THE GOODS MARKET AND REAL BUSINESS CYCLES

Size: px
Start display at page:

Download "THE GOODS MARKET AND REAL BUSINESS CYCLES"

Transcription

1 CHAPTER 11 THE GOODS MARKET AND REAL BUSINESS CCLES It is now time to put togethe ou analyses of consumption, investment, and the labo maket into a simple model of the economy. This simple model focuses attention on shocks to the economy's poduction function and shocks to investment demand. The model is often called a eal business cycle model, o RBC model fo shot, because it does not include the money maket. We will, of couse, include money in the model late, but fist we will see how fa we can go without it. Most economists conside these models to be impotant building blocks towad a moe complete theoy. A thoough undestanding of how cetain "shocks" alte the equilibium of eal business cycle models will povide you with the intuition to fom "educated guesses" about how simila shocks might affect eal wold economies. Fo example, how changes in the availability of foeign oil influence U.S. inteest ates. Many inteactions between economic vaiables would be difficult to identify if one poceeded immediately to moe ealistic (complex!) settings. Some economists believe eal business cycle models dastically ove-simplify to the point of being misleading. Othes believe the models, as they ae, can explain a geat deal about how actual economies wok. Ou view is that these models ae an essential stating point fo leaning how to use economic theoy to make sense of the eal wold, whethe o not they ae captuing the whole stoy. We begin the model building by summing togethe consumption demand and investment demand to make so-called aggegate demand. Aggegate demand is the total quantity of goods and sevices that the people, both consumes and poduces, want to buy. This povides one side of the maket. The next step extends the study of the labo maket to deive the aggegate supply

2 2 chapte 11 cuve. Aggegate supply is the total quantity of output that poduces want to supply to the maket. This is the othe side of the maket. With these pats we can establish equilibium in the goods maket. This equilibium detemines the inteest ate, the level of output, and, though the labo maket, the eal wage, and the level of wok effot. We ae then in a position to study the esponse of these key macoeconomic vaiables to changes in the envionment. Of paticula inteest to us will be the esponse of the economy's equilibium to technological pogess, oil pice shocks, and shocks to the poductivity of investment pojects. We end the chapte with an oveview and some extensions of the model. Aggegate Demand As we just mentioned, aggegate demand is the just the sum of investment demand and consumption demand. Let's stat by witing it down in symbols and then discuss it. Aggegate demand, d, can be witten as d = C d + I d = C( t, t, t+1,...) + I( t,a t+1,...) Aggegate demand depends on the same vaiables that detemine consumption and investment demand. Both investment and consumption demand depend on the inteest ate and so also will aggegate demand. Consumption depends on the expected income steam and the esponse of consumption to a change in cuent income depends citically on whethe households peceive the change in income to be pemanent o tempoay. The same holds tue fo aggegate demand. Finally, investment depends on the expected pofit steam fom investment pojects and the expected pofit steam caies ove as a deteminant of aggegate demand. Moeove, the potential easons fo volatile investment now apply as potential explanations fo volatile aggegate demand. As usual, it poves convenient to have a pictue, so we now deive the aggegate demand cuve plotted against the eal inteest ate. Both consumption and investment demand shae the eal inteest ate as a detemining vaiable and both decline when the inteest ate inceases. This

3 the goods maket and eal business cycles 3 means that aggegate demand must also decline when the inteest ate inceases. Fo example, suppose that the inteest ate is initially 3%. At this inteest ate suppose that consumption demand is 16,200 and investment demand is 6,000. This makes aggegate demand 22,200. This initial position is shown in Figue Now suppose the inteest ate ises to 5%. Consumption falls by, say, 1,600 to 14,600, and investment follows, declining by 1,000 units to 5,000. This means that aggegate demand declines by 2,600 (= 1, ,000) to 19,600 (= 14, ,000). This second point is also shown in Figue When we tace out all such points we have the aggegate demand cuve, labeled d. Along any d cuve the steam of income and the pofitability of investment pojects ae held constant. We need to know how the d cuve esponds when these vaiables change. Fist, conside a pemanent change in income of 200 units. Ealie we agued that the maginal popensity to consume out of a pemanent change in income equaled one. When income inceases pemanently thee is no need to smooth the consumption fom it and as a esult households consume the entie incease. Since consumption inceases by 200 so also does aggegate demand. This is shown in Figue 11.2 by a 200 unit shift to the ight in the aggegate demand cuve. What happens if the incease in income is only thought to be tempoay? In this 5% 3% 3% 19,600 22,200 d Figue 11.1 The Aggegate Demand Cuve 22,200 22,400 Figue 11.2 Effect of a Pemanent Incease in Income of 200 units d' d

