Review of the previous lecture

• Advocates of active monetary and fiscal policy view the economy as

inherently unstable and believe policy can be used to offset this inherent
instability.

• Critics of active policy emphasize that policy affects the economy with a lag
and our ability to forecast future economic conditions is poor, both of which
can lead to policy being destabilizing.

• Advocates of rules for monetary policy argue that discretionary policy can
suffer from incompetence, abuse of power, and time inconsistency.

• Critics of rules for monetary policy argue that discretionary policy is more
flexible in responding to economic circumstances.
 Review of the previous lecture

• Advocates of a zero-inflation target emphasize that inflation has many costs

and few if any benefits.

• Critics of a zero-inflation target claim that moderate inflation imposes only

small costs on society, whereas the recession necessary to reduce inflation
is quite costly.

• Advocates of reducing the government debt argue that the debt imposes a
burden on future generations by raising their taxes and lowering their
incomes.

• Critics of reducing the government debt argue that the debt is only one
small piece of fiscal policy.
 Review of the previous lecture

• Advocates of tax incentives for saving point out that our society discourages
saving in many ways such as taxing income from capital and reducing
benefits for those who have accumulated wealth.

• Critics of tax incentives argue that many proposed changes to stimulate

saving would primarily benefit the wealthy and also might have only a small
effect on private saving.
 Lecture 20

Advances in Business Cycle

Theory

Instructor: Prof. Dr. Qaisar Abbas

 Lecture outline

• Real Business Cycle theory

• New Keynesian economics

 The Theory of Real Business Cycles

• all prices flexible, even in short run

– implies money is neutral, even in short run

– classical dichotomy holds at all times

• fluctuations in output, employment, and other variables are the optimal

responses to exogenous changes in the economic environment

• productivity shocks the primary cause of economic fluctuations

 The economics of Robinson Crusoe
• Economy consists of a single
producer-consumer,
like Robinson Crusoe on a desert island.

• Assume Crusoe divides his time between

– leisure
– working
• catching fish (production)
• making fishing nets (investment)

• Assume Crusoe optimizes given the constraints he faces.

 Shocks in the Crusoe island economy

• Big school of fish swims by island.

Then, GDP rises because
 Crusoe’s fishing productivity is higher
 Crusoe’s employment rises: he decides to shift some time from
leisure to fishing to take advantage of the high productivity

• Big storm hits the island. Then, GDP falls:

 The storm reduces productivity, so Crusoe spends less time
fishing for consumption.
 More importantly, investment falls, because it’s easy to postpone
making nets until storm passes
 Employment falls: Since he’s not spending as much time fishing
or making nets, Crusoe decides to enjoy more leisure time.
 Economic fluctuations as
optimal responses to shocks

• In Real Business Cycle theory, fluctuations in our economy are

similar to those in Crusoe’s economy.

The shocks aren’t always desirable.

But once they occur, fluctuations in
output, employment, and other
variables are the optimal
responses to them.
 The debate over RBC theory

…boils down to four issues:

• Do changes in employment reflect voluntary changes in labor

supply?

• Does the economy experience large, exogenous productivity shocks

in the short run?

• Is money really neutral in the short run?

• Are wages and prices flexible in the short run? Do they adjust
quickly to keep supply and demand in balance in all markets?
 The labor market
• Intertemporal substitution of labor:
In RBC theory, workers are willing to reallocate labor over time in
response to changes in the reward to working now versus later.

• The intertemporal relative wage equals

(1  r )W1
W2
where W1 is the wage in period 1 (the present)
and W2 is the wage in period 2 (the future).
 The labor market

• In RBC theory,
• shocks cause fluctuations in the intertemporal wage
• workers respond by adjusting labor supply
• this causes employment and output to fluctuate

• Critics argue that

• labor supply is not very sensitive to the intertemporal real wage
• high unemployment observed in recessions
is mainly involuntary
 Technology shocks

• In RBC theory, economic fluctuations are caused by productivity shocks.

