Download Mankiw 5/e Chapter 19: Advances in Business Cycle Theory

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CHAPTER NINETEEN
Advances in Business
Cycle Theory
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
Learning objectives
This chapter presents an overview of recent
work in two areas:
 Real Business Cycle theory
 New Keynesian economics
CHAPTER 19
Advances in Business Cycle Theory
slide 1
The Theory of Real Business Cycles
 all prices flexible, even in short run
– implies money is neutral, even in short run
– classical dichotomy holds at all times
 fluctuations in output, employment, and
other variables are the optimal responses to
exogenous changes in the economic
environment
 productivity shocks the primary cause of
economic fluctuations
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The economics of Robinson Crusoe
 Economy consists of a single
producer-consumer,
like Robinson Crusoe on a desert island.
 Assume Crusoe divides his time between
– leisure
– working
• catching fish (production)
• making fishing nets (investment)
 Assume Crusoe optimizes given the
constraints he faces.
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Advances in Business Cycle Theory
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Shocks in the Crusoe island economy
1. Big school of fish swims by island.
Then, GDP rises because
 Crusoe’s fishing productivity is higher
 Crusoe’s employment rises: he decides to
shift some time from leisure to fishing to
take advantage of the high productivity
CHAPTER 19
Advances in Business Cycle Theory
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Shocks in the Crusoe island economy
1. Big storm hits the island.
Then, GDP falls:
 The storm reduces productivity, so Crusoe
spends less time fishing for consumption.
 More importantly, investment falls,
because it’s easy to postpone making nets
until storm passes
 Employment falls: Since he’s not spending
as much time fishing or making nets,
Crusoe decides to enjoy more leisure time.
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Advances in Business Cycle Theory
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Economic fluctuations as
optimal responses to shocks
 In Real Business Cycle theory, fluctuations in
our economy are similar to those in Crusoe’s
economy.
The shocks aren’t always desirable.
But once they occur, fluctuations in
output, employment, and other
variables are the optimal
responses to them.
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Advances in Business Cycle Theory
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The debate over RBC theory
…boils down to four issues:
 Labor Market: Do changes in employment
reflect voluntary changes in labor supply?
 Technology: Does the economy experience
large, exogenous productivity shocks in the
short run?
 Is money really neutral in the short run?
 Are wages and prices flexible in the short run?
Do they adjust quickly to keep supply and
demand in balance in all markets?
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The labor market
 Intertemporal substitution of labor:
One period problem:
A household has to distribute limited time (normalized to 1) between work and leisure
U (c, l )  ln c  b ln(1  l ),
where c - consumption, l - labor, 1  l - leisure.
Household derives income by providing its labor at the wage rate w :
I  wl ,
cI
max ln c  b ln(1  l )
c ,l
s.t. c  wl
Labor supply:
1
l
1 b
CHAPTER 19
Advances in Business Cycle Theory
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The labor market
 Intertemporal substitution of labor:
Two period problem:
max ln c1  b ln(1  l1 )   (ln c2  b ln(1  l2 ))
c1 ,c2 ,l1 ,l2
1
1
w2l2
c2  w1l1 
1 r
1 r
Relative labor supply:
w2
1  l1

1  l2  (1  r ) w1
s.t. c1 
w1
 increase l1 relative to l2

w2
 r  increase l1 relative to l2
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Advances in Business Cycle Theory
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Labor market
 In RBC workers work more when wage is
temporarily high of when interest rate is
temporarily high
 Labor supply and output fluctuate because
of shocks that cause changes in rt or wt
 Empirically, intertemporal substitution of
labor is too small – changes in real wage
lead to only small changes in hours worked
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Technology Shock
Labor demand:
F (k , l )
wP
 value of marginal product of labor
l
Technology shock that causes VMPL to increase
 VMPL t  shift in L t D  wt  lt
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Technology shocks
 In RBC theory, economic fluctuations are
caused by productivity shocks.
 The Solow residual is a measure of
productivity shocks: it shows the change in
output that cannot be explained by changes
in capital and labor.
 RBC theory implies that the Solow residual
should be highly correlated with output.
Is it?
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Solow Residual
Yt  At F ( K t , Lt )  At K t L(1t  )
ln Yt  ln At   ln K t  (1   ) ln Lt
Yt At
Kt
Lt
 