4 4 chapte 11 case we agued that households smooth thei consumption, and the maginal popensity to consume out of tempoay changes in income was appoximated by 1/planning hoizon. If geneations ae linked, because paents cae about thei kids, gandkids, and so on, then the planning hoizon will be vey long. The long planning hoizon makes the MPC out of tempoay change in income vey small, and we take it to equal zeo. This is convenient gaphically because it implies that consumption demand, and hence aggegate demand do not shift when the change in income is peceived to be tempoay. Now suppose that compute technology makes investment pojects moe poductive, o pofitable. Computes may aid in the design of moe efficient machines, o, pehaps, cuent geneation machines may be monitoed moe effectively with the assistance of computes. This aises the steam of expected pofits (A t+1, A t+2,...), and makes some pojects acceptable that wee ealie ejected. At the oiginal ate of inteest investment demand inceases fom, say, 6,000 to 7,200. This, in tun, inceases aggegate demand to 23,400 at the going 3% ate of inteest. This means that the d cuve shifts out and to the ight, and this shift is pictued in Figue These ae the basics of aggegate demand, and the aggegate demand cuve. They ae basic in the sense that they ae fist pinciples, o, moe to the point, implications of fist pinciples. They ae also basic in the sense that they play an impotant ole in just about all that follows. It is theefoe wothwhile to eview, pehaps taveling to ealie chaptes, and to mull ove the above analysis so that you become comfotable 3% with it. d' d Aggegate Supply We now link the aggegate supply of output, which we call s, to the inteest ate. They ae connected though the labo maket, and the connection is 22,200 23,400 Figue 11.3 Effect of an Incease in the Pofitability of Investment Pojects

5 the goods maket and eal business cycles 5 staightfowad. Suppose that the inteest ate is initially 2%, and at this inteest ate poduces supply 15,000 units of output. This gives one point, point A in Figue 11.4, on the aggegate supply cuve. Now, suppose the inteest ises to 4%. At the highe inteest ate it is a good time to save. One way to incease savings is to incease income, but to do so equies additional wok effot. This motivates an incease in the supply of labo, and equilibium wok effot inceases as well. With moe wok effot geate output is poduced, and aggegate supply inceases to, say, 15,500. These two points allow us to daw the aggegate supply cuve in Figue Though this connection is simple, it takes thee gaphs to make it. In Figue 11.5 the gaphs of labo maket equilibium, the poduction function, and the aggegate supply cuve fomalize the above connection. At the inteest ate of 2% the supply cuve of labo is N s (=2%) and equilibium employment is 120. The 120 units of wok effot tanslates though the poduction function into an output of 15,000 units. When the inteest ate inceases to 4%, the labo supply shifts out to N s (=4%), and wok effot ises to 130 units. This inceases output to 15,500 and gives us the upwad sloping s cuve. Note also that the eal wage falls. Movements along an aggegate supply cuve epesent movements along a poduction function. In Figue 11.5 the movement fom point a to point b along the s cuve coesponds to the movement fom point a' to point b' along the poduction function. Shifts in the poduction, whateve thei cause, will shift the aggegate supply cuve. Let's look at a few examples. Suppose an impoved technology comes on line. This shifts the poduction function up and to the left. At the cuent ate of inteest moe output will be supplied, say an incease fom 15,000 units to 16,500. This means that the aggegate supply cuve shifts out and to the ight to s'. This is shown in Figue Thee ae two loose ends hee. Fist, the incease in technol - ogy inceases the maginal poduct of labo and hence labo demand. This causes an incease in employment, which adds to the incease in output, and einfoces the diect effect fom the 4% 2% A 15,000 15,500 s Figue 11.4 The Aggegate Supply Cuve

6 6 chapte 11 change in the poduction function. Second, since technical pogess is pemanent, wealth inceases. Highe wealth educes wok effot so yet anothe effect opeates. This woks in the opposite diection fom the othe two effects. Howeve, it is vey unlikely that this wealth effect changes ou conclusions. We expect an incease in wealth to educe wok effot so that moe leisue can be enjoyed, but we do not expect leisue to incease by so much that total output falls. Indeed, we expect that as household incomes ise moe of both consumption and leisue will be enjoyed. Fom now on we assume, vey safely, that a pemanent incease in the poduction function, fom whateve souce, shifts the aggegate supply cuve out and to the ight, and we say that the s cuve has inceased. Now let's conside a tempoay shock to the poduction function. Suppose a Middle East dictato invades a small neighboing oil poducing county. The est of the wold potests and militaily engages the dictato. As one of the consequences, oil poduction in the egion declines, the specte of futue shotages appeas, and oil pices ise shaply. Oil, and enegy moe geneally, is a ubiquitous input, and the highe enegy pices discouage s N (=2%) s N (=4%) poduction of goods and sevices boadly acoss the economy. In the context of ou model, we intepet these events as causing a decline in the poduction function. Since poduction oppotu - nities have deteioated, the supply of output falls. In Figue 11.7, we again begin with an 4% 2% 15,500 15,000 W/P a a' b' b 15,000 15,500 s N d Figue 11.5 The Deivation of the Aggegate Supply Cuve F N N

