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Second Edition Chapter 14 The Real Business Cycle Model: Shocks and Transmission Mechanisms Chapter Outline Uncertainty and Irreversible Investments Labor Adjustment Costs Time Bunching Collateral Damage Appendix: Business Fluctuations and the Solow Model 2 Introduction Transmission mechanisms – economic forces that can amplify the impact of shocks on the economy We focus on five transmission mechanisms: • • • • • Intertemporal substitution Uncertainty and irreversible investments Labor adjustment costs Time bunching Shocks to collateral and net worth 3 Intertemporal Substitution Intertemporal substitution – the allocation of consumption, work, and leisure across time to maximize well-being. Examples: • Lack of rainfall affects crops directly, but it also affects the farmer’s willingness to work hard, which may reduce output further. • When unemployment is high, some productive people fearing they may lose their job leave the work force and go back to college reducing output even further. 4 Intertemporal Substitution Intertemporal substitution magnifies economic shocks. • When things go a bit bad, the rate of return to work and investing falls and people work and invest less. • On the upside, Intertemporal substitution can feed an economic boom and make it more intense. We can see this in the next diagram. 5 Transmission Mechanisms Amplify Shocks Inflation rate (p) Solow growth curve Shocks with Intertemporal substitution Shocks without Intertemporal substitution Negative shock (2%) Average (3%) Positive shock (2%) Real GDP growth rate 6 Intertemporal Substitution Point: When GDP is growing slower than the trend, the employment to population ratio is also growing slower than the trend. The reverse is also true. 7 Uncertainty and Irreversible Investments Irreversible investments – have high value only under specific conditions—they cannot be easily moved, adjusted, or reversed if conditions change. Negative shocks increase uncertainty especially for irreversible investments Uncertainty slows investment and keeps resources in less productive uses. 8 Labor Adjustment Costs Labor adjustment costs – the costs of shifting workers from declining sectors of the economy to growing sectors. • Adjustments to shocks are not always rational: A union worker in the auto industry making $100,000 a year without a high school degree will probably turn down a lot of available jobs before he finally accepts reality and takes a job at a lower wage. Result: even higher unemployment and lower real GDP growth. 9 Time Bunching Time Bunching – the tendency of economic activities to be coordinated at common points in time. • Bunching causes shocks to spread through the economy and through time. Suppose a negative economic shock slows the economy down. • Many people will be less keen to work (because of Intertemporal substitution). • This will induce others to cut back on their work as well. 10 Time Bunching The “seasonal business cycle” is one form of economic clustering in time. • The fourth quarter October-December brings more economic activity than any other time. • After Christmas the party is over and economic activity is the lowest. Once some economic activity is moving in given direction, other parts of economic activity tend to follow that momentum. 11 Collateral Damage Collateral – a valuable asset that is pledged to a lender to secure a loan. If the borrower defaults, ownership of the collateral transfers to the lender. Collateral shock – a reduction in the value of collateral. Collateral shocks make borrowing and lending more difficult. 12 Collateral Damage A negative shock slows the economy down and asset prices fall causing the value of collateral to fall. • Loans are more difficult to obtain if the value of collateral is low. • Investment slows down and growth slows even further. During an economic boom, asset prices rise and it becomes easier to get loans and makes the boom even bigger. 13 Collateral Damage Collateral damage also affects consumers: • Falling asset prices like homes make it difficult for people to move to better jobs. General lesson: If the nominal owner of a property has no equity in it they don’t do a good job of taking care of it. • Banks • Houses 14 Takeaway Transmission mechanisms magnify shocks. We identified five of these mechanisms. A medium-sized negative economic shock is capable of causing a disproportionately large downturn in production and employment 15 Appendix: Business Fluctuations and the Solow Model Second Edition 16 Business Fluctuations and the Solow Model Some business fluctuations can be analyzed using the Solow growth model. Main ideas of a modified Solow model… • Labor is added to the aggregate production function so that: Y A t F(K,L) • In this version of the model At jumps around in the short-run as productivity shocks hit the economy. L changes during booms and busts due to intertemporal substitution. 17 Business Fluctuations and the Solow Model The effects of productivity shocks can be simulated using an excel spreadsheet. • We use the random number generator to simulate changes in At. • At can fluctuate randomly around 1. If At is a little bigger than one → Positive productivity shock. If At is a little smaller than one → Negative productivity growth. The following spreadsheet will generate this result. 18 Business Fluctuations and the Solow Model B2 = RAND( )(1/0.95−0.95) + 0.95 and D2 so it reads = B2*C2^(1/2); Plotting output over time is shown next. 19 Business Fluctuations and the Solow Model 20 Second Edition End of Chapter 14 21