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Advances in Business Cycle Theory

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  1. 1. Class Slides for EC 204 To Accompany Chapter 19
  2. 2. Learning objectives <ul><li>This chapter presents an overview of recent work in two areas: </li></ul><ul><li>Real Business Cycle theory </li></ul><ul><li>New Keynesian economics </li></ul>
  3. 3. The Theory of Real Business Cycles <ul><li>all prices flexible, even in short run </li></ul><ul><ul><li>implies money is neutral, even in short run </li></ul></ul><ul><ul><li>classical dichotomy holds at all times </li></ul></ul><ul><li>fluctuations in output, employment, and other variables are the optimal responses to exogenous changes in the economic environment - natural rate is fluctuating </li></ul><ul><li>productivity shocks are the primary cause of economic fluctuations </li></ul>
  4. 4. The economics of Robinson Crusoe <ul><li>Economy consists of a single producer-consumer, like Robinson Crusoe on a desert island. </li></ul><ul><li>Assume Crusoe divides his time between </li></ul><ul><ul><li>leisure </li></ul></ul><ul><ul><li>working </li></ul></ul><ul><ul><ul><li>catching fish (production) </li></ul></ul></ul><ul><ul><ul><li>making fishing nets (investment) </li></ul></ul></ul><ul><li>Assume Crusoe optimizes given the constraints he faces. </li></ul>
  5. 5. Shocks in the Crusoe island economy <ul><li>Big school of fish swims by island. Then, GDP rises because </li></ul><ul><ul><li>Crusoe’s fishing productivity is higher </li></ul></ul><ul><ul><li>Crusoe’s employment rises: he decides to shift some time from leisure to fishing to take advantage of the high productivity </li></ul></ul><ul><li>Big storm hits the island. Then, GDP falls: </li></ul><ul><ul><li>The storm reduces productivity, so Crusoe spends less time fishing for consumption. </li></ul></ul><ul><ul><li>More importantly, investment falls, because it’s easy to postpone making nets until storm passes </li></ul></ul><ul><ul><li>Employment falls: Since he’s not spending as much time fishing or making nets, Crusoe decides to enjoy more leisure time. </li></ul></ul>
  6. 6. Economic fluctuations as optimal responses to shocks <ul><li>In Real Business Cycle theory, fluctuations in our economy are similar to those in Crusoe’s economy. </li></ul>The shocks aren’t always desirable. But once they occur, fluctuations in output, employment, and other variables are the optimal responses to them.
  7. 7. The debate over RBC theory <ul><li>… boils down to four issues: </li></ul><ul><li>Do changes in employment reflect voluntary changes in labor supply? </li></ul><ul><li>Does the economy experience large, exogenous productivity shocks in the short run? </li></ul><ul><li>Is money really neutral in the short run? </li></ul><ul><li>Are wages and prices flexible in the short run? Do they adjust quickly to keep supply and demand in balance in all markets? </li></ul>
  8. 8. The labor market <ul><li>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. </li></ul><ul><li>The intertemporal relative wage equals: </li></ul>where W 1 is the wage in period 1 (the present) and W 2 is the wage in period 2 (the future). (1+r)W 1 / W 2
  9. 9. The labor market <ul><li>In RBC theory, </li></ul><ul><ul><li>shocks cause fluctuations in the intertemporal wage </li></ul></ul><ul><ul><li>workers respond by adjusting labor supply </li></ul></ul><ul><ul><li>this causes employment and output to fluctuate </li></ul></ul><ul><li>Critics argue that </li></ul><ul><ul><li>labor supply is not very sensitive to the intertemporal real wage </li></ul></ul><ul><ul><li>high unemployment observed in recessions is mainly involuntary </li></ul></ul>
  10. 10. Technology shocks <ul><li>In RBC theory, economic fluctuations are caused by productivity shocks. </li></ul><ul><li>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. </li></ul><ul><li>RBC theory implies that the Solow residual should be highly correlated with output. Is it? </li></ul>
  11. 11. The Solow residual and growth in output Year Output growth Solow residual 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 1945 10 8 6 4 2 0 -2 -4 Percent per year
  12. 12. Technology shocks <ul><li>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. </li></ul><ul><li>Critics note that the measured Solow residual is biased, appearing more cyclical than the true, underlying technology. </li></ul>
  13. 13. Productivity shocks <ul><li>Procyclical bias may be due to: </li></ul><ul><ul><li>Labor Hoarding - Labor input is overestimated in a recession. Workers are kept on payroll even though they are not working as hard. Just sitting around waiting for recession to end. </li></ul></ul><ul><ul><li>Output Mismeasurement - In a recession, workers may produce things that are hard to measure. They might clean the factory, organize inventory, get some training. </li></ul></ul>
  14. 14. The neutrality of money <ul><li>RBC critics note that reductions in money growth and inflation are almost always associated with periods of high unemployment and low output. </li></ul><ul><li>RBC proponents respond by claiming that the money supply is endogenous: </li></ul><ul><ul><li>Suppose output is expected to fall. Central bank reduces money supply in response to an expected fall in money demand. </li></ul></ul>
  15. 15. The flexibility of wages and prices <ul><li>RBC theory assumes that wages and prices are completely flexible, so markets always clear. </li></ul><ul><li>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. </li></ul><ul><li>They also prefer to assume flexible prices to be consistent with microeconomic theory. </li></ul><ul><li>Critics believe that wage and price stickiness explains involuntary unemployment and the non-neutrality of money. </li></ul>