7 the goods maket and eal business cycles 7 inteest ate of 2% and an output of 15,000, but the oil pice shock causes output to decline at the oiginal ate of inteest to 13,500. The maginal poduct of labo also falls, shinking labo demand and wok effot, and einfocing the decline in output. Thee is no wealth effect to woy about since the change is tempoay. The aggegate supply cuve shifts back and to the left, and we say that the s cuve has deceased. In late 1985 and into 1986 the pice of oil fell. Fo the case of falling oil pices the evese analysis holds. The poduction function shifts up and to the left, and the aggegate supply cuve shifts out and to the ight. A pictue of this shift would look exactly like the pictue fo the pemanent technology shock in Figue Indeed, if you wee shown Figue 11.6 without its title, you could tell that poduction oppotunities impoved, but you could not tell whethe the shock was tempoay o pemanent. In geneal, shocks that incease the poduction function incease aggegate supply and shocks that decease the poduction function decease aggegate supply. This elationship does not depend on whethe the shock is tempoay o pemanent. 2% 2% 15,000 16,500 s Figue 11.6 An Incease In Technology s' s' s Equilibium in the Goods Maket With the aggegate demand and supply of goods in hand, we ae now eady to study 13,500 15,000 Figue 11.7 A Tempoay Incease in the Pice of Oil equilibium in the goods maket. By definition equilibium occus when the quantity of goods that poduces want to supply equals the

8 8 chapte 11 quantity of goods that consumes and poduces demand. In symbols we wite that equilibium occus when s = d, o s = C d + I d. It is vey useful to have anothe intepetation of equilibium. We define desied savings, o we could say the supply of savings, as the diffeence between desied income, s, and desied consumption, C d. In symbols we wite desied savings, S d, as S d = s - C d. It is easy to see, by simple subtaction, that in equilibium we must have s - C d = I d, o S d = I d In othe wods, equilibium equies that desied savings equals investment demand. This altenative intepetation helps us undestand the state of the economy outside of equilibium. Fo example, suppose that the aggegate supply of goods exceeds the aggegate demand fo goods. In symbols, this means that s > d and we say that thee is an excess supply of goods. Ou altenative intepetation implies that this is also a situation whee desied savings is geate than desied investment. In a sense, thee is too much savings. This excess of savings causes inteest ates to fall. To see why, emembe that households who want to save want to buy bonds. Those bonds may come in the fom of CDs at thei local bank, U.S. teasuy bonds, o some othe financial instument. Whateve the fom, thee ae many household who want to buy bonds, and elatively few households and fims that want to sell them. This excess demand fo bonds causes bond pices to ise. But we know that highe bond pices mean lowe inteest ates. In this way an excess supply in the goods maket educes

9 the goods maket and eal business cycles 9 the inteest ate. We could constuct an analogous agument, and you should, that an excess demand fo goods causes the inteest ate to ise. We ae now in a position to find the goods maket equilibium. In Figue 11.8 we have dawn the aggegate supply and demand fo goods. It comes as no supise that equilibium occus at the intesection of the two cuves. The equilibium ate of inteest is * and equilibium output is *. It is, howeve, impotant to convince ouselves that thee ae foces at wok that will move the economy towads this point. Afte all, we ae inteested in equilibium only because we believe the economy moves towad it, and, once thee, stays thee. Conside the inteest ate h in Figue At h thee is an excess supply of goods. This coesponds to an excess of desied savings ove investment demand. Thee is thus an excess demand fo bonds, bond pices ise, and the inteest ate falls towad equilibium. At the inteest ate l thee is an excess demand fo goods. This tanslates into an excess of desied investment ove desied savings. This implies that thee is an excess supply of bonds, bond pices fall, and the inteest ate ises towad equilibium. We can now conclude that if the economy is away fom equilibium, thee ae foces at wok that dive it back towad equilibium. h * l excess supply of goods excess demand fo goods s d * Figue 11.8 Equilibium in the Goods Maket Applications of the Model a. technical change In the fist 10,000 yeas o so of civilization technical change occued, but it was painfully slow. Sometimes methods wee fogotten and hundeds of yeas passed until they wee einvented. In the past 200 yeas, technology has pogessed apidly. Wate- and

