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Chapter 13
Business
Cycle Models
with Flexible
Prices and
Wages
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Three Business Cycle Models
• Real Business Cycle Model
• Keynesian Coordination Failure Model
• New Monetarist Model
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Key Questions in this Chapter
• How does each model fit the data? The first two models
are intended to fit the “average” business cycle. The last
one is intended to capture particular features of the
financial crisis.
• What is the role for government policy in each model?
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Real Business Cycle Model
• Business cycles are caused by fluctuations in total factor
productivity.
• There is no role for the government in smoothing
business cycles – cycles are just optimal responses to the
technology shocks.
• Model fits the data well.
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Figure 13.1
Solow Residuals and GDP
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Figure 13.2
Effects of a Persistent Increase in Total Factor
Productivity in the Real Business Cycle Model
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Figure 13.3
Average Labor Productivity with Total
Factor Productivity Shocks
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Table 13.1
Data Versus Predictions of the Real Business
Cycle Model with Productivity Stocks
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Figure 13.4
Procyclical Money Supply in the Real Business Cycle
Model with Endogenous Money
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Keynesian Coordination Failure
Model
• Strategic complementarities imply that the aggregate
production function has increasing returns to scale, and
the labor demand function can be upward sloping.
• There can be multiple equilibria.
• In an example, the model fits the data as well as the real
business cycle model.
• GDP fluctuates in the model because of self-fulfilling
waves of optimism and pessimism.
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Figure 13.5
A Production Function with Increasing
Returns to Scale
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Figure 13.6
Aggregate Labor Demand with Sufficient
Increasing Returns to Scale
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Figure 13.7
The Labor Market in the Coordination Failure Model
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Figure 13.8
The Output Supply Curve in the Coordination
Failure Model
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Figure 13.9
Multiple Equilibria in the Coordination
Failure Model
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Table 13.2
Data Versus Predictions of the Coordination
Failure Model
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Figure 13.10
Average Labor Productivity in the Keynesian
Coordination Failure Model
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Figure 13.11
Procyclical Money Supply in the Coordination
Failure Model
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Figure 13.12
Stabilizing Fiscal Policy in the Coordination
Failure Model
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A New Monetarist Model: Financial Crises and
Deficient Liquidity
• Two classes of liquid assets in the economy: currency
and financial liquid assets.
• Financial liquid assets include relatively safe assets that
are widely-traded in the financial system – e.g.
government debt, bank reserves, asset-backed securities.
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Financial Liquid Assets
• Can be expressed as
a
B
 k (r )
P
• B = nominal government debt.
• k is a decreasing function of r, and k(r) denotes financial
liquid assets that are “produced” in the private financial
system.
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Financial Liquid Assets
• Assume that, in the model, there can be two possible
states of the world: adequate financial liquidity and
deficient financial liqudity.
• Deficient financial liquidity occurs in a financial crisis
due to factors that impair the ability of the financial
sector to create financial liquid assets.
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Modifying the Basic Monetary Intertemporal
Model
• In the New Monetarist model, financial liquid assets, a,
have a positive effect on output demand if there is
deficient financial liquidity.
• Given equilibrium in the money market,
BL(Y , r )
a
 k (r )
M
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New Effect in the New Monetarist Model
• An open market purchase (M goes up, B goes down)
shifts the output demand curve to the left, if there is
deficient financial liquidity.
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Figure 13.13
A Reduction in Financial Liquid Assets,
Producing Deficient Financial Liquidity
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Figure 13.14
Monetary Policy Response to Deficient Financial
Liquidity
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Excess Reserves and the Liquidity Trap
• If reserves pay interest, as is the case currently in the
United States, and there is a positive supply of reserves in
the financial system, then the interest rate on reserves
determines the market interest rate.
• Open market operations have no effect.
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Excess Reserves and the Liquidity Trap
• Mr denotes reserve account balances, Mc denotes
currency
• Now, re-define financial liquid assets as:
( M r  B) L(Y , r )
a
 k (r )
Mc
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Figure 13.15
Monetary Policy with Excess Reserves and a
Liquidity Trap, an Increase in the Interest Rate on
Reserves is Beneficial
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