Download Classical Economics and the Business Cycles

Classical Economics and the Business Cycles
1. A short history of thought
Dominant questions regarding Business Cycles
2. Real business cycle theory
3. How well does the RBC model fit the facts?
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4. The Solow residual
5. Variable capital utilization
1. What do we believe is the best theory of how GDP, prices, and other variables are
determined in the short run? Such a theory may allow more than one potential cause
of business cycles.
6. Money and the business cycle
2. Given such a theory, which of the potential causes do we believe are actually responsible for the business cycles that all economies seem to observe?
7. The money surprise model
3. What, if anything, should be done about business cycles?
8. Rational expectations and monetary policy
A short history of thought regarding business cycles since the Great Depression
Keynes and the Neo-Classical Sysnthesis
• Answer to Question 1)
Friedman and the Monetarists
– Short run GDP and other variables are determined by markets that work far from
well.
• Answer to Question 1)
– Prices move slowly and thus supply and demand can be unequal for long periods
of time.
– Not much different than Keynesians and Neo-Classical Synthesis.
– Recessions due to IS and LM intersecting left of FE.
– Same potential causes to business cycles.
• Answer to Question 2)
– Booms due to IS and LM intersecting right of FE.
– Money shocks thought to be relatively unimportant.
– Waves of optimism and pessimism important.
– IS curve constantly moving around for no good reason
– FE curve is pretty solid.
• Answer to Question 3)
– Government should engage in active fiscal policy to counter-act movements in the
private sector and thus keep IS curve stable.
– Might also consider using monetary policy to shift LM curve around to stabilize
Y given shifts in IS curve.
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• Answer to Question 2)
– Real side of economy (FE and IS) stable.
– Business cycles due to fluctuating LM curve due mainly to bungling or overreacting monetary authorities.
• Answer to Question 3)
– Government should generally butt out and not try to manage economy.
– Central bank should simply keep money supply growing at the real rate of growth
(implies zero inflation) or perhaps slightly more.
1950’s and 1960’s
Paradigm Lost
• Self-confidence of macroeconomists diminished in 1970’s due to low GDP growth
(recession) and high inflation (stagflation).
1970’s to present
• Why did this cause such problems?
• Increased focus on role of expectations and interaction with government policy.
– Economists at the time didn’t worry too much about FE curve.
• Increased focus on real shocks.
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– The current theory of the business cycle was due to fluctuations in the IS and LM
curves.
• Profound decrease in confidence that we have it all figured out.
• Seek to unify growth theory with theory of short-run fluctuations
∗ In short run, GDP determined by intersection of IS and LM.
∗ Only over time did prices adjust so LM curve shifted to where all three intersected.
• Effect on policy has been enormous.
– Stable FE curve are makes stagflation impossible. Note both the Keynesians
and the Monetarists basically accepted the IS-LM model, arguing chiefly over the
source of fluctuations.
Real Business Cycle Theory
Example 1: A temporary decrease in A .
• Real Shocks. Shocks to capital (earthquakes), productivity (A) which would include
weather, wars, and oil supply shocks.
• FE shifts in because labor demand shifts in and because Y decreases directly.
• IS curve stays constant because temporary change in A does not affect desired investment (by temporary, assume expected value of capital tomorrow unchanged).
• An A shock is anything that effects out productive are capital and labor.
– Purely temporary shocks affect only FE curve.
– Longer lived shocks affect FE and IS curves.
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• Nominal shocks.
– Shocks to money supply or demand.
– Essentially movements in LM curve.
Real business cycle theorists contend it is the real shocks that matter.
• Recessions and booms “just happen.”
• Business cycles are the optimal responses to these shocks.
• LM curve moves to meet new intersection of IS and FE because price level P changes
(price rise) immediately to make this so (markets clear instantly).
• Note the labor market is never out of equilibrium.
• The real business cycle story of a recession thus has Y decrease, r increase, and prices
increase in response to a temporary shock in A.
Pretty good explanation of 1970’s stagflation. (Falling GDP and rising prices.)
Poor explanation of the Great Depression where you saw falling GDP and falling prices.
How well do real business cycle theories fit the facts?
Example 2: A longer lasting decrease in A .
Surprisingly well. Look at temporary shock model.
1. Generates fluctuations.
• Depending on the shapes of the FE and IS curves and the magnitudes of the shifts,
it is possible to get the LM curve (the follower) to shift down instead of up.
3. Real wages pro-cyclical. (labor supply constant, labor demand moving.)
2. Employment moves pro-cyclically.
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• Firms are going to want to invest less because productivity is going to be low for
many period now. So the IS curve shifts in due to lower value of capital in future.