10 10 chapte 11 steam-poweed engines eplaced human and animal effot. These powe souces wee then supplanted by the moe efficient gas and electic engines, and now wok goes on to develop sola and othe enegy souces. The advance of powe technology had effects on almost all aspects of poduction. Fo example, in tanspotation the aveage speed on the nation's highways 150 yeas ago was about 5 miles an hou. The oads wee ough, and intempeate weathe often made tavel impossible. Today, laws hold down the legal speed on ou highways to 55 miles pe hou; and tains and planes move two to ten times that fast. To take anothe example, the efficiency of tansfoming cotton into thead, and hence a cop into clothes, multiplied by factos in the thousands as the wate fame and jenny eplaced the spindle. These two examples of technological pogess could be inceased many fold without difficulty. Technological impovements allow moe goods to be poduced fom a given set of esouces and this means that the poduction function shifts up. This, in tun, shifts the aggegate supply cuve out and to the ight. The shift fom s to s ' in Figue 11.9 depicts this change. The impovement in technology aises income pemanently. Since the change is pemanent, thee is no incentive fo households to smooth the consumption of thei additional income. Consumption demand, and hence aggegate demand, shifts out and to the ight by the same distance as the shift in the s cuve. Hee we ae putting to wok ou esult that the maginal popensity to consume out of pemanent changes in income is one. Thee is no initial excess supply o demand fo goods, and so no distubance to the oiginal equilibium inteest ate. The new equilibium occus at * and **. The model thus pedicts that impovements to technology do not affect the equilibium inteest ate. Equilibium output inceases as we would expect. This analysis assumes that the pofitability of investment pojects is unaffected by the technical change. This may not be plausible since new technology is often embodied in new machines, o othe types of capital. Electicity equied electic motos; you couldn't just plug in a steam engine. We will deal with this complication late. Fo now it is best to take ou shocks one at a time b. tempoay fall in the pice of oil We now analyze a fall in the pice of oil that is peceived to be tempoay. Recall fom ou ealie discussion that oil pices both ise and fall; and that a shap fall occued in late To

11 the goods maket and eal business cycles 11 finance thei wa effot, Ian and Iaq poduced moe oil than allowed by thei OPEC quotas and Saudi Aabia, the lagest poduce in the catel, punished them by inceasing its poduction. Ove this peiod the pice poduces paid fo pocessed fuels and lubicants fell by 25%. Cheape enegy shifts the poduction function up and to the left, aggegate supply inceases, and s shifts to s ' in Figue The consumption demand cuve will not shift. This is because the shock is tempoay, and the consumption fom any change in income will be spead ove a long planning hoizon. Hee we ae using the esult that the maginal popensity to consume out of tempoay changes in income is negligible. Thee is also no diect impact on investment since the poductivity, o pofitability of potential pojects, has not changed. The incease in aggegate supply coupled with no change to aggegate demand leaves an initial excess supply of goods. This means that thee is an excess supply of savings as people attempt to save in ode to spead out the consumption of thei tempoay gain ove thei planning hoizon. So, thee ae many people tying to buy bonds and elatively few tying to sell them. Bond pices ises and inteest ates fall. The new equilibium in Figue has a lowe inteest ate and highe output. Although thee is no diect effect on eithe consumption o investment, thee is an indiect one. The tempoay decease in the pice of oil lowes inteest ates, and lowe inteest ates motivate moe consumption and investment. We add to ou pedictions that in the new equilibium both consumption and investment will be highe. * ** Let's contast the esults hee with the effects of a pemanent incease in the poduction function. When oil pices fall tempoaily, the poduction function inceases, and the inteest ate falls. An impovement in technology also inceases the poduction function, but thee is no change in the inteest ate. What explains the diffeence? When technology impoves things ae * s d s' d' Figue 11.9 Effects of Technological Pogess

12 12 chapte 11 bette today and they will be bette tomoow as well. Thee is no change in the oppotunities today elative to the oppotunities in the futue. On the othe hand, oil pices will etun to thei oiginal level next peiod. When oil pices fall tempoaily, oppotunities today impove elative to tomoow. It is this change in elative oppotunities that influences savings behavio, and is esponsible fo the fall in inteest ates. c. incease in the pofitability of investment * ** s d s' * ** Figue Effect of a Tempoay Decease in the Pice of Oil Now let's suppose that investment pojects, new plants and equipment, become moe pofitable. Fo example, computes now aid in the design of machines and the oganization of factoies. Though simulations of vaious possibilities, too expensive to actually ty out in pactice, designes may see altenatives that would othewise be missed and develop new plant configuations o equipment designs that ae moe efficient. An incease in the pofitability of investment pojects inceases investment demand, shifting the investment demand cuve out and to the ight. The aggegate demand cuve shifts out in the same diection by the same amount. This is shown in Figue The cuent poduction function does not shift since the plant o equipment does not come on line until the next peiod. It takes time to delive and install new equipment, o to constuct new plants. This implies that the cuent s cuve stays put. The incease in aggegate demand togethe with no change in aggegate supply poduces an initial excess demand fo goods and an excess of investment demand ove desied savings. Fims eagely ty to sell bonds to aise funds to invest in the now moe poductive pojects. The esulting excess supply of bonds causes bond pices to fall and so inteest ates ise. The highe

