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CHAPTER
20
Advanced Topics
Learning objectives




Understand that in a rational expectations model, people
form expectations that are consistent with the way the
economy operates. Anticipated monetary policy has no
real effects in the short run or the long run.
Understand that the random walk theory of GDP argues
that most shifts in output are permanent, as opposed to
transitory booms and recessions, and that changes in
aggregate demand are much less important than changes
in aggregate supply.
Understand that real business cycle theory argues that
money is very important and that economic fluctuations
are due largely to changes in technology.
Understand the New Keynesian models of price stickiness
offer “microfoundations” explaining why the price levels
does not always adjust quickly to changes in the money
supply.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Advanced Topics
1)Rational Expectations
2)The Random Walk of GDP
3)Real Business Cycle Theory
4)New Keynesian Models of Price
Stickiness.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Four New Theories in this
Chapter:
Slide 2
Overview of the New Macroeconomics
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Rational Expectations Equilibrium: A model in
which expectations are formed rationally and
markets are fully in equilibrium.
o Rational Expectations: Theory of expectations
formation in which expectations are based on all
available information about the underlying
economic variables; frequently associated with
New Classical macroeconomics.
o Policy Irrelevance: Refers to the inability of
monetary or fiscal policy to affect output in
rational expectations equilibrium models.
Slide 3
Overview of the New Macroeconomics
Chapter 20: Advanced Topics
o Random Walk of GDP: A variable in which
changes over time are unpredictable.
o Real Business Cycle Theory: Theory that
recessions and booms are due primarily to
shocks in real activity, such as supply shocks,
rather than to changes in monetary factors.
o Propagation mechanism: Mechanism by which
current economic shocks cause fluctuations in
the future, for example, intertemporal substitution
of leisure.
o Intertemporal substitution of leisure: The extent to
which temporarily high real wages cause workers to
work harder today and enjoy more leisure tomorrow.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 4
Overview of the New Macroeconomics
o Productivity Shock: Changes in the level of technology
that affect workers’ productivity.
o New Keynesian Models of Price Stickiness
o New Keynesians: Those who develop models whose
basis is rational behaviour and conclude that the
economy is not inherently efficient and that, at times,
the government ought to stabilize output and
employment.
o Price Stickiness: When prices do not move with the
infinite speed assumed in the Classical model.
o Menu cost: Small cost incurred when the nominal price
of good is changed.
o Imperfect competition: Forms of competition in which
firms have market power.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Disturbances
Slide 5
Rational Expectations Revolution
o AS
p = p +  (y - y*)
e
(2)
1
1

e
y=
m+
v - p )+
y * (3)
(
 1+ 
1+ 
1+ 


1
e
(4)
y=
m + v - y *)+
p
(
1+ 
1+ 
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Simple Aggregate Supply-Aggregate
Demand Model
o AD
m+v = p+ y
(1)
Slide 6
Rational Expectations Revolution

1
e
p = p=
m + v - y *)+
p
(
1+ 
1+ 
e
p = p = m + v- y*
y = y*
e
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Lucas critique: Points out that many
macroeconomic models assume that
expectations are given by a particular function,
when that function can change.
o Perfect foresight: Assumption that people know
the future value of all relevant variables, or that
their expectations are always correct.
(5)
(6)
(7)
Slide 7
Rational Expectations Revolution
Chapter 20: Advanced Topics
o A Rational Expectations Model
m = m - m

p=
m +  )+ v - (y
(
[
1+ 
e
m
e

e
e
*e
+  y*
1
e
+
p (8)
1+ 
)]
1
e
p =
m + v - y )+
p
(
1+ 
1+ 
e
p = m +v- y
*e
*e
Copyright 2005 © McGraw-Hill Ryerson Ltd.
(9)
(10)
Slide 8
Rational Expectations Revolution
1

y= y +
m +
 y*
1+ 
1+ 
(11)
*e
e
*e
p = m +v- y +
e
e
p = m +v- y


(
1+ 
*e
Copyright 2005 © McGraw-Hill Ryerson Ltd.
m
-  y*
)
(12)
Chapter 20: Advanced Topics
o A Rational Expectations Model (cont’d)
(10)
Slide 9