  16. 16. New Keynesian Economics <ul><li>Most economists believe that short-run fluctuations in output and employment represent deviations from the natural rate, </li></ul><ul><li>and that these deviations occur because wages and prices are sticky. </li></ul><ul><li>New Keynesian research attempts to explain the stickiness of wages and prices by examining the microeconomics of price adjustment. </li></ul>
  17. 17. Small menu costs and aggregate-demand externalities <ul><li>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. </li></ul><ul><li>Menu costs are the costs of changing prices (e.g., costs of printing new menus or mailing new catalogs) </li></ul><ul><li>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. </li></ul>
  18. 18. Small menu costs and sticky prices <ul><li>At an optimum, firm faces on second-order costs of deviating from optimum. </li></ul><ul><li>So, if cost of changing prices is small but a little larger than the cost of not adjusting (i.e., cost of deviating from optimum), then the firm won’t change its price. </li></ul><ul><li>This argument requires the firm to have some degree of monopoly power over its price. </li></ul>
  19. 19. Recessions as coordination failure <ul><li>In recessions, output is low, workers are unemployed, and factories sit idle. </li></ul><ul><li>If all firms and workers would reduce their prices, then economy would return to full employment. </li></ul><ul><li>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. </li></ul>
  20. 21. The staggering of wages and prices <ul><li>All wages and prices do not adjust at the same time. </li></ul><ul><li>This staggering of wage & price adjustment causes the overall price level to move slowly in response to demand changes. </li></ul><ul><li>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. </li></ul>
  21. 23. Top reasons for sticky prices: results from surveys of managers <ul><li>1. Coordination failure: firms hold back on price changes, waiting for others to go first </li></ul><ul><li>2. Firms delay raising prices until costs rise </li></ul><ul><li>3. Firms prefer to vary other product attributes, such as quality, service, or delivery lags </li></ul><ul><li>4. Implicit contracts: firms tacitly agree to stabilize prices, perhaps out of ‘fairness’ to customers </li></ul><ul><li>5. Explicit contracts that fix nominal prices </li></ul><ul><li>6. Menu costs </li></ul>
  22. 25. Inflation Inertia <ul><li>Staggered price setting leads to slow adjustment in the price level in response to changes in aggregate demand. </li></ul><ul><li>But, this is not the case for inflation. </li></ul><ul><li>Inflation is expected to decline when output is above its natural rate and vice versa. </li></ul><ul><li>Reason is that the Phillips curve consistent with staggered price setting expresses current inflation as a function of future inflation and the output gap. </li></ul>
  23. 26. Inflation Inertia <ul><li>The evidence contradicts this implication and shows inflation to be highly persistent (e.g., NAIRU theory). </li></ul><ul><li>Reasons for this: </li></ul><ul><ul><li>Delays in adjusting prices </li></ul></ul><ul><ul><li>Indexing fixed prices to inflation between adjustments </li></ul></ul><ul><ul><li>Persistence in deviations of output from its natural rate </li></ul></ul>
  24. 27. Inflation Inertia <ul><li>Perhaps the model is incorrect. </li></ul><ul><li>Instead of sticky prices, we have sticky information (Mankiw and Reis, QJE 2002) </li></ul><ul><li>Firms can freely change prices but may not have latest information available. </li></ul><ul><li>So, they set price path when new information is available. </li></ul><ul><li>Overlapping information availability leads to backward looking Phillips curve. </li></ul>
  25. 28. Inflation Inertia <ul><li>Problems with Sticky Information: </li></ul><ul><ul><li>Evidence of fixed prices in the economy </li></ul></ul><ul><ul><li>Most firms do not seem to set predetermined paths for prices </li></ul></ul><ul><ul><li>Fixed prices also appear essential for explaining why shifts in aggregate demand have smaller and short-lasting effects in high inflation economies </li></ul></ul><ul><ul><li>Fixed prices help explain why announcing disinflation policy in advance doesn’t have big effect on ultimate cost </li></ul></ul>
  26. 29. Conclusion: the frontiers of research <ul><li>This chapter has explored two distinct approaches to the study of business cycles: Real Business Cycle theory and New Keynesian Theory. </li></ul><ul><li>Not all economists fall entirely into one camp or the other. </li></ul><ul><li>An increasing amount of research incorporates insights from both schools of thought to advance our study of economic fluctuations. </li></ul>
  27. 30. Chapter summary <ul><li>1. Real Business Cycle theory </li></ul><ul><ul><li>assumes perfect flexibility of wages and prices </li></ul></ul><ul><ul><li>shows how fluctuations arise in response to productivity shocks </li></ul></ul><ul><ul><li>the fluctuations are optimal given the shocks </li></ul></ul><ul><li>2. Points of controversy in RBC theory </li></ul><ul><ul><li>intertemporal substitution of labor </li></ul></ul><ul><ul><li>the importance of technology shocks </li></ul></ul><ul><ul><li>the neutrality of money </li></ul></ul><ul><ul><li>the flexibility of prices and wages </li></ul></ul>
  28. 31. Chapter summary <ul><li>3. New Keynesian economics </li></ul><ul><ul><li>accepts the traditional model of aggregate demand and supply </li></ul></ul><ul><ul><li>attempts to explain the stickiness of wages and prices with microeconomic analysis, including </li></ul></ul><ul><ul><ul><li>menu costs </li></ul></ul></ul><ul><ul><ul><li>coordination failures </li></ul></ul></ul><ul><ul><ul><li>staggering of wages and prices </li></ul></ul></ul>