Syllabus

Lecutres

Outlines

Assignments

Objectives
1. Explain the causes of business cycles according to the classical theory
2. Predict the behavior of macro-variables over the cycle according to the classical theory
3. Examine the validity of the classical theory: are its predictions consistent with data on macro-variables?

I. Business Cycles in the Classical Model

A. A theory of business cycles must be able to answer the following three key questions:

1. What are the main economic causes of business cycles?
2. How do key macro-variables behave over business cycles?
3. What should policy-makers do about business cycles?

B. Real Business Cycle (RBC) Theory (Kydland and Presscott)

1. Real shocks the primary cause of business cycles; They consist of

a. Supply shocks: shocks to production function, and labor supply,
b. Shocks to IS: changes in real quantity of government spending, consumers saving and spending, businesses investment

c. Nominal Shocks do not cause business cycles (changes in money supply)

d. The most important real shock is the productivity shock (represented by in A in production function)
Examples:
- new production technology,
- new management technique,
- changes in the quality of capital and labor,
- discovery of new resources,
- unusual changes in whether,
- changes in government regulations affecting production

Beneficial productivity shocks (+A) cause economic boom, adverse productivity shocks (-A) cause recession.

2. How does a supply shock affect macro-variables (RBC theory predictions)?

a. Use the IS-LM/AD-AS model
b. Assume wage and price flexibility

Example 1: Effect of an adverse supply shock ( a rise in price of oil)

Start with long-run equilibrium (point a) with Y*, N*, w0, P0, r0, S0, and I0.
Production function rotates downward
Labor demand falls, Y falls, FE and LRAS fall.
Fall in Y reduces national saving, and raises real interest rate, causes a movement up on the IS curve (no shift) until it intersects the FE line at point b.
At b labor and commodity markets are in long-run equilibrium but money market is not.
In AD/AS diagram, EDG causes a rise in P, reduces M/P, and shifts the LM left-ward to intersect FE and IS at point b.

Since wages and prices are assumed very flexible, the labor and commodity markets adjust very fast.

3. Predictions of RBC theory:
§ The model predicts that business cycles are caused by productivity shocks.
§ Adverse productivity shocks reduce Y, N, w, C, S, and I, but raise r and P; favorable productivity shocks do the opposite.

4. Are these predictions correct?

§ It correctly predicts that employment (N) and real wages (w) are pro-cyclical
§ It correctly predicts that average labor productivity (Y/N) is pro-cyclical.
§ It predicts counter-cyclical movements in the price level, which seems inconsistent with earlier evidence.
§ However, K-P's work suggests that P is also counter-cyclical in most instances.
§ Exceptions are during the Great Depression.

5. Are productivity shocks the only source of recession?
§ RBC theory: yes

§ Critics: Except for the oil shock of 1973, 79, and 90, there are no major productivity shocks that can be identified as cause of recessions (say, 1981-82 recession)

§ RBC response: Does not have to be a big shock. Instead, the accumulation of many small shocks can cause a business cycle.

6. Example 2: How does a temporary increase in government spending (fiscal policy shock) affect key macro variables

§ Start with the general equilibrium position (a) with Y*, N*, w0, P0, r0, S0, I0, G0, C0
§ Increase G from G0 to G1

§ Effect on FE and LRAS: The finance of G (higher current or future taxes) reduces workers' wealth. They have to increase their labor supply. Employment rises, Y rises, FE and LRAS shift to the right.

§ Effect on S and IS: The rise in G reduces S, raises r, and causes a rightward shift in the IS curve.

§ Effect on AD: The rise in G increases AD and shifts it to the right.

§ Point c where the new FE and IS intersect is the new long-run equilibrium. At c labor and commodity markets are in equilibrium but money market is not.

§ Money Market Adjustment: In the AD-AS diagram, at P=P0 there is excess demand for goods; P rises, M/P falls, LM shifts left until crosses the IS and new FE.

§ Final effect: Y, N, r, and P rise; S, I, C, and w fall.
§ Workers are worse off.

7. Question: Should fiscal policy be used to dampen business cycles (recessions)?

§ RBC theorists: No.
- Since w and p are flexible, market does the job rapidly.
- Fiscal policy increases Y but makes workers worse off.
- There are long lags in enacting the correct policy and in implementing it
- Choice of right policy requires good forecast of future.
- Our forecasts are not very good.
- Our policies might end up wrong.

8. Example 3: How a change in money supply (Monetary Policy) affect key macro variables

§ Start with the general equilibrium position (a) with Y*, N*, w0, P0, r0, S0, I0, G0, C0
§ Increase money supply from M0 to M1
§ Effect on FE and LRAS: None.
§ Effect on S and IS: None.
§ Effect on money market and LM: M/P increase, people use the excess money to buy bonds, r decrease, LM shifts right.
§ AD: The fall in r increases C and I, and shifts AD to the right.
§ Point a where the FE and IS intersect is the long-run equilibrium. At this point, labor and commodity markets are in equilibrium but money market is not.

§ Money Market Adjustment: In the AD-AS diagram, at P=P0 there is excess demand for goods; P rises, M/P falls back to its original position, LM shifts back to its original position.

§ Final effect:
- Real variables: Y, N, w, r, S, I, and C no change.
- Nominal variables: P and W increase proportionally.

§ Money neutral in both short-run and long-run (because W and P is flexible even in the short-run)

9. Problem: RBC theory says money is neutral. Data shows money is a leading indicator. How to reconcile the two?

§ Reverse causation: Money does not cause Y; Y causes M.
§ How? When people expect higher income, they demand more money.