximise its total lifetime utility. • This is described by a utility function: U U C1 , C2 • From this, an indifference curve can be constructed, which just gives the combinations of consumption that yields a certain amount of utility. Accepting the law of diminishing marginal utility of consumption, these indifference curves will be convex in shape. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • Naturally, the household consumption decision is constrained by lifetime resources, which is defined by household income in each period. • The two period budget constraint ties the present discounted value of lifetime consumption to be no greater than the present discounted value of lifetime resources: C2 Y2 C1 1 r Y1 1 r • The optimal consumption decision sees the household choosing consumption so that they can reach the highest level of utility given their lifetime resources. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Optimal Consumption Decision Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • A key feature of this model is that optimal consumption decisions imply consumption smoothing behaviour. Faced with fluctuations in income, households are generally better off if they can use saving and borrowing in order to smooth consumption. • Ironing out fluctuations in income enables the household to move on to a higher indifference curve which represents the achievement of a higher level of lifetime utility, whilst still being consistent with their lifetime budget constraint. This result is due to the convexity of the indifference curves, which in turn is a consequence of the law of diminishing marginal utility. This always leads to a preference of averages over extremes. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • Due to the circular flow of income, total household income should equal aggregate output. • Output in turn is determined by two things, the level of productivity and the level of capital stock. This can be represented using a simple production function: Yt At 1 r K t Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Production Function Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • The production function describes the level of output an economy can produce at each level of capital stock. • Firstly, a higher level of capital stock enables a higher level of output to be produced. The production function is linear because there are constant returns to scale with respect to the capital stock. • Secondly, a change in the current level of productivity would lead to a shift in the production function, implying that the same level of capital can then produce a different level of output. No attempt is made in this model to account for the current level of productivity. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • By writing the production function in this form – with additive productivity and constant returns in production, the marginal product of capital will always be constant regardless of the current level of productivity or the size of the capital stock. This form of production function is a simplifying assumption but allows us to emphasize the role that consumption smoothing may play as a propagation mechanism. • The capital stock is determined by the level of saving undertaken by households. Any income that is not used for consumption is saved. However, this will be deposited in financial institutions, which will recycle the funds by lending to firms who will invest. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • Therefore, the link between saving and capital can be established via a number of identities. • Firstly, all income is either consumed or saved: Ct St Yt • From the circular flow of income, income and output must be equal to expenditure: Ct I t Yt • Therefore, it can be instantly seen that: St I t Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • Current investment will then generate the size of the capital stock in the following period: Kt 1 I t • Therefore, using these relationships in the production function, future income will depend on the current level of saving: Yt 1 At 1 1 r St • This accounts for how the household consumption and saving decisions affect the level of output in an economy. When a household saves, they are effectively trying to postpone current consumption until the future. The way that works here is through the capital stock – a higher level of saving generates more future capital which increases future income. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Real Business Cycle Theory • By using this mechanism in the two period optimal consumption model, it is then possible to see how temporary productivity shocks can generate persistent movements in output. • Suppose there was a one period temporary increase in productivity: A A A 1 1 2 • The capital stock in period 1 is assumed to be predetermined. As a result, the production function will shift upwards and income in period 1 will increase with productivity: Y1 A1 F K1 Y1 A1 F K1 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Temporary increase in productivity Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Temporary increase in productivity • Following the unexpected productivity shock, an increase in period 1 income will lead to an increase in the household’s lifetime resources and an outward shift in its two period budget constraint: C1 C2 Y2 Y1 1 r 1 r • However, utility maximising behaviour would require the household to smooth their consumption, so although period 1 income has risen, the household would optimally prefer to save more and enjoy higher period two consumption as well. The new optimal consumption decision sees higher consumption in both periods. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Utility maximisation Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Increase in investment Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Temporary increase in productivity • Postponing consumption requires the household to save some of the current rise in their income for future use. This is achieved through investment. By increasing the period 2 capital stock, they can increase future income which funds higher future consumption. This consumption smoothing behaviour acts as the propagation mechanism which can turn temporary productivity shocks into fairly persistent changes in output. For simplicity, we have just used a two period model, but the results can be easily generalised to n periods. • Therefore, the initial increase in income would lead to a higher level of saving, capital stock and output in all of the proceeding periods. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Output persistence and the Degree of Consumption Smoothing • The persistence of output movements entirely depends upon the strength of the propagation mechanism, which in this case is the consumption smoothing behaviour of households. • The desire to smooth consumption results from the convexity of the indifference curve. As a result, an initial shock can be propagated over a long period of time. • The household indifference curve, though, will lose its convexity the more that future utility is discounted. An increase in current income will therefore not generate large increases in saving, and hence the propagation mechanism would be fairly weak. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Weak propagation mechanism Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Output persistence and the Degree of Consumption Smoothing • It is fairly plausible to argue that households will place a higher value on current rather than future utility. Households may be myopic or just impatient. A more rational argument for discounting the future would be a reflection of human mortality – there is less point in making provision for the future when there is a probability that death will occur before it is reached. • Once the future is increasingly discounted, we begin to move away from perfect consumption smoothing. Then, a current period productivity shock will lead to less persistence in output, as saving and investment taper off over time. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Propagation mechanism Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Evaluating Real Business Cycle models • Real business cycles are just the combination of impulses and propagation. Therefore, an evaluation of the theory can centre on each of these two parts. • In terms of impulses, it can be asked if there are enough of them, and are they sufficiently large in order to create the type of cycles that have been experienced in developed economies? • Second, are the propagation mechanisms strong enough to produce the necessary persistence in output movements? Example: U.S. productivity growth and economic growth Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Global Applications 9.1 • Productivity and Economic Growth in the U.S. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning New Keynesian Theories of Fluctuations • Recall from the aggregate demand and supply (AD-AS) model that in the long run, the economy cannot deviate from the equilibrium level of output. • However, this is not the case for the short run. • Therefore, following a demand shock, the economy can settle at a different level of output in both the short and the long run. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Disequilibrium following a demand shock Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning New Keynesian Theories of Fluctuations • Following a negative demand shock, output will fall below the equilibrium level of output in the short run. • Over time, wages and prices will fall and the economy will move to its new long run equilibrium, but this may only happen gradually, in which case the demand shock has a persistent effect on output. This type of slow adjustment is required to account for cycles of a reasonable duration. • When output falls below its equilibrium level, it implies that unemployment has risen above the non-accelerating inflation rate of unemployment (NAIRU). The process by which unemployment returns to the NAIRU and output to the equilibrium level, is seen in the bargaining model. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Unemployment after a negative demand shock Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning New Keynesian Theories of Fluctuations • Once it is accepted that wages and prices might adjust slowly, it is then easily apparent why output can deviate from the equilibrium level for sustained periods. • The New Keynesian approach to business cycles argues that this is the case – demand shocks will generate persistent movements in output because wages and prices respond very sluggishly. • The New Keynesian contribution to the study of business cycles is to account for rigidities in wages and prices. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Wage Rigidities • There are several factors which may account for slow wage adjustments when the labour market is in a position of excess demand or supply. • These fall into three camps: – Contracting – Efficiency wages – Bargaining and institutional structures Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price Rigidities • Menu costs • These are the real resources that are used up in changing prices; for example, if a restaurant had to reprint it menus. • It is often argued that these play a limited role in creating price rigidities. However, if combined with other factors, the small rigidities implied by menu costs may actually be much more significant. If firms face little incentive to change prices in the first place, then the additional menu costs of doing so may be very significant at the margin. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price Rigidities • Kinked Demand Curve • The kinked demand curve is a concept of oligopolistic markets. An oligopoly is a form of imperfect competition where the market consists of a few large firms. The kink in the demand curve arises because the price elasticity of demand is different depending on whether the firm is raising or cutting prices. • With a kink in the demand curve, there will be a discontinuity in the corresponding marginal revenue curve. As a result, there are several different levels of marginal cost that all have the same level of profit maximising prices. In this case, prices will be rigid. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price Rigidities • Recessions as the result of coordination failure • If one firm were to reduce prices, it should have a small effect on the overall price level, which then subsequently affects the demand for the products made by other firms. Blanchard and Kiyotaki (1987) refer to this as an aggregate demand externality. An individual firm will not take these externalities into consideration when setting prices, but in the aggregate they are very important. • This model has two equilibria: fix-fix and cut-cut. If the economy enters the fix-fix equilibrium, the only way it can escape to the preferable cut-cut equilibrium if there is strong coordination between firms. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Recessions as the result of coordination failure Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation Policies • There are two main reasons why policy makers might wish to intervene and iron out the business cycle. • First, there are welfare losses associated with fluctuating income. If households are permanent income consumers, they are made better off in terms of lifetime utility if they can smooth income. • Secondly, short run cycles may actually lower the trend rate of growth. Volatility could impede investment which drives long run growth, and hysteresis mechanisms imply that short run movements in output and unemployment can be very persistent. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation Policies • Despite this, there are several grounds against using an active policy response to smooth the economic cycle. • If markets clear quickly, then active policy will be unnecessary, as prices will adjust and quickly reverse the cycle. In addition, policy intervention may be harmful as it can interfere with this automatic adjustment process. • Secondly, policy makers may find it difficult to implement the correct policies for two reasons. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation Policies • Lags – Recognition lags – Implementation lags – Effectiveness lags • The presence of lags makes the timing of policy difficult. Instead of correcting the economic cycle, the policy maker may actually make it worse. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation Policies • Coefficient sizes and the multiplier • To prescribe the right corrective policy, the government must have complete knowledge of the structure of the economy, including the interest sensitivity of investment, the marginal propensity to consume, the size of the multiplier, etc. Without all of this accurate information, prescribing the right policy action becomes exceedingly difficult. • In addition, the Lucas critique argues that predicting the effects of policy changes on the equilibrium level of income/output is very difficult because major economic relationships are unstable over different policy regimes. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation Policies Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation Policies • Following a fall in aggregate demand , the economy will move from point a to point b and output will fall below the equilibrium level. Eventually prices will fall and output will be restored at the equilibrium level. In the long run, the economy will move back to point c. • If policy makers believe that the economy will only make this adjustment over a long period of time, they may choose to use active policy to restore output. This would simply act to shift the aggregate demand curve back to whence it came. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stabilisation Policies • However, those against active policy would make the two arguments above, and suggest that active policy will enhance rather than neutralise the cycle. • If the policy maker cannot calculate the exact policy requirement, then there is a risk that policy may be overactive and move the economy from . Output will now rise too far and require further policy in order to control prices. If the economy follows path A, then the aim of stabilisation policy is to move it onto a path B. However, incorrectly administered policy could move it on to a path, such as C. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary • We have evaluated the existence of business cycles in the macroeconomy. • Real business cycles and fluctuations around long-run trend output were analysed. • We then turned to new Keynesian economics to gain a perspective on sources of short-run fluctuations • We identified and modelled wage and price rigidities, including efficiency wage theories. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary • The welfare effects of cycles were considered. • Whether or not we feel we should be worried about business cycles, governments have and use monetary and fiscal policies in order to offset the cycle, which is known as stabilisation policy or demand management. • The use of stabilisation policy, however, is not uniformly welcomed, and the protests fall into two camps which we covered. First, there is no need for stabilisation policy as the economy self-corrects. Second, the policy inadequacy debate argues that active policy, if inappropriate, may do more harm than good and is best not implemented. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning