Download E719_No09_Chapter10

No 09. Chapter 10
Classical Business Cycle
Analysis
Before We Begin …
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Before proceeding with Chapter 10, look at
this handout from the material in Chapter 9:
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Chapter 9 Appendix: The Model in Equations
Introduction
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This Chapter:
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Develops the Classical variant of the model we have been
developing
Uses that model to provide an explanation for business
cycles
 Productivity shocks
 Government spending shocks
Compares the implications of the Classical model with the
business cycle facts
Considers an alteration of the basic Classical model that
help it to fit the facts better
Real Business Cycle (RBC)
Theory
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The classical model assumes that the economy is
constantly at its full-employment output level
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However, fluctuations resulting from “real” shocks
can produce fluctuations in output and other variable
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This would appear to greatly limit the ability of the classical
model to explain business cycles.
Because of the emphasis on “real” shocks, the Classical
model is now often called the “Real Business Cycle
Theory”
Real shocks include productivity changes, changes
in real government spending, changes in population,
and changes in the preferences of individuals
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Productivity shocks are emphasized.
Robinson Crusoe
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One might ask if a single individual, in an isolated
environment, outside of all market contexts, would
ever be subject to “fluctuations”
Clearly, seasonal variations, unusual weather,
external environmental changes, as well as changes
in ways of producing, could all affect an individual’s
level of activity and output
Such fluctuations would be of the real business
cycle variety
A Temporary Adverse
Productivity Shock
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We will analyze a temporary negative productivity shock
 Perhaps an increase in the price of oil
Immediate Effects
 Reduces MPN and demand for labor
 Shifts the production function downward
Consequences:
 The real wage falls
 Output falls
 The real rate of interest rises (as FE shifts left)
 Investment and Consumption fall (because r rises)
 P rises (as LM must rise to intersect IS and FE)
Recall Figure 9.8 (next slide)
A Temporary Adverse
Productivity Shock (Diagram)
RBC Theory and (Convenient)
Business Cycle Facts
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If the economy is frequently hit by shocks, business
cycles can occur
Employment and output are procyclical
Real wages are procyclical
Investment and consumption are procyclical
Average labor productivity is procyclical
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A fact difficult to explain if something other than a
productivity shock causes labor input and output to change
(because of diminishing marginal productivity)
RBC Theory and (Inconvenient)
Business Cycle Facts
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In the RBC theory price is countercyclical (price rose
in the recession caused by a temporary adverse
supply shock).
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There is some dispute over the “facts” regarding cyclical
behavior of the price level.
The “theoretical” correlation between productivity
and output is “too large”
How is unemployment to be explained?
How do we explain the leading and procyclical
relationship of money growth?
What are Productivity Shocks?
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Productivity shocks could be associated with
inventions, weather, natural disasters, and
possibly “institutional change”
Energy price increases, reflecting increased
scarcity of energy resources, are cited as
negative productivity shocks that have been
important in several recessions
But, more generally, identifying particular
events with productivity shocks and resulting
business cycles has been difficult
Solow Residuals
Solow Residuals (More)
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If one assumes that Solow residuals are shocks to
the production function, one can use calibrated real
business cycles to simulate the reaction of the
economy to such shocks
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The resulting model cycles mimic real-world fluctuations
rather well.
However, Solow residuals might NOT really
measure shifts in technology
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Suppose measured input usage and actual input usage
differs, because of the intensity with which they are used
Consider labor hoarding (next slide).
Labor Hoarding
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For example, suppose that when demand for its
product falls, a firm does not immediately fire
workers as production is cut, but instead assigns
them to maintenance, cleaning, updating records,
and other tasks
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The firm may suspect that the drop in demand is
temporary, and it does not want to incur substantial costs of
rehiring and retraining new workers.
Output falls, but labor input does not drop in proportion. So
measured productivity (the Solow residual) falls.
However, this is not really a technology shock. Variations in
Solow residuals can be a consequence of business cycles;
not a cause
Fiscal Policy Shocks
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The classical model emphasizes technology shocks,
but it permits impacts of other variables
Consider a government spending increase for a
temporary foreign war.
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The IS curve shifts to the right (consumers do not reduce
consumption by the full amount of the government
spending increase)
The diversion of output from civilian to military
purposes leaves households less wealthy; this
encourages work effort and a rightward shift of labor
supply
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Labor supply and FE curves shift to the right.
Temporary Increase in
Government Spending
Fiscal Policy Shock
(continued)
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The preceding diagram showed shifts of NS, IS, and FE.
LM must adjust to reach the point where IS and FE intersect
 For the case shown this requires an increase in price and a
leftward shift in LM (this case is most likely, since the increase in
the supply of labor due to the wealth change is probably small).
For this shock there are differing implications for business cycles
(compared to the productivity shock):
 P is procyclical
 Labor productivity is countercyclical.
