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Slides for Part III-A
The Great Divide in Business
Cycle Theory
The issues:
•Are mature, market industrialized economies
inherently stable—that is, are they selfequilibrating in nature and tend to the full
employment of resources?
•Should the powers of governments and central
banks be deployed for purposes of countercyclical stabilization?
Development of Business
Cycle Theory
Theory
Key Figures
Classical
J.B. Say, I. Fisher, A. Pigou
Keynesian
J.M. Keynes, J. Hicks, A. Hansen, P.
Samuelson, J. Tobin, P. Davidson,
J. Stiglitz
Monetarism (New
Classical, phase I)
M. Friedman, D. Meiselman,
D. Laidler
Rational Expectations
(New Classical, Phase II)
R. Lucas, T. Seargent,
N. Wallace
Real Business Cycle
Theory
C. Plosser, E. Prescott, F. Kydland
You can look at the Classical
system as an application, or
generalization, of the laws of
supply and demand to the
problems of total output, total
employment, and the general
price level
The Classical theory of employment
Say’s law (time preference theory of
interest)
The quantity theory of money
Definitions
Y  Real GDP (Income)
N  Employment of labor
NS  Supply of labor services
ND  Demand for labor services
S  Saving
I  Investment
i  Rate of interest (or yield of bonds)
p  Price level
w  Nominal (money) wage
W  Real wage = w/p
M0  (Exogenously-determined) nominal money supply
v  Income-velocity of money
The short-run aggregate production function--again
Y
Y = f(N)
(1)
Y’(N) > 0
(1.1)
Y”(N) < 0
(1.2)
0
N
The labor market
ND = f(w/p)
ND’(w/p) < 0 
NS = f(w/p)
NS’(w/p) > 0
(2)
(2.1)
(3)
W*
(3.1)
The labor market equilibrium
condition is given by:
ND = NS
NS
w/p
ND
0
N*
(4)
 Due the the diminishing marginal revenue product of labor
N
Say’s Law
•“Supply creates its own demand.”
•The production of a given flow of output will
result in the distribution of a flow of income (via
factor market transactions) that is sufficient to
give spending units the wherewithal purchase the
output at prices that would enable firms to cover
their costs of production (including a normal
profit).
•Say’s Law apparently rules out the possibility of a
“general” commodity glut.
Note: Goods includes
consumer services
Simple circular flow
Factor
markets
Product
markets
Knocks on Say’s Law
Since income is received in money, households can
withhold spending power from the income-expenditure
stream—that is, they can save.
Even if leakages (savings) are made available to
potential borrowers as “loanable funds,” a shortage of
profitable investment opportunities may prevent an offset
of leakages to injections (investment spending).
Re-establishing the
validity of Say’s law in
a money-using
economy?
The loanable funds market
S = f(i)
S’(i) > 0
I = f(i)
I’(i) < 0
(5)
i (%)
S = f(i)
(5.1)
(6)
i*
(6.1)
The equilibrium
condition is given by:
I = f(i)
0
I=S
(7)
S,I
The quantity theory of money
The theory is formally articulated using
Irving Fisher’s equation of exchange:
Mv = pY
(8)
let  = 1/v. Now rewrite (8)
M = pY
(9)
Let Y* denote the value of real GDP corresponding to the
equilibrium condition described in equation (4). Taking into
account that M is presumed to be under the control of the
monetary authority, (9) can be rewritten:
M0 = pY*
(9.1)
Equation 9.1 expresses the Classical neutrality of
money postulate--that is, the time path of ‘real”
variables Y, N, I, S, C, and I are invariant
with respect to changes in the money supply. Money
is a “veil” over economic activity which is capable
of producing changes in the general price level--but
not relative prices and quantities
.
The complete Classical system
Y
Y
M1 v
Y*
i(%)
M2 v
Y*
S = f(i)
i*
I = f(i)
0
w/p
0
N*
p1
w
N
NS
p2
0
p
W = w/p
W2
W*
ND
W1
0
N*
N
0
p1
p2
p
S,I
What can explain
unemployment?
Answer: Labor market
disequilibrium
Real wages
NS
$12
•Actual wage = $12
$9
•Equil. Wage = $9
•U = 89 – 65 = 24
ND
0
65
80
89
Employment (millions)
Sources of friction in the
labor market
•Minimum wage legislation
•Labor union truculence