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21-1 Chapter 21 Advanced Topics • • • • Item Item Item Etc. McGraw-Hill/Irwin Macroeconomics, 10e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 21-2 Introduction • • This chapter offers advanced material presenting the revolution in macroeconomics that has developed over the last 30 years We look at four theories in this chapter: • • • • Rational expectations The random walk of GDP Real business cycle theory New Keynesian models of price stickiness These models yield contrasting conclusions about the conduct of monetary policy, but they are alike in their emphasis on the importance of consistency between macroeconomic and microeconomic theory. 21-3 Rational Expectations Equilibrium Models • In a rational expectations equilibrium model, markets clear and there is nothing systematic that monetary policy can do to affect output or unemployment • The term “rational expectations equilibrium” identifies two key features of this approach • It places weight on the role of expectations (rational ones) • • • Economic agents do not know the future with certainty base their plans/decisions on their forecasts or expectations about the future If agents are rational, they will use all available information when forming those expectations The rational expectations model insists on equilibrium • Markets clear immediately 21-4 Rational Expectations Equilibrium Models • The full neoclassical theory of AS asserts that: Unemployment is always at the natural rate Output is always at the full-employment level Any unemployment is purely frictional Neither monetary nor fiscal policy changes will have any systematic effect on output • The rational expectations equilibrium approach offers a deviation from that model: Some people do not know the aggregate price level but do know the nominal wage or price at which they can buy or sell. 21-5 Rational Expectations Equilibrium Models • • Assume a simple AD schedule: mv p y (1) Assume a simple short run AS curve, including price expectations: p pe ( y y* ) • (2) The AD and AS equations can be combined to solve for output (3) and prices (4) in terms of m and other variables • Rewrite AD as p = m + v – y, equating AD and AS, and solving for y: m v y pe ( y y* ) m v p e y * y (1 ) m v p e y * y (1 ) m (v p e ) y * (3) (1 ) (1 ) (1 ) 21-6 Rational Expectations Equilibrium Models • • Assume a simple AD schedule: mv p y (1) Assume a simple short run AS curve, including price expectations: p pe ( y y* ) • (2) The AD and AS equations can be combined to solve for output (3) and prices (4) in terms of m and other variables • Plugging equation (3) into the rewritten AD schedule, and solve for p yields: m v p e * p m v y 1 1 1 m v pe * m v y 1 1 1 1 1 e * m v y p (4) 1 1 21-7 Rational Expectations Equilibrium Models • Together, equations (3) and (4) tell us the equilibrium output and prices in our model economy • • If money supply rises 1 percent, output rises by 1/(1+) percent and prices rise by /(1+ ) percent If m, v, and y* are known, given price expectations, predictions for y and p can be calculated using equations (3) and (4) • Often the model generates values that are different from expectations the standard AS/AD model assumes that economic agents make predictions for the economy that are inconsistent with the predictions the model itself makes The Lucas Critique 21-8 The Perfect-Foresight Model • The previous model can be altered to assume that economic agents are correct in their predictions, or p = pe • Economic decision makers use equation (4) to predict prices and 1 compute pe: e p p (m v y * ) pe (1 ) (1 ) (5) • Collecting terms containing pe, we can rearrange (5) to give the perfect foresight forecast and solution for the price level and the corresponding solution for output: p p mv y e y y* * (6) (7) 21-9 The Perfect-Foresight Model • The perfect-foresight predictions in equations (6) and (7) are quite different from the original AS/AD predictions embodied in equations (3) and (4) The latter assume exogenously given price expectations The former assume that price expectations are formed endogenously, and that expectation formation is consistent with the predictions of the model • These differences have implications for the effectiveness of monetary policy • Under a perfect foresight model: A 1% increase in the money supply leads to exactly a 1% increase in the price level A 1% increase in the money supply leads to NO increase in output 21-10 A Rational Expectations Model • A rational expectations model assumes that: Agents make the best use of whatever information is available to them • Expectations are formed in a manner consistent with the way the economy actually operates Similar to a perfect foresight model in which some of the key variables are uncertain • • Suppose before money supply is known, economic decision makers expect the money supply to equal me • If the money supply turns out to be m, the difference between e m m agents’ expectations and the actual money supply is m 21-11 A Rational Expectations Model • • • The monetary policy multiplier with respect to anticipated money, me, is zero, just as in the perfect-foresight model The monetary policy multiplier with respect to unanticipated money, m, is positive, just as in the AS/AD model The equilibrium solutions for price and output are: 1 yy m y* (1 ) (1 ) e *e p m v y ( m y* ) (1 ) *e (11) (12) 21-12 A Rational Expectations Model y y *e 1 m y* (1 ) (1 ) p m e v y *e • ( m y ) (1 ) * The effect of an increase in the money supply under rational expectations must be broken down into two parts: • The effect of an anticipated increase in the money supply • • • Rational expectations predicts NO effect on output Rational expectations predicts an equal change in prices The effect of an unanticipated increase in the money supply • • Rational expectations predicts an increase in output of 1/(1+) Rational expectations predicts an increase in prices of /(1+ ) 21-13 The Random Walk of GDP • Fluctuations in output can be transitory or permanent • If fluctuations are primarily permanent, changes in AD must be of relatively little importance: According to the AS/AD model, the effect of AD shocks wears off with time because the long-run aggregate supply curve is vertical If the effect of shocks is permanent, their source must be something other than aggregate demand • The idea that changes in output are permanent can be described by saying that GDP follows a random walk • Having wandered up or down, GDP has no tendency to return to trend stark contrast to implicit model of text 21-14 The Random Walk of GDP • Nelson and Plosser challenged the predominating idea that: • • [Insert Figure 21-3 here] GDP fluctuates about a smooth trend line Shocks to AD are the primary cause of the transitory fluctuations Suggested that the trend is not so smooth and is subject to large and frequent shocks that have a permanent effect on the level of GDP Figure 21-3 presents a stylized view of trend growth and fluctuations around the trend 21-15 The Random Walk of GDP • Need to detrend the data: • Suppose the trend in y can be represented by a literal time trend: y t t • • (22) Equation (22) states that y rises by β in every time period Subtracting last period’s y from each side of the equation yields: yt yt 1 [ t ] [ (t 1)] (23) OR yt yt 1 y (24) Equations (22) and (24) are equivalent to one another 21-16 The Random Walk of GDP • Suppose we add an output shock, ut, to equation (22): y t t u t OR • According to equation (25), the effect of a shock lasts one period • (25) y t u t u t 1 • • Alternatively, the shock could be added to equation (24): yt yt 1 u t OR (26) • Can be made stationary by taking out a time trend trend stationary Dominated by transitory shocks According to equation (26), the effect of a shock on the level of y is permanent • yt t u t u t 1 u t 2 ... u 0 • Can be made stationary by differencing difference stationary Dominated by permanent shocks 21-17 The Random Walk of GDP • According to the AS/AD model: • • • • [Insert Figure 21-4 here] Business cycles caused by AD fluctuations are relatively short-lived Shocks to AS might be permanent if the derived from permanent productivity improvements Nelson and Plosser showed that GDP includes both permanent and transitory shocks, but GDP process dominated by permanent shocks Figure 21-4 shows the importance of permanent shocks • • Prior 1973 consistent with fluctuations about trend Post 1973 a permanent downward shift 21-18 The Random Walk of GDP • The idea that shocks with long-lasting impact are important to the economy is now generally accepted • • The inference that AD is relatively unimportant remains controversial An alternative view is that large and relatively permanent aggregate supply shocks occur, but only on rare occasions • • In between, AD shocks dominate (Pierre Perron) Trend stationary with breaks Importance of aggregate demand shocks remains a controversial area. 21-19 Real Business Cycle Theory • RBC theory asserts that: • • • Fluctuations in output and employment are the result of a variety of real shocks that hit the economy Markets adjust rapidly and remain in equilibrium RBC theory is the natural outgrowth of the theoretical implication of: • • The rational expectations approach anticipated monetary policy has no real effect The empirical implication of the random walk theory aggregate demand shocks are not an important source of fluctuations 21-20 Real Business Cycle Theory • RBC must do two things: 1. 2. Explain the shocks that hit the economy Explain the propagation mechanisms mechanism through which a disturbance is spread through the economy Why do shocks to the economy seem to have long-lived effects? • The intertemporal substitution of leisure is the propagation mechanism that is most associated with equilibrium business cycles • Why do people work more at some times than at others? • During booms employment is high and jobs are easy to find • During recessions employment is lower and jobs are hard to find Empirical evidence does not support the explanation that people work more when wages are higher. 21-21 Real Business Cycle Theory • RBC models explain large movements in output with small movements in wages as follows: • There is a high elasticity of labor supply in response to temporary changes in the wage • • • People are willing to substitute leisure intertemporally People care about their total work effect but care very little about when they work Suppose that within a two-year period they plan to work 4,000 hours at the going wage • • If wages are equal in the two years, they would work 2,000 each year If wages are 2% higher in one year than the other, they might work 2,200 in the high wage year, and 1,800 in the other 21-22 Real Business Cycle Theory • RBC models explain large movements in output with small movements in wages as follows: • • There is a high elasticity of labor supply in response to temporary changes in the wage Labor is not sensitive to permanent changes in wages • • If the wage rises, and will remain high, there is nothing gained by working more in one year over another The intertemporal substitution of leisure is clearly capable of generating large movements in the amount of work done in response to small shifts in wages • Could account for large output effects in the cycle accompanied by small changes in wages 21-23 Real Business Cycle Theory • The mechanisms that propagate business cycles are set in motion by events/disturbances that change the equilibrium levels of output and employment in individual markets and the economy as a whole • The most important disturbances in RBC theory are: • Shocks to productivity or supply shocks • • Weather, new methods of production Shocks to government spending The evidence for the importance of money seems persuasive, making it difficult for proponents of the RBC to be successful at converting the profession to their views. 21-24 New Keynesian Models of Price Stickiness • The previous three models presented in this chapter are all in the equilibrium-market-clearing tradition • • Inconsistent with the AS/AD behavior that many economists believe characterizes the real world New Keynesians accept the premise of individual rational behavior but develop models in which: Markets do not quickly reach the full classical equilibrium Prices do not always adjust to changes in the money supply • Gregory Mankiw developed a model of price stickiness • Gives an explanation for why prices to not adjust rapidly and the economy can be in disequilibrium 21-25 New Keynesian Models of Price Stickiness • Suppose the money supply increases • • According to equilibrium theories, firms should all increase prices proportionately But suppose changing prices is expensive menu costs are the costs associated with changing prices • • • Firms might choose to leave their prices at the old (wrong) value as the cost of changing prices outweighs the benefits An increase in the nominal money supply (and imperfect competition) may leave prices unchanged real money increases, as does output New Keynesian models explain how individually rational decisions under imperfect competition lead to socially undesirable booms and busts 21-26