BOX
Rational Expectations Forecast Errors Are Unpredictable
20-1
 = p- p
e
 =0
e
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 10
Rational Expectations Revolution
Figure 20-1: Actual, Anticipated, And Unanticipated M2 Growth, 1973-2003
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 11
Rational Expectations Revolution
o Rational expectations models predict that
unanticipated changes to the money supply
change the overall price level proportionately,
leaving output unchanged.
o With respect to anticipated money growth,
rational expectations models operate as if the
long run aggregate supply curve is applied
instantaneously, not just in the long run.
o While the intellectual appeal of rational
expectations models is very strong, the
empirical evidence is less supportive.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
Recap
Slide 12
Rational Expectations Revolution
Figure 20-2: Expected Money Growth and Growth of Output, 1973-2002
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 13
The Imperfect Information AS Curve
o Supply of output produced on the ith island i:
yi =  (pi - p)
(13)
yi = [pi - E (pislandi)]
1
E (p pi )= k 0 + pt ,0 <  < 1

(14)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Imperfect Information Model: Forecasts based on
imperfect information will be less than fully
accurate, although not necessarily biased.
(15)
Slide 14
The Imperfect Information AS Curve
(16)
o Demand for product i:
yi = y + zi -  (pi - p)
(17)
Chapter 20: Advanced Topics
yi = [pi - (k0 + pi  )]= [(1-   )pi - k0 ]
o Equilibrium price:
[(1-   )pi - k0 ]= y + zi -  (pi - p)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
(18)
Slide 15
The Imperfect Information AS Curve
y = [(1-   )p - k0 ]
(19)
1
p
 y  k 0 
 1  
(20)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o In the aggregate:
Slide 16
The Imperfect Information AS Curve
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
Recap
o Agents forecast the overall price level on the
basis of imperfect information. As a result,
increases in market-specific prices are
attributed partially to increases in the overall
price level and increases in real demand.
o Unanticipated increases in the overall price
level generate partial increases in the
anticipated price level and partial increases in
output. The positive associations between
increases in p and y become the Phillips curve
that we see in the data.
Slide 17
BOX
A Visual Example of Forming an Expectations
20-2
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 18
The Random Walk of GDP…
o Trend (secular) component: Potential
output.
o Cyclical component: Fluctuations of
output around its trend; the output gap.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Output is composed of a …
Slide 19
The Random Walk of GDP…
Figure 20-3: A Stylized Business Cycle
Output
Peak
Trend
Peak
Trough
Time
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 20
The Random Walk of GDP…
Trend
yt    t
(21)
yt  yt1    t     t 1
(22)
yt  yt1  
OR
Copyright 2005 © McGraw-Hill Ryerson Ltd.
yt  
Chapter 20: Advanced Topics
o Representations of Trend and Shock…
(23)
Slide 21
The Random Walk of GDP…
By adding a shock to eq. 21…
yt    t  ut
OR
yt    ut  ut1
(24)
By adding a shock to eq. 23…
yt  yt1    ut OR

yt    t  ut  ut1  ut2 ... u0
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Is the effects of shocks permanent or transitory?
(25)
Slide 22
The Random Walk of GDP…
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o Trend Stationary: A variable is trend stationary
when temporary shocks do not permanently
affects its level. Changes in AD, for example, can
only temporarily affect output. If changes in
output were driven primarily by demand shocks,
output would be trend stationary.
o Difference Stationary: Temporary shocks to a
variable permanently affect its level. A randomwalk is an example of a difference-stationary
process.
o Trend stationary with Breaks: Trend stationary,
but with a trend that sometimes changes.
Slide 23
The Random Walk of GDP…
Figure 20-4: Actual and Potential GDP, 1960-2002
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 24
The Random Walk of GDP…
Figure 20-5: Actual and Two Estimates of Potential GDP, 1960-2002
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 25
The Random Walk of GDP…
o There is significant empirical evidence that
macroeconomic fluctuations are dominated by
shocks with permanent effects. Since aggregate
demand shocks do not have permanent effects,
this evidence argues that aggregate demand
fluctuations are less important than aggregate
supply fluctuations. Changes due to aggregate
supply shocks, in particular shocks to technology,
could well be permanent.
o An alternative view of the evidence is that there are
occasional episodes of large, permanent aggregate
supply shocks, but that between these episodes,
aggregate demand shocks predominate.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
Recap
Slide 26
o Real Business Cycle Theory: The theory asserts
that fluctuations in output and employment are
the result of a variety of real shocks that hit the
economy, with markets adjusting rapidly an d
remaining always in equilibrium.
o The single parameter model: The intertemporal
elasticity of substitution of labour.
Yt   t Lt

U Ct ,L  Lt   Ct L  Lt 
Chapter 20: Advanced Topics

Real Business Cycle Theory
(26)
(27)
Ct Ct 1 Ct 2 ...  wt Lt  wt 1Lt 1  wt 2 Lt 2 ... (28)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 27
Real Business Cycle Theory
U t
L  Lt
MU Leisure  wt wt 1  MU Leisure
t 1
(29)
(30)
1
1  
L  Lt wt 1 
  