• The point? Productivity shocks can be consistent with a lot of observations. This
helps when trying to see if the theory is consistent with the data.
4. Output per worker (average productivity) pro-cyclical.
• Again the labor market is never out of equilibrium.
6. The RBC model is in some sense overkill regarding stagflation.
5. Prices.
7. But what about unemployment?!?
The Solow Residual
• Recall our discussion on growth accounting.
∆At ∆Yt
∆Kt
∆Nt
=
−α
− (1 − α)
At
Yt
Kt
Nt
Why care about pro-cyclical labor productivity?
• The RBC guys (and gals) want to do this quarter-by-quarter.
• In the book,
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• A gets called the Solow residual.
• If demand shocks drive the cycle, then labor productivity should be counter-cyclical.
• If supply shocks drive the cycle, then labor productivity should be pro-cyclical.
Yt
At = α 1−α
Kt Nt
• Big debate in the profession, on how to interpret the Solow residual.
• What is a negative A shock? Why should positive A shocks across industries be
correlated? Recall in a business cycle all the sectors of the economy move together.
• Recall the facts...
Variable capital utilization
• Can a demand shock be misinterpreted as an A shock?
• What is K? How do you measure K? Does K vary across time? Why care?
Where is real business cycle theory now?
• Note that changes in K will corrupt you measure of A, the Solow residual.
• Consider more than just shocks to A.
• But you say surely it takes so much time to build the capital stock, K can’t be moving
around that much.
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• But think about how capital gets used. Sometime more than others. This classroom
sits empty most of the time. Ski lifts sit idle over the summer. Movie theaters,
churches ...
• Book covers shocks to government spending due to such things as the end of the Cold
War.
• Generally, adding more shocks allows the model builder more ways to try to match
the correlations in the data.
• Allow for cyclical capital utilization.
• Think about a barber shop ...
• Think more about measuring unemployment.
– On Friday, shop open 9-5, 20 customers
– On Saturday, shop open 9-5, 30 customers
• Was there a positive A shock on Saturday? Or is capital and labor being measured
incorrectly?
Money and Real Business Cycles.
Evidence against neutrality
• In RBC models, LM curve follows and follows immediately. Money is neutral.
• Paul Volker’s tightening of money supply in early 1980’s.
• Is this a good assumption? Subject for debate
– Recall the quantity theory stories.
• But money is pro-cyclical.
• But the proponents of short-term monetary neutrality argue this is reverse causation.
• Does the Fed cause Christmas?
• Friedman and Schwartz
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– Those that argue that money is neutral point to things like currency reforms.
1. every major recession is associated with a large contraction in the money supply
2. every large contraction in the money supply is associated with a large recession.
• Overall RBC models probably cannot explain all short run movements in GDP. On the
other hand, most macroeconomists were amazed by the amount they could explain.
A classical model with short-term monetary non-neutrality
• In the classical model, money is neutral since prices adjust quickly. So in this case
the only relevant curve is the long-run aggregate supply curve.
• So movements in aggregate demand have no effect on output – just on the price level.
• But what if producers have imperfect information about the general price level?
Monetary Policy and the money surprise theory
– Producers cannot observe the aggregate price level, they only get to observe a
subset of prices. As a result they may misinterpret changes in relative prices to
be changes in the price level.
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– These guys aren’t dumb – they just can’t see everything.
• Recall our quantity theory of money (in the POW camp) story.
• In the the money surprise model, unanticipated monetary monetary policy has real
effects; anticipated money has no real effects.
• Simple example – a baker – it is as good as any
• Unanticipated change in the money supply.
• An increase in the price level that is higher than expected induces people to work
more and thus increase the economy’s output.
• Anticipated changes in the money supply
• Similarly, an increase in the price level that is lower than expected reduces output.
• The equation
Y = Ȳ + b(P − P e)
summarizes the money surprise theory.
Rational expectations and the role of monetary policy
At the hands of mathematically powerful and arrogant theorists, the beguiling methodologies of rational expectations and price-cleared competitive markets
have made macroeconomics Panglossian: the outcomes of market economies are
all for the best, cycles of employment and output are benign, and monetary and
fiscal policies are useless or worse.
Jim Tobin
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• The only way the Fed can use monetary policy to affect output is to surprise people.
• But people realize that the Fed would want to increase the money supply in recessions
and decrease it in booms, so they won’t be fooled.
• If the public has rational expectations, the Fed won’t be able to surprise people in
response to the business cycle; only random monetary policy has any effects.
• So even if smoothing the business cycle were desirable, the combination of the money
surprise theory and rational expectations suggests that the Fed can’t systematically
use monetary policy to stabilize the economy.