13 the goods maket and eal business cycles 13 inteest ate induces geate wok effot and this causes a movement along the aggegate supply cuve. The equilibium inteest ate and output incease in Figue The model pedicts that an incease in investment demand esults in highe output and a highe inteest ate. Let's assume that thee is no diect effect on consumption; an assumption that we will dop late, but is useful now. Nevetheless, the incease in investment demand causes consumption to decline because of its effect on the inteest ate. The highe inteest ate encouages saving, savings that is needed to take advantage of the moe poductive investment oppotunities, and consumption falls. Often times, pehaps even most of the time, highe inteest ates ae viewed by the media as a bad thing. In the pesent case the inteest ate ises, but the highe ate eflects something good going on in the economy. Plants and equipment ae moe poductive, and when they come on line in the futue we will enjoy geate output and consumption. The highe inteest ates should be cheeed, not jeeed. In geneal, just looking at a pice change will not be infomative on whethe things ae looking up o down. To decide if a change in a pice potends good o ill, you must look deepe into mattes to find the cause of the change. This task is much hade than just epoting the change. ** * s * ** d d' Figue Effect of an Incease in Investment Demand Examples of Shocks Shocks to the economy may oiginate fom many diffeent souces. Thee ae many diffeent types of technology shocks anging fom new supesonic aiplanes flown by computes to new stains of wheat that esist cold weathe and pests. We may also think of cetain institutional changes as constituting pemanent shocks. Fo example, the ceation of compute viuses may be intepeted as causing a pemanent decease in the poduction function since esouces

14 14 chapte 11 must be siphoned off fom the poduction of goods to the defense fom viuses. On the othe hand, if an economy is able to shed old pejudices, esouces ae likely to be bette allocated. Talents bette matched with oppotunities. This would incease efficiency and we may think of it as shifting out the poduction function. To take anothe example, the judiciay may be eoganized so that cases un moe smoothly though it. In some aeas this has aleady occued as cetain couts specialize in cetain types of cases, fo example patent cases. When couts adjudicate cases moe apidly, fewe esouces need be expended on lawyes, expet witnesses, and so foth; and instead these esouces may go into to the poduction of goods and sevices. Again, we may think of this institutional change as a pemanent positive shock to the poduction function. Oil pice shocks seved as ou example of a tempoay shock to the economy and this is no accident. The economist James Hamilton pointed out that of the eight ecessions between Wold Wa II and 1983 six have coincided o been immediately peceded by shap inceases in the pice of oil. 20 If, as some economists have agued, the ecessions in 1980 and 1982 ae consideed as one, then the numbe ises to seven of the last eight. Hamilton published his pape in 1983, long befoe the last ecession in July of It is inteesting to ecall that this ecession also coincided with a shap incease in the pice of oil as a esult of Iaq's invasion of Kuwait. The ealie oil pice shocks wee also associated with simila political events. In Ian nationalized oil companies and thee wee stikes by oil and coal wokes. The ecession that began in the thid quate of 1957 was peceded by a spike in oil pices caused by the Suez Canal cisis. The behavio of the elative pice of oil fom 1947 though 1972, measued by the atio of the pice of cude petoleum to the CPI, is plotted in Figue Shaded pats of the diagam indicate ecessions. The elative pice of oil has been extaodinaily volatile since This can be seen by compaing the scales in Figues and Fo the peiod the uppe bound is highe and the lowe bound is smalle than they ae fo the ealie peiod. The fist oil pice shock in the late peiod occued in late The OPEC embago, caused at least in pat by the U.S. suppot fo Isael in the om Kippu wa, poduced a shap incease in the pice of cude, and a shap and long ecession ensued. The Ianian evolution fueled the shock in the late 20 See James Hamilton's "Oil and the Macoeconomy since Wold Wa II" in the Jounal of Political Economy 91, Apil, 1983.