L  Lt 1  wt 
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
MU Leisure  Ct L  Lt  
 1

(31)
Slide 28
Real Business Cycle Theory
w
*
OR
L 
*

 
%Y  %a %L


1

%Y  1 3 
%a
1    

L
(32)
(33)
(34)
Chapter 20: Advanced Topics
L L 
*
* *


w
  L 
Deep parameters: Parameters that describe the
preferences of individuals and the production of
firms, and that can be identified from
macroeconomic studies.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 29
Real Business Cycle Theory
o Real business cycle theory models the
macroeconomy through the optimizing decisions
about work and consumption made by individuals
and the optimizing decisions about production made
by firms. The model presented above is a simple
version of the non-linear, dynamic models deployed
by RBC theorists.
o Real business cycle theory minimizes the role of
nominal fluctuations and money.
o RBC theorists try to identify deep parameters that
can be measured in microeconomic studies. The
elasticity of the intertemporal substitution of leisure
is a key example. The conclusion from the
measurement of such parameters are not always
favourable to the RBC models.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
Recap
Slide 30
New Keynesian Model of Sticky Nominal Prices
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o New Keynesian Models: Generally rely on an
assumption of imperfect competition. New
Keynesian models explain how individually
rational decisions under imperfect competition
lead to a socially undesirable booms and busts.
o Mankiw’s Model: Explains why individual,
imperfectly competitive firms might leave
nominal prices unchanged (“sticky”) in the
face of a change in nominal money supply.
o Mankiw shows that the private benefits of
changing a price can be much smaller than the
social benefits of changing a price…
o …if there is substantial monopoly power in the
economy.
Slide 31
New Keynesian Model of Sticky Nominal Prices

Pi  M
Yi   
P  P
(35)
The price charged by the firm is
  W
Pi  

 1  a
(36)
Chapter 20: Advanced Topics
The demand facing firm i as
The firm’s nominal profit will be
 W 
Pt  Yi

a 
Copyright 2005 © McGraw-Hill Ryerson Ltd.
(37)
Slide 32
New Keynesian Model of Sticky Nominal Prices
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o New Keynesian Models: Generally rely on an
assumption of imperfect competition. New
Keynesian models explain how individually
rational decisions under imperfect competition
lead to a socially undesirable booms and busts.
o Mankiw’s Model: Explains why individual,
imperfectly competitive firms might leave
nominal prices unchanged (“sticky”) in the
face of a change in nominal money supply.
o Mankiw shows that the private benefits of
changing a price can be much smaller than the
social benefits of changing a price…
o …if there is substantial monopoly power in the
economy.
Slide 33
New Keynesian Model of Sticky Nominal Prices
1) If the deviation between optimal price and
existing price is small, the profit opportunity is
very small.
2) If the elasticity of firm demand is low, profit is
relatively less sensitive to getting the price
exactly right.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
o If the firm raises its price, there is a menu
cost Mankiw showed that the potential
profit can be very small when two
conditions hold:
Slide 34
New Keynesian Model of Sticky Nominal Prices
Figure 20-6: Profit Loss and Deviation From Optimal Price
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 35
New Keynesian Model of Sticky Nominal Prices
o The New Keynesians try to build models
based on maximizing behaviour that result
in aggregate supply-aggregate demand-like
behaviour.
o Most New Keynesian models rely on
imperfect competition.
o Prices can be sticky, even though the menu
costs of adjustment are quite small,
because the increased profit from resetting
prices is even smaller.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
Recap
Slide 36
Chapter Summary
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
• Modern theories emphasize the consistency of
macroeconomic and microeconomic theories.
• The rational expectations approach
emphasizes the consistency of public
expectations about the behaviour of the
economy.
• Rational forecasts make errors, but not
predictable ones.
• The rational expectations approach suggests
that anticipated monetary policy is neutral
even in the short run.
Slide 37
Chapter Summary (cont’d)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
• An imperfect-information approach will explain
a short run upward-sloping aggregate supply
curve, but one in which the trade-off between
output and inflation cannot be exploited
through anticipated monetary policy.
• The random walk model of output suggests
that economic fluctuations are highly
persistent-and therefore not dud to changes in
aggregate demand.
• The real business cycle approach builds
models of a dynamic economy in which real
shocks are propagated. These models
minimize the role of the monetary sector.
Slide 38
Chapter Summary (cont’d)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 20: Advanced Topics
• New Keynesian models attempt to
reintegrate aggregate demand,
especially sticky prices, with solid
microeconomic foundations.
Slide 39
The End
Chapter 20: Advanced Topics
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 40