Both results may improve the overall ability of the model to fit the
facts.
Policy Implications
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The RBC model implies that all firms and workers
are making optimal, maximizing decisions.
In a competitive economy, demand-supply equilibria
produce “efficient” results.
So all outcomes in a RBC cycle are optimal
responses to shocks, and require no intervention
from government to improve matters (again consider
the Robinson Crusoe analogy).
We see that added government spending can
increase GDP, but even in a recession it would be
inadvisable to increase spending for the purpose of
stabilizing GDP.
Revisiting Two More Problems
with RBC Theory
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Recall that
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The RBC model has no obvious implications
about the cyclical behavior of the unemployment
rate.
The RBC model has difficulty explaining why
money growth is leading and procyclical
Is there any way to reconcile these problems
with modified versions of the RBC theory?
Unemployment
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An adverse productivity shock could result in higher
unemployment if it increased the likelihood of
mismatches between workers and jobs
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The facts seem to be that many unemployed are not
between jobs, but are temporarily laid off and
waiting to be recalled
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However, positive (as well as negative) productivity shocks
could produce mismatches.
This is not an indication of a mismatch.
Also, more mismatches should see an increase in
vacancies as well as unemployment
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But in recessions unemployment rises while vacancies
decline.
Money Growth
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If markets equilibrate immediately, then a monetary expansion
should affect only nominal variables. Money is neutral.
However, money growth is procyclical and leading—How can the
RBC model account for this?
Reverse causality:
 Firms may anticipate higher future output, and transactions and
money demand may rise in advance of production
 Further, the Federal Reserve Bank (Fed) may then increase
money to meet demand (while permitting the price level to remain
unchanged)
 So the money supply rises in advance of output, but does not
cause the increase in output
 Does the Fed cause Christmas? The money supply regularly
grows before Christmas
More Evidence that Money
Causes Cycles
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Despite the logic of the reverse causality
explanation, there is more evidence that
independent shocks to money can cause
business cycles
There are historically documented cases
where a central bank purposely altered
monetary policy in order to head off inflation,
even at the cost of a downturn
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In fact, downturns followed (e.g. 1979).
Monetary Misperceptions: A
Classical Reconciliation?
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We may be able to reconcile procyclical
money with a model that is classical in spirit
Lucas’s Monetary Misperceptions Theory is
one such theory
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This theory permits some imperfection in
information, while maintaining the assumption of
quick market-clearing.
The Lucas Model
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Suppose that the money supply increases and that, in accord
with the classical model, the price level begins to rise.
Consider an individual, say a baker. The baker watches the
bread market carefully, and notices an increase in the price of
bread. He does not immediately monitor the prices of all other
goods.
Since the baker does not know what has happened to other
prices, he is likely to suspect that the relative (real) price of bread
has risen.
Thinking that the relative price of bread is high, the baker works
more and produces more output. But so do those in other
occupations, producing a business cycle.
The Lucas Model (continued)
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The Lucas model can explain procyclical
money while also maintaining the
assumptions that markets clear. Imperfect
information permits this result.
The key to the model is that AD shifts and
price “surprises” are associated with cycles.
Price Surprises
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In the absence of surprise (P = Pe), output is
at the full-employment level
But if P > Pe, output is higher than the full
employment level
And if P < Pe then output is lower than the full
employment level
Explain the next two diagrams!
Upward-Sloping SRAS
Long-Run and Short-Run
What if a Money Supply
Increase is Expected?
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If a money supply increase were perfectly
expected, then both AD and SRAS would
shift up, keeping the economy on the LRAS
curve
An anticipated money supply increase does
NOT have an impact on output
Policy Implications
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Suppose that a central bank would like to use
monetary policy to stabilize output in a recession.
When a recession starts, the Fed would like to
increase output
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According to the Lucas model, it would need to engineer a
surprise increase in the money supply to raise output.
But what if the Fed always increased the money
supply in recessions?
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This behavior should become expected, hence ineffective.
Rational Expectations
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The idea that the Central bank cannot repeatedly and
systematically trick the public leads to the hypothesis of rational
expectations.
If people cannot be repeatedly fooled, then systematic
movements in policy should be anticipated
Only unsystematic variations in policy affect output, but
unsystematic variations will not stabilize output (and are
otherwise undesirable).
So, the Lucas model explains why money growth and output are
correlated in real-world data, but simultaneously argues that any
attempt to exploit that correlation to stabilize business cycles will
be doomed to fail
Criticism of the Lucas Model
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The Lucas model is clever, but it relies on the
inability of the public to observe surprise policy
changes by the Federal Reserve
Money supply statistics are reported with short lags,
so expectational errors should be short-lived
This would seem to imply that business cycles
arising from money surprises should be short
(although it is possible that cycles could persist
longer than the original misperception)
The End