15 the goods maket and eal business cycles s. Some economists do not believe that these oil pice shocks wee lage enough to cause ecessions, but it seems clea that, at least, they ae contibutos to the economic downtuns. Thee ae othe impotant examples of tempoay shocks. Floods, doughts, huicanes, eathquakes, and tonadoes all disupt poduction tempoaily. Even less pice of cude petoleum/cpi Figue Relative Pice of Oil: shaded aeas indicate ecessions time damatic vaiations in the weathe can have impotant effects on agicultue, constuction, and othe weathe dependent activities. Stuctual change in the economy may also esult in a tempoay deteioation in poduction oppotunities. Fo example, suppose thee ae 2 sectos in pice of cude petoleum/cpi Figue The Relative Pice of Oil: shaded aeas indicate ecessions time the economy and initially they both poduce 100 units of output. Now, assume that tastes in the economy shift away fom output of secto 1 towad the output of secto 2 so that people want 60 units of secto 1 output and 140 units of secto 2 output. If the tansition fom one stuctue of poduction to the othe wee costless, no shift in aggegate poduction would occu. Output in secto 1 would fall by 40 units, output in secto

16 16 chapte 11 2 would ise by the same amount, and total output would stay at 200. Howeve, it is unlikely that the stuctual change doesn't involve costs. Wokes and capital may have to move o be modified, contaction in the one industy is likely to poceed faste than expansion in the othe as the changes involved may be costly and time consuming to implement. Output in secto 1 may fall apidly to 60 units, while output in secto 2 ises only to 120 units. Aggegate poduction would decline, fom 200 units to 180 units, as some esouces ae used to cay out the tansition. Disuptions o advances in poduction may have many souces. Some may be eadily identifiable, like shap inceases in the pice of oil. Some may be had to pin down, like stuctual change that occus slowly and acoss many sectos. This list of pemanent and tempoay shocks is not meant to be exhaustive, only illustative. Oveview and Extensions a. demand and supply: maco vs. mico ou may have aleady ecognized one featue of macoeconomic demand and supply analysis that makes it moe difficult than standad micoeconomics. A macoeconomic shock may well cause both demand and supply cuves to shift (think back to ou examples). When both cuves shift it is hade to make clea pedictions about movements in both and. In macoeconomics knowing something about the elative sizes of the shifts is cucial in allowing fo unambiguous pedictions. Fo example, a tempoay decease in poduction shifts the s cuve leftwad. Lowe cuent peiod income deceases wealth and this puts downwad pessue on consumption. But since the change is tempoay, consumption will only decline by a small faction of the change in s. To make compaisons easie we have assumed that thee is no shift in d. Whethe o not we make this simplification, a tempoay negative shock to the poduction function esults in an excess demand fo goods and this causes inteest ates to ise. Without knowing something about elative shifts, we would not have been able to make these pedictions. The key piece of infomation was that the change was viewed as tempoay. In studying any event, it is then vey impotant to ask whethe it is tempoay o pemanent in natue.

17 the goods maket and eal business cycles 17 b. ole of investment An initial equilibium with an inteest ate of 10% and output of 500 units is dawn in Figue Let's suppose that 100 units of aggegate output ae devoted to investment and the othe 400 units ae consumed. Now suppose a tempoay negative shock to output occus, like a tempoay incease in the pice of oil, and the s cuve shifts 150 units to the left. The inteest ate ises to 15% and output settles at 425 units. Thee ae thee impotant points hee. Fist, ecall that the incease in the inteest ate calls foth geate wok effot so the net decline in output is only 75 units instead of the initial 150 units. Second, because the inteest ate inceases investment falls to, say, 70 units and consump - tion falls to 355 units. The decline in investment acts as a buffe fo consumption and allows households to keep thei consumption close to its nomal (oiginal) level. Thid, output declines by 15%, consumption by 12.5%, and investment by 30%. In popotional tems, the fall in investment is much lage than the fall in output, while the change in consumption is small elative to the change in income. Hee it is impotant to emembe the agument that if investment is a small faction of the capital stock, it may eact vey stongly to a change in the demand fo capital. So, a change in the inteest ate has to alte the desied capital stock by only a small amount to change investment demand by a lot. This s' makes investment much moe sensitive to s changes in the inteest ate than consumption, and as a esult investment will be the 15% 10% moe volatile of the two aggegates. c. shifts in investment and consumption demand d With capital in the model you must always ask: "Will the shock change the Figue Investment as a Buffe

18 18 chapte 11 futue pofitability of capital?" If the answe is no, then you have to woy only about the esponse of consumption. Recall the effects of a pemanent technological advance, which does not make capital moe poductive. The s cuve shifts out, and the d cuve shifts out one-foone with it, as consumption esponds to a pemanently highe level of income. Since investment demand does not change, the inteest ate stays the same. Suppose the technological advance does incease the poductivity of new capital and hence inceases investment demand. In this case, the demand fo new plant and equipment will ise at the going inteest ate. This ceates an additional incease in aggegate demand and the total incease in demand now exceeds the incease in supply. This ceates an excess demand fo goods, the cost of funds,, is bid up, and the new equilibium occus at a highe ate of inteest and a highe level of income. We can addess the issue of simultaneous shocks in anothe way. The outcome of two simultaneous shocks is shown in Table In the fist ow of this table the effects of a pemanent incease in the poduction function ae summaized. These ae the esults we obtained in ou analysis of an impovement in technology. In the second ow the effects of an incease in investment ae shown. The combined effects of these two shocks occupy the thid ow. It shows a cetain incease in the inteest ate, output, and investment; but consumption may eithe fall o ise. Table 11.1 The Effects of a Simultaneous Technical Pogess and an Incease in the Poductivity of Capital C I technical pogess incease in investment demand combined effect + +? + d. capacity utilization and the inteest ate We have aleady mentioned that many economists do not believe that the wok effot esponds much at all to changes in the inteest ate. This would mean that the s cuve is vetical

