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Chapter 11 Market-Clearing Models of the Business Cycle Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Study Three Market-Clearing Business Cycle Models • Real Business Cycle Model • Segmented Markets Model • Keynesian Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-2 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. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-3 Figure 11.1 Solow Residuals and GDP Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-4 Figure 11.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-5 Figure 11.3 Average Labor Productivity with Total Factor Productivity Shocks Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-6 Table 11.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Shocks Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-7 Figure 11.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-8 Equation 11.1 Cobb-Douglas production function, with labor share of output of 64%: Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-9 Segmented Markets Model • Business cycles can be caused in this model by unanticipated shocks to the money supply. • Model exhibits a liquidity effect – the interest rate falls in the short run when the money supply increases. • Monetary policy can only improve the functioning of the economy if the central bank has an informational advantage over the private sector. • Fit to the data is not as good as with the real business cycle model. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-10 Figure 11.5 Effects of an Unanticipated Increase in the Money Supply in the Segmented Markets Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-11 Table 11.2 Data Versus Predictions of the Segmented Markets Model with Monetary Shocks Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-12 Figure 11.6 A Welfare-Improving Role for Active Monetary Policy Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-13 Figure 11.7 Percentage Deviations from Trend in Money Supply and GDP Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-14 Figure 11.8 Real and Nominal Interest Rates Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-15 Figure 11.9 Relative Price of Energy Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-16 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. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-17 Figure 11.10 A Production Function with Increasing Returns to Scale Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-18 Figure 11.11 Aggregate Labor Demand with Sufficient Increasing Returns to Scale Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-19 Figure 11.12 The Labor Market in the Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-20 Figure 11.13 The Output Supply Curve in the Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-21 Figure 11.14 Multiple Equilibria in the Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-22 Table 11.3 Data Versus Predictions of the Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-23 Figure 11.15 Average Labor Productivity in the Keynesian Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-24 Figure 11.16 Procyclical Money Supply in the Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-25 Figure 11.17 Stabilizing Fiscal Policy in the Coordination Failure Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-26