Business Cycle Theory

Transcription

1 Business Cycle Theory Until the 1960s, macroeconomists believed that money was not neutral in the short-run, arising from the short-run inflexibility of wages and prices Rational Expectations revolution in the early 1970s Macro models should be based on micro principles Models with flexible prices and wages can be useful for studying macro phenomena

2 Business Cycle Models with Flexible Prices and Wages Real Business Cycle Model Keynesian Coordination Failure Model

3 Key Questions How does each model fit the data? The first two models are intended to fit the average business cycle. The last one is intended to capture particular features of the financial crisis. What is the role for government policy in each model?

4 Key Graphs Before getting into the specifics of the different Market clearing Business Cycle models Let s make sure we re familiar with the graphical analytical tools Labor Demand and Labor Supply Output and Labor (zf(k,n) as function in N) Output and interest rate (YS and YD) Recall that higher interest rates implies higher labor supply Price level and Money Supply (MS and PL(Y,r))

5 Graphs: Labor and Output In (a), the intersection of the current labor supply and demand curves determines the current real wage and current employment In (b), the production function determines aggregate output

6 Graphs: Output Curves An increase in real interest rate shifts the labor supply curve to the right, increasing employment and output Hence the output supply curve YS is upward sloping

7 Graphs: Money Supply and Demand Money Demand increases with income, price level and decreases with interest rates Money Supply is given exogenously

8 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.

9 Solow Residuals and GDP Kydland and Prescott show that a standard model of economic growth with random productivity shocks (real) match observed business cycles They were perhaps motivated by the fact that detrended TFP closely tracks detrended GDP

10 Persistent Increase in TFP With a persistent increase in TFP, firms labor demand shifts to the right leading to a shift of the output supply curve to the right lower interest rates lead to lower labor supply higher income leads to higher money demand leading to decrease in price levels

11 Average Labor Productivity with TFP Shocks When output and productivity are high, average labor productivity is also high, as in the data

12 Data vs. Predictions of the Real Business Cycle Model

13 Procyclical Money Supply with Endogenous Money A persistent increase in TFP increases aggregate real income reduces the real interest rate money demand increases If central bank attempts to stabilize the price level, money supply increases As a result, money supply is procyclical!

14 Implications of RBC Model Business Cycles are efficient no role for government stabilization policy If there are distortionary taxes (e.g. income tax, sales tax), it is optimal to have smooth tax rates over time built-in stabilizer since tax revenue drops in recessions and increases in booms Critique: Business Cycles are not explained driven by exogenous fluctuations in productivity

15 Keynesian Coordination Failure Model Strategic complementarities (e.g. number of people at party, computer software and hardware producers) give rise to multiple equilibria Business cycles can be driven by waves of optimism and pessimism The model can fit the data as well as the real business cycle model. GDP fluctuates in the model because of self-fulfilling waves of optimism and pessimism.

16 A Production Function with Increasing Returns to Scale Strategic complementarities among firms imply that there can be increasing returns to scale at the aggregate level convex production function marginal product of labor increases as the quantity of labor input increases

17 Labor Demand with Sufficient Increasing Returns to Scale With sufficient increasing returns to scale, aggregate marginal product of labor increases with aggregate employment aggregate labor demand curve slopes upward

18 The Labor Market in the Coordination Failure Model With sufficient increasing returns to scale, labor demand curve is steeper than the labor supply curve required for the coordination failure model to work

19 Output Supply Curve in the Coordination Failure Model An increase in real interest rate shifts the labor supply curve to the right, reducing employment and output Hence the output supply curve YS in the coordination failure model is downward sloping

20 Multiple Equilibria in the Coordination Failure Model Because the output supply curve is downward sloping, there can be two equilibria In one equilibrium, aggregate output is low and real interest rate is high In the other, aggregate output is high and the real interest rate is low

21 Data Versus Predictions of the Coordination Failure Model * *: with extension

22 Average Labor Productivity in the Coordination Failure Model In the good (bad) equilibrium output is high (low), employment is high (low) average labor productivity is high (low)

23 Procyclical Money Supply in the Coordination Failure Model If the money supply is a sunspot variable in the coordination failure model, money may appear to be nonneutral because people believe it to be When money supply is high (low), everyone is optimistic (pessimistic), and output is high (low)

24 Stabilizing Fiscal Policy in the Coordination Failure Model Fiscal Policy can stabilize output in the coordination failure model by eliminating multiple equilibria With a decrease in govt spending, the output demand curve shifts to the left and the output supply curve shifts to the right this can produce a unique equilibrium where Y = Y* and r = r*

25 Implications of Coordination Failure Model Policies that promote optimism are beneficial (e.g. encouraging statements from the Fed Chairman) Critique: this model requires increasing returns to scale at the aggregate level evidence is mixed, at best Business Cycles are driven by expectations which are unobservable, making the model difficult to test