19 the goods maket and eal business cycles 19 and would change seveal of ou ealie esults. Most impotantly, if the s cuve is vetical, an incease in investment demand only esults in a highe inteest ate. Equilibium output would not change. Some economists have suggested that a stong esponse by households to a change in the inteest ate is not essential. If we allow the capacity utilization of capital to change, we do not have to ely solely on the esponse of wok effot to give s a positive slope. Vaiations in the usage of existing capital may be enough. To begin the stoy, we fist need to know why thee may be existing slack. Why don't fims opeate thei plants and equipment at 100% capacity? The eason hinges on the depeciation of capital. The moe intensively a fim uses its capital stock, the faste the capital stock weas out. O, to put it in a slightly diffeent way, the geate is the capacity utilization ate, the geate is the depeciation ate of capital. Fo example, if a fim keeps its capital in use all the time, thee shifts a day with no down time, the capital may wea out vey fast, say in 3 yeas. On the othe hand, if the capital is used only two shifts a day and expeiences some down time fo outine maintenance checks, it may be able to last quite a bit longe, say 10 yeas. Because of this elationship it may not be in the fim's best inteest to use its capital at full capacity. The output poduced ove the longe peiod of time may well compensate the fim fo not unning the capital continuously at full capacity. Table 11.2 Changing Capacity Utilization peiod 1 peiod 2 pesent values shifts y1 shifts y2 pv (10%) pv (20%) stategy A stategy B stategy C A simple numeical example may help claify this point. Suppose a fim makes plans ove a two-peiod hoizon and has a machine with a lifetime of two shifts. The fim may un the machine fo two shifts in the fist peiod, o two shifts in the second peiod, o the fim may un the machine fo one shift in each of the two peiods. If the machine is used fo one shift in a

20 20 chapte 11 peiod it poduces 7 units of output in that peiod. If capital is employed two shifts in a peiod, it yields only 13 units of output in that peiod, because the moe intense utilization causes the machine to wea down faste. Table 11.2 gives the choices available to the fim. If it chooses stategy A, it poduces no output today and 13 units of output in the second peiod. Stategy B yields 7 units of output in each peiod. Stategy C calls fo 13 units of cuent output, but nothing in the second peiod. Since output is ealized in diffeent peiods, the thee possible steams of output ae not diectly compaable. We must calculate the pesent value of the output steam geneated by each stategy to compae the choices and to find out which one the fim will choose. To calculate a pesent value an inteest ate is needed. Let's fist suppose that the inteest ate is 10%. The pesent value of each output steam when the inteest ate is 10% is given in column 5. The calculation is staightfowad. Fo example, the pesent value of the output steam geneated by stategy B is 13.4 = 7 + 7/(1+.1) When the inteest ate is 10% stategy B gives the highest pesent value and the fim will poduce 7 units of output in each of the two peiods. Now suppose the inteest ate ises to 20%. The highe inteest ate means that we ae discounting futue output at a highe ate. The pesent value of stategy B falls to 12.8 and it is now below the pesent value fo stategy C. The fim chooses stategy C, so in esponse to the incease in the inteest ate, the fim inceases the use of its capital stock and cuent output goes up. In shot, we do not have to ely solely on a labo supply effect to have a positively sloped supply cuve. Instead, we can explain a positive elationship between output and the inteest ate by an appeal to geate capacity utilization. Thee is, howeve, a close connection between the labo supply explanation and the capacity utilization. An incease in the inteest ate means it is a good time to incease you eanings. In a wold with capital, thee ae two ways that this can be done. Fist, you can incease wok effot and this is the labo supply effect. Second, you can wok machines hade. This is the capacity utilization explanation. The geneal agument is that when the inteest ate inceases, thee is an incentive fo inputs (labo and capital) to wok hade and longe, and this causes an incease in cuent output.

