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Advances in Business Cycle TheoryAdvances in Business Cycle Theory

This chapter presents an overview of recentwork in two areas:

Real Business Cycle theory

New Keynesian economics

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The Theory of Real Business CyclesThe 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

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 exogenous changes in the economicenvironment

productivity shocks the primary cause of economic fluctuations

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The economics of Robinson CrusoeThe economics of Robinson Crusoe

Economy consists of a singleproducer-consumer,

like Robinson Crusoe on a desert island.

 Assume Crusoe divides his time between

 –

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 – working

• catching fish (production)

• making fishing nets (investment)

 Assume Crusoe optimizes given theconstraints he faces.

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Shocks in the Crusoe island economyShocks in the Crusoe island economy

1. Big school of fish swims by island.

Then, GDP rises because

Crusoe’s fishing productivity is higher

Crusoe’s employment rises: he decides to

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shift some time from leisure to fishing totake advantage of the high productivity

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Shocks in the Crusoe island economyShocks in the Crusoe island economy

1. Big storm hits the island.

Then, GDP falls:

The storm reduces productivity, so Crusoespends less time fishing for consumption.

 

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ore mpor an y, nves men a s,because it’s easy to postpone making netsuntil storm passes

Employment falls: Since he’s not spendingas much time fishing or making nets,

Crusoe decides to enjoy more leisure time.

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Economic fluctuations as Economic fluctuations as 

optimal responses to shocks 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.The shocks aren’t always desirable.

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But once they occur, fluctuations inBut once they occur, fluctuations inoutput, employment, and otheroutput, employment, and other

variables are the optimalvariables are the optimal

responses to them.responses to them.

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The debate over RBC theoryThe debate over RBC theory

…boils down to four issues:

Do changes in employment reflect voluntary

changes in labor supply?

Does the economy experience large,

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 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 anddemand in balance in all markets?

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The labor marketThe labor market

Intertemporal substitution of labor:In RBC theory, workers are willing to

reallocate labor over time in response tochanges in the reward to working now versuslater.

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The intertemporal relativewage equals

1

2

(1 )r W  

W  

+

where W  1 is the wage in period 1 (the present)and W  2 is the wage in period 2 (the future).

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The labor marketThe labor market

In RBC theory,

• shocks cause fluctuations in the

intertemporal wage• workers respond by adjusting labor supply

• this causes employment and output to

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uc ua e Critics argue that

• labor supply is not very sensitive to the

intertemporal real wage• high unemployment observed in recessions

is mainly involuntary

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Technology shocksTechnology shocks

In RBC theory, economic fluctuations arecaused by productivity shocks.

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

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in capital and labor.

RBC theory implies that the Solow residual

should be highly correlated with output.Is it?

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Output growth

10

8

6

4

Percent 

 per year 

The Solow residual and growth in outputThe Solow residual and growth in output

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Year

Solow residual

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 20001945

2

0

-2

-4

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Technology shocksTechnology shocks

Proponents of RBC theory argue that thestrong correlation between output growth and

Solow residuals is evidence that productivityshocks are an important source of economicfluctuations.

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Critics note that the measured Solow residualis biased to appear more cyclical than thetrue, underlying technology.

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The neutrality of moneyThe neutrality of money

RBC critics note that reductions in moneygrowth and inflation are almost always

associated with periods of highunemployment and low output.

 

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the money supply is endogenous:

 – Suppose output is expected to fall.Central bank reduces money supply in

response to an expected fall in moneydemand.

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The flexibility of wages and pricesThe flexibility of wages and prices

RBC theory assumes that wages and prices arecompletely flexible, so markets always clear.

RBC proponents argue that the extent to whichwages or prices may be sticky in the real worldis not important for understanding economic

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fluctuations. They also prefer to assume flexible prices

to be consistent with microeconomic theory.

Critics believe that wage and price stickinessexplains involuntary unemployment and thenon-neutrality of money.

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New Keynesian EconomicsNew Keynesian Economics

Most economists believe that short-runfluctuations in output and employment

represent deviations from the natural rate,and that these deviations occur becausewages and prices are sticky.

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New Keynesian research attempts to explainthe stickiness of wages and prices byexamining the microeconomics of priceadjustment.

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Small menu costs andSmall menu costs and

aggregateaggregate--demand externalitiesdemand 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 increasesaggregate demand, which benefits other firms.

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enu cos s are e cos s o c ang ng pr ces(e.g., costs of printing new menus or mailing newcatalogs)

In the presence of menu costs, sticky prices maybe optimal for the firms setting them even thoughthey are undesirable for the economy as a whole.

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Recessions as coordination failureRecessions as coordination failure

In recessions, output is low, workers areunemployed, and factories sit idle.

If all firms and workers would reduce theirprices, then economy would return to full

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.

But, no individual firm or worker would bewilling to cut his price without knowing that

others will cut their prices. Hence, pricesremain high and the recession continues.

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The staggering of wages and pricesThe staggering of wages and prices

 All wages and prices do not adjust at thesame time.

This staggering of wage & price adjustmentcauses the overall price level to move slowly

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.

Each firm and worker knows that when itreduces its nominal price, its relative price

will be low for a time. This makes themreluctant to reduce their price.

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Top reasons for sticky prices:Top reasons for sticky prices:

results from surveys of managers 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 ualit service or deliver la s

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4. Implicit contracts: firms tacitly agree to stabilizeprices, perhaps out of ‘fairness’ to customers

5. Explicit contracts that fix nominal prices

6. Menu costs

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Conclusion: the frontiers of researchConclusion: the frontiers of research

This chapter has explored two distinctapproaches to the study of business cycles:

Real Business Cycle theory and NewKeynesian Theory.

 

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or the other.

 An increasing amount of research incorporatesinsights from both schools of thought toadvance our study of economic fluctuations.

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Chapter summaryChapter summary

1. Real Business Cycle theory

assumes perfect flexibility of wages and prices

shows how fluctuations arise in response toproductivity shocks

the fluctuations are optimal given the shocks

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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

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Chapter summaryChapter 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,

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including menu costs

coordination failure

staggering of wages and prices

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