 (1   )
Yt At
Kt
Lt
Empirically, we define Solow residual as
At Yt
K t
Lt


 (1   )
At
Yt
Kt
Lt
At
is the change in output that can not be explained
At
by changes in labor and capital
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The Solow residual and growth in output
Percent
10
per year
8
Output growth
6
4
2
0
-2
Solow residual
-4
1945
1950
1955
CHAPTER 19
1960
1965
1970
1975
1980
1985
1990
Advances in Business Cycle Theory
1995
2000
Year
slide 14
Technology shocks
 Proponents of RBC theory argue that the strong
correlation between output growth and Solow
residuals is evidence that productivity shocks are an
important source of economic fluctuations.
 Critics note that the measured Solow residual is
biased to appear more cyclical than the true,
underlying technology.
– Labor hoarding (firms keep labor that is
underemployed during recessions)
– Changes in the production process that are not part
of technology (during recessions workers often do
different tasks not directly related to production e.g.
training, organizing the inventory etc.)
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An econometric detour
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Correlation does not imply causation!
 Corr(X,Y)>0 or Corr(X,Y)<0 does not mean that X
causes Y
– during rainy days people carry umbrellas
– rain is correlated with umbrellas
– Some alien may wrongly infer that umbrellas cause
rain
 Moreover, Corr(X,Y)>0 or Corr(X,Y)<0 does not
necessarily imply that either X causes Y or Y causes
X:
– There can be the third factor Z that causes both X
and Y
• i.e sleeping with one's shoes on is strongly
correlated with waking up with a headache.
• Therefore, sleeping with one's shoes on causes
headache.
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One more example
 An episode of The Simpsons (Season 7, "Much Apu About Nothing")
 Springfield had just spent millions of dollars creating a highly sophisticated
"Bear Patrol" in response to the sighting of a single bear the week before.
–
–
–
–
–
–
–
Homer: Not a bear in sight. The "Bear Patrol" is working like a charm!
Lisa: That's specious* reasoning, Dad.
Homer: [uncomprehendingly] Thanks, honey.
Lisa: By your logic, I could claim that this rock keeps tigers away.
Homer: Hmm. How does it work?
Lisa: But I don't see any tigers around, do you?
Homer: (pause) Lisa, I want to buy your rock.
Source: Wikipedia, click here
*specious - plausible but false; "a specious claim"; "spurious inferences"
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The neutrality of money
 RBC critics note that reductions in money growth
and inflation are almost always associated with
periods of high unemployment and low output.
– Lower money supply growth and/or lower inflation
is correlated with higher unemployment in the
short run
 RBC proponents respond by claiming that the
money supply is endogenous:
– Suppose output is expected to fall.
Central bank reduces money supply in response to
an expected fall in money demand.
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Reverse causality or “money illusion”
 It could be the case that
Md
A  Y 
 The central bank responds by M S 
P
 This argument is called “money illusion”
– Even though we observe that episodes of low
unemployment are correlated with episodes of high
growth of money supply, the causality goes from
output to money
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Empirical strategies to check the
direction of causation
 Ideally: controlled experiment
– Every January, the chairman of the Fed flips the
coin
• If Heads: increase money supply
• If Tails: reduce money supply
• Therefore, money supply is exogenous random
process
– If output and labor are still positively correlated
with changes in money supply then money are not
neutral in the short run!
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Event Studies
 Alternative: study how some exogenous historical
changes in monetary policy influence real variables
– “A Monetary History of the US” M. Friedman and A.
Schwartz
• Death of B. Strong – the chairman of the New
York Federal Reserve Bank in 1928 was one of the
causes of the Great Depression
– C. and D. Romer (1989) studied how the Fed’s
Open Market Committee announcements about the
shift in the monetary policy influenced the output
and employment
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The flexibility of wages and prices
 RBC theory assumes that wages and prices are
completely flexible, so markets always clear.
 RBC proponents argue that the extent to which
wages or prices may be sticky in the real world
is not important for understanding economic
fluctuations.
 They also prefer to assume flexible prices
to be consistent with microeconomic theory.
 Critics believe that wage and price stickiness
explains involuntary unemployment and the
non-neutrality of money.
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New Keynesian Economics
 Most economists believe that short-run
fluctuations in output and employment
represent deviations from the natural rate,
and that these deviations occur because
wages and prices are sticky.
 New Keynesian research attempts to explain
the stickiness of wages and prices by
examining the microeconomics of price
adjustment.
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New Keynesian economics
 Why exactly prices are sticky?
– menu costs prevent firms to adjust prices which
leads to high costs to society
– coordination failure
• Strategic motives in price setting
– staggering of wages and prices
• staggering makes the overall price level adjust
gradually
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How sticky the prices are?
 “Economist” Sticky situations
– Bils and Klenow (2004)
• used data on 350 goods and services collected by
the Bureau of Labour Statistics for calculating the
consumer-price index.
• in 1995-97 half of these prices changed at least
every four or five months.
– Nakamura and Steinsson “Five Facts About Prices:
A Reevaluation of Menu Cost Models”
• importance of sales and special promotions in the
frequency of American price changes
• In the US, median duration of retail prices lay
between eight and 11 months in 1998-2005
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Conclusion: the frontiers of research
 This chapter has explored two distinct
approaches to the study of business cycles:
Real Business Cycle theory and New
Keynesian Theory.
 Not all economists fall entirely into one camp
or the other.
 An increasing amount of research incorporates
insights from both schools of thought to
advance our study of economic fluctuations.
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Chapter summary
1. Real Business Cycle theory
 assumes perfect flexibility of wages and prices
 shows how fluctuations arise in response to
productivity shocks
 the fluctuations are optimal given the shocks
2. Points of controversy in RBC theory
 intertemporal substitution of labor
 the importance of technology shocks
 the neutrality of money
 the flexibility of prices and wages
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CHAPTER 19
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