• The Solow residual is a measure of productivity shocks: it shows the

change in output that cannot be explained by changes in capital and labor.

• RBC theory implies that the Solow residual should be highly correlated with
output.
Is it?
 The Solow residual and growth in output
Percent
10
per year
8
Output growth
6

-2 Solow residual

-4
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Year
 Technology shocks

• Proponents of RBC theory argue that the strong correlation between output
growth and Solow residuals is evidence that productivity shocks are an
important source of economic fluctuations.

• Critics note that the measured Solow residual is biased to appear more
cyclical than the true, underlying technology.
 The neutrality of money

• RBC critics note that reductions in money growth and inflation are almost
always associated with periods of high unemployment and low output.

• RBC proponents respond by claiming that the money supply is endogenous:

– Suppose output is expected to fall.
Central bank reduces money supply in response to an expected fall in
money demand.
 The flexibility of wages and prices
• RBC theory assumes that wages and prices are completely flexible,
so markets always clear.

• RBC proponents argue that the extent to which wages or prices may
be sticky in the real world is not important for understanding
economic fluctuations.

• They also prefer to assume flexible prices to be consistent with

microeconomic theory.

• Critics believe that wage and price stickiness explains involuntary

unemployment and the non-neutrality of money.
 New Keynesian Economics

• Most economists believe that short-run fluctuations in output and

employment represent deviations from the natural rate,
and that these deviations occur because wages and prices are sticky.

• New Keynesian research attempts to explain the stickiness of wages and

prices by examining the microeconomics of price adjustment.
 Small menu costs and
aggregate-demand externalities

• There are externalities to price adjustment:

A price reduction by one firm causes the overall price level to fall (albeit
slightly).
This raises real money balances and increases aggregate demand, which
benefits other firms.

• Menu costs are the costs of changing prices (e.g., costs of printing new
menus or mailing new catalogs)

• In the presence of menu costs, sticky prices may be optimal for the firms
setting them even though they are undesirable for the economy as a whole.
 Recessions as coordination failure

• In recessions, output is low, workers are unemployed, and factories sit idle.

• If all firms and workers would reduce their prices, then economy would
return to full employment.

• But, no individual firm or worker would be willing to cut his price without
knowing that others will cut their prices. Hence, prices remain high and the
recession continues.
 The staggering of wages and prices

• All wages and prices do not adjust at the same time.

• This staggering of wage & price adjustment causes the overall price level to
move slowly in response to demand changes.

• Each firm and worker knows that when it reduces its nominal price, its
relative price will be low for a time. This makes them reluctant to reduce
their price.
 Top reasons for sticky prices:
results from surveys of managers

1. Coordination failure: firms hold back on price changes, waiting for others to
go first

2. Firms delay raising prices until costs rise

3. Firms prefer to vary other product attributes, such as quality, service, or

delivery lags

4. Implicit contracts: firms tacitly agree to stabilize prices, perhaps out of

‘fairness’ to customers

5. Explicit contracts that fix nominal prices

6. Menu costs
 Conclusion: the frontiers of research

• This chapter has explored two distinct approaches to the study of

business cycles: Real Business Cycle theory and New Keynesian
Theory.

• Not all economists fall entirely into one camp or the other.

• An increasing amount of research incorporates insights from both

schools of thought to advance our study of economic fluctuations.
 Summary
1. Real Business Cycle theory
 assumes perfect flexibility of wages and prices
 shows how fluctuations arise in response to productivity shocks
 the fluctuations are optimal given the shocks

2. Points of controversy in RBC theory

 intertemporal substitution of labor
 the importance of technology shocks
 the neutrality of money
 the flexibility of prices and wages
 Summary
3. New Keynesian economics
 accepts the traditional model of aggregate demand and supply
 attempts to explain the stickiness of wages and prices with
microeconomic analysis, including
 menu costs
 coordination failure
 staggering of wages and prices