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LECTURE NOTES ON MACROECONOMICS
ECO306
SPRING 2014
GHASSAN DIBEH
Chapter 7: New Classical Macroeconomics and
Economic Fluctuations
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
Rational Expectations became the springboard for new ideas on
how to reconcile the classical doctrine that the capitalist economy
is stable and at full employment with the empirical facts of
economic fluctuations.
The new business cycle theory initiated by Nobel laureate
Robert Lucas (1975) attempted to revive the age old project of
embedding the business cycle into equilibrium theory and making
economic fluctuations compatible with competitive equilibrium; a
project that was largely abandoned with the triumph of
Keynesian economics.
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Lucas and Sargent (1978) said that, "increased attention and respect are
accorded to the theoretical casualties of the Keynesian revolution, to the
ideas of Keynes's contemporaries and of earlier economists whose thinking
for years has been regarded as outmoded" (p. 57).
The New Classical Macroeconomics revived albeit in rigorous
formulation the old Classical school of macroeconomics.
The two main tenets of the new theory are:
1- Markets always clear: The flexibility of prices and rational expectations
ensure that the economy is always at full employment equilibrium (the
natural rate)
2- Policy is ineffective: Only monetary surprises will have an effect on
output albeit transitory.
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The main task that confronted the New Classical School was the
explanation of economic fluctuations and unemployment that
Keynesian theory well explained.
If Keynesian theory is to be discarded, how can market clearing and
rational expectations be reconciled with the empirical facts of
fluctuating output and employment in capitalist economies?
Two main market clearing approaches were developed to provide an
alternative to the Keynesian explanation of the business cycle: the
Lucas equilibrium business cycle and the Real Business Cycle
model (RBC).
The equilibrium business cycle

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The building blocks of the basic Lucas (1975) model consist of
rational optimizing agents that are geographically separated in an
island-type economy. These individuals lack the ability to obtain
perfect information on prices.
If a certain general price increase (inflation) is perceived by the
agents as an increase in the relative price of the commodity they are
producing, then their immediate rational reaction would be to
increase the production and supply of the commodity.
Once the agents discover their error--the error being that they
confused a general price level for a relative price increase--which
should have no effects on their production plans, they scale back
production.
The equilibrium business cycle


Hence, the business cycle is a result of misperception on the part of
rational optimizing agents because of imperfect information. In
addition, since the equilibrium state is maintained throughout time, the
cycle is perfectly compatible with economic theory.
Formalizing the model, the model gives the following equation for
cyclical output:

𝑦𝑡𝑐 = 𝑏 1 − 𝛽 (𝑝𝑡 − 𝑝)

Where





b=constant
𝛽 = a measure of reaction of agents to price changes and 0 ≤ 𝛽 ≤ 1.
𝑦𝑡𝑐 =cyclical real output
𝑝𝑡 = price level at time t
𝑝=mean price level
The equilibrium business cycle
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
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The parameter 𝛽 is central to the model. In the presence of imperfect
information (0 ≤ 𝛽 < 1), (𝑝𝑡 − 𝑝) will push agents to increase
production in a cyclical manner i.e., 𝑦𝑡𝑐 > 0.
Given that the price level 𝑝𝑡 deviates from the mean 𝑝 as a result of
unanticipated demand shocks then the cycle in the capitalist economy
is generated by unanticipated demand shocks that are transmitted
into real output cycles.
𝛽 then measures the belief of economic agents of a change in the
relative price level
If output is a function of lagged output also, then the complete model
becomes:


𝑐
𝑦𝑡𝑐 = 𝜆𝑦𝑡−1
+ 𝑏 1 − 𝛽 (𝑝𝑡 − 𝑝)
Where 0 < 𝜆 < 1.
The equilibrium business cycle

The iterative solution of the model becomes

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
𝑦𝑡𝑐 =
∞
𝑗
𝑗=0 𝜆 𝑏
1 − 𝛽 (𝑝𝑡−𝑗 − 𝑝)
Thus, the cyclical component of output at any time t is a function of all
past shocks to the economy realized in real output. Moreover, since
economic agents are on their supply function then the economy is at
equilibrium at all times.
We can represent graphically the dynamics of the economy in this
model.
Figure 17 shows the dynamics of output if there is perfect information
(𝛽 = 1). The economy experiences no fluctuations and output
converges to potential output at all times.
The equilibrium business cycle

Figure 18 shows the fluctuating output under imperfect information
𝛽 ≠ 1. The sum of the aggregate demand shocks in the past are
transformed into real output changes as economic agents misperceive
price changes resulting from those shocks as relative price changes.
Figure 18. Stochastic fluctuation under imperfect information and demand shocks
Real business Cycles [Robinson Crusoe + max U)

Plosser (1989b) motivates the Real Business Cycle models by
providing a methodological introduction to RBC modeling which
criticizes Keynesian economics on two grounds:
(1)
(2)

the absence of a consistent foundation based on a choice theoretic
framework of economics
the static nature of the Keynesian model that contains none of the dynamic
elements found in the earlier business cycle research of Mitchell and Von
Hayek.
According to Plosser, the introduction of dynamics into the Keynesian
system was at best done in an ad hoc fashion such as the accelerator
mechanism and the wage and price adjustment equations (the Phillips
curve).
Real business Cycles [Robinson Crusoe + max U)
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
The basic building block of the RBC model is an aggregate
production function that is shocked by technology shocks that shift the
marginal product of labor (MPL) causing fluctuations in output. Again,
given that workers are on their labor supply function then the
economy is in equilibrium.
The economy is represented by a dynamic aggregate production
function


The capital accumulation equation is given by


𝑦𝑡 = 𝜙𝑡 𝐹(𝐾𝑡 , 𝐿𝑡 )
𝐾𝑡 = 1 − 𝛿 𝐾𝑡−1 + 𝐼𝑡−1
which says that capital increases as a result of additional investment
minus depreciation (𝛿).
Real business Cycles [Robinson Crusoe + max U)

If there are serially correlated technology shocks such that

𝜙𝑡 = 𝜂𝜙𝑡−1 + 𝜖𝑡
or


∞
𝑗
𝑗=0 𝜂 𝜖𝑡−𝑗
Substituting in the production function, we get


𝜙𝑡 =
𝑦𝑡 =
∞
𝑗𝜖
𝜂
𝑡−𝑗
𝑗=0
𝐹 𝐾𝑡 , 𝐿𝑡
The production function is shifted continuously through shocks
causing shifts in output. Then given a savings rate out of output,
capital accumulation will also be a function of the technology shocks.
Hence, given random shocks generated by coin tosses for example,
both output and capital accumulation will show random fluctuations.
Real business Cycles [Robinson Crusoe + max U)
Figure 19. Capital stock and output fluctuations in RBC model
Real business Cycles [Robinson Crusoe + max U)

In the labor market, such shocks cause shifts in the marginal product of
labor

𝑀𝑃𝐿𝑡 =

𝑀𝑃𝐿𝑡 =
𝜕𝑦𝑡
𝜕𝐿𝑡
𝜕𝐹𝑡
∞
𝑗𝜖
𝜆
𝑡−𝑗 𝜕𝐿
𝑗=0
𝑡
Figure 20. MPL fluctuations
in RBC model