21 the goods maket and eal business cycles 21 e. shocks to a small open economy We can extend the analysis to small open economies in a faily staightfowad way. An open economy is one that can engage in intenational tade and we want to know how the cuent account balance fo such a county will change when the economy is shocked. A small economy is defined hee as economy small enough so that the behavio of its citizens does not affect the wold inteest ate. The U.S. is pobably not a small economy, Sweden is. We now ecognize that aggegate demand includes the demand fo goods and sevices poduced aboad as well as those poduced at home and some of aggegate supply is now sold to foeignes. The d and s cuves still look the same and still shift fo the same easons as befoe. Howeve, it is no longe tue that aggegate demand must equal aggegate supply in equilibium. In any paticula peiod d may exceed s. In this case the county's consumption and investment exceeds its poduction, which means it must be boowing fom foeignes (o dawing down its claims on foeignes) and unning a cuent account deficit. If, on the othe hand, s exceeds d, then the county poduces moe than it demands; and the emainde is lent to foeignes (o used to epay ealie debts). To simplify mattes, we begin with a county whose cuent account is in balance. This means that s equals d at, say, 7,000 units. Now suppose the county suffes a spell of poo weathe. This is a tempoay negative shock. The s cuve will shift back and to the left, but, because the shock is tempoay, the d cuve will not shift. This is shown in Figue We know fom ou ealie analysis that the households in this county will ty to boow in ode to maintain thei cuent living standads. In ou ealie model, this led to an incease in the inteest ate. Howeve, in a small open economy this is not the case. The inteest ate is set in wold makets at wold and ou county is, by assumption, too small to affect this ate. In a closed economy one household can boow only by inducing anothe one to lend. In an open economy this is no longe tue. All of the households in one county can simultaneously incease thei boowing by seeking loans fom aboad. As households boow fom foeignes, the county will expeience a capital inflow, thei capital account balance will be positive, and thei cuent account will be in deficit. The size of the deficit in Figue is the diffeence between s and d, 600 units.

22 22 chapte 11 To study anothe type shock, suppose that investment pojects in this county become moe popula. In this case the d cuve shifts out and to the ight, but, since the capital will not come on line until the next peiod, the s cuve will not shift. This means that thee is an excess demand fo goods; that is, s is less than d. Again, in a closed economy this would esult in highe inteest ates. In a small open economy the inteest ate is not affected, and, instead, the county expeiences a capital inflow, and a cuent account deficit. This is shown in Figue whee the cuent account deficit is 200 units. The shocks that cause an initial excess demand fo goods aise inteest ates in a closed economy and poduce cuent account deficits in a small open economy. Shocks that cause an initial excess supply of goods, such as a spell of vey good weathe, lowe inteest ates in a closed economy and ceate cuent account supluses in a open economy. What happens if no initial excess demand o supply is ceated? Fo example, a pemanent shock to the poduction function, say fom an invention, ceates neithe a shotage o a suplus. In this case, we can theefoe conclude that such a shock will not affect the cuent account balance. We have not addessed two questions. Fist, what happens if a county is lage? In this case we would expect some combination of the two esults. Fo example, if thee is an investment boom in the U.S., we would expect that the wold inteest ate would ise and the U.S. would expeience a cuent account deficit. The second question we have left open is what happens to exchange ates? A discussion of this issue will have to wait until the extensions section of chapte 14. wold 6,400 s' 7,000 s d Figue A Tempoay Negative Shock in an Open Economy Summay

23 the goods maket and eal business cycles 23 In this chapte we developed a model of the goods maket. We fist found the equilibium and then subjected it to shocks. Thee ae thee types of shocks: pemanent shifts in the poduction function, tempoay shifts in the poduction function, and changes in the poductivity of capital. Of couse, in an actual economy two o moe shocks may occu at once and we leaned how to deal with this situation. Even though the model was kept simple, it can be used to study a boad aay of events that can have impotant effects on the economy. wold 7,000 s 7,200 d' d Figue A Tempoay Negative Shock in an Open Economy Review Questions 1) To pactice using the model analyze the impact of the following events on, C, and I, and. Remembe to ask two questions: 1. Is the event pemanent o tempoay in natue? 2. If pemanent, is it likely to affect the pofitability of investment? a. An OPEC decision to poduce moe oil lowes oil pices. Most analysts believe the decision is tied to financial poblems in the OPEC counties and will not last. b. The U.S. inceases aid to those suffeing fom the dought in Afica. c. A shift in demand away fom U.S. manufactuing goods towad the sevice secto leaves some wokes and capital unemployed. d. A new compute is developed to help detect mino beakdowns in manufactuing pocesses. Which esults would be alteed if aggegate supply does not espond to inteest ates?

24 24 chapte 11 2) Often times economists ae pesented with data and asked to guess what shock caused the movements. Below descibe a shock o set of shocks that can explain the data. a. an incease in the inteest ate and lowe output b. no change in the inteest ate and highe consumption c. highe consumption, investment, and inteest ate d. a lowe inteest ate and highe investment