Class Slides for EC 204

To Accompany Chapter 19

CHAPTER 19

Advances in Business Cycle Theory

slide 1

Learning objectives
This chapter presents an overview
of recent work in two areas:

Real Business Cycle theory

New Keynesian economics

CHAPTER 19

Advances in Business Cycle Theory

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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 - natural rate is fluctuating

productivity shocks are the primary cause

of economic fluctuations

CHAPTER 19

Advances in Business Cycle Theory

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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.
CHAPTER 19

Advances in Business Cycle Theory

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Shocks in the Crusoe island economy

Big school of fish swims by island.

Then, GDP rises because

Crusoes fishing productivity is higher
Crusoes 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
its easy to postpone making nets until
storm passes
Employment falls: Since hes not spending
as much time fishing or making nets, Crusoe
decides to enjoy more leisure time.

CHAPTER 19

Advances in Business Cycle Theory

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Economic fluctuations as
optimal responses to shocks
In Real Business Cycle theory,
fluctuations in our economy are similar
to those in Crusoes economy.

The shocks arent always

desirable. But once they occur,
fluctuations in output,
employment, and other variables
are the optimal
responses to them.

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Advances in Business Cycle Theory

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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?
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Advances in Business Cycle Theory

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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).
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Advances in Business Cycle Theory

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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
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Advances in Business Cycle Theory

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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?
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Advances in Business Cycle Theory

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The Solow residual and growth in output

Percent
10
per year
8

Output growth

6
4
2
0
-2

Solow residual

-4
1945

1950

1955

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1960

1965

1970

1975

1980

1985

1990

Advances in Business Cycle Theory

1995

2000
Year

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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, appearing
more cyclical than the true,
underlying technology.

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Advances in Business Cycle Theory

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Productivity shocks
Procyclical bias may be due to:
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.
Output Mismeasurement - In a
recession, workers may produce things
that are hard to measure. They might
clean the factory, organize
inventory, get some training.
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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.

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Advances in Business Cycle Theory

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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.
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New Keynesian Economics

Most economists believe that shortrun 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.

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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.

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Advances in Business Cycle Theory

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Small menu costs and sticky prices

At an optimum, firm faces on secondorder costs of deviating from
optimum.

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 wont change its price.

This argument requires the firm to

have some degree of monopoly power
over its price.
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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.
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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.
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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

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Inflation Inertia
Staggered price setting leads to slow

adjustment in the price level in response

to changes in aggregate demand.

But, this is not the case for inflation.

Inflation is expected to decline when

output is above its natural rate and vice

versa.

Reason is that the Phillips curve

consistent with staggered price setting

expresses current inflation as a function
of future inflation and the output gap.

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Inflation Inertia
The evidence contradicts this
implication and shows inflation
to be highly persistent (e.g.,
NAIRU theory).

Reasons for this:

Delays in adjusting prices
Indexing fixed prices to
inflation between adjustments
Persistence in deviations of
output from its natural rate
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Inflation Inertia
Perhaps the model is incorrect.
Instead of sticky prices, we have
sticky information (Mankiw and Reis,
QJE 2002)

Firms can freely change prices but may

not have latest information available.

So, they set price path when new

information is available.

Overlapping information availability

leads to backward looking Phillips
curve.
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Inflation Inertia
Problems with Sticky Information:
Evidence of fixed prices in the
economy
Most firms do not seem to set
predetermined paths for prices
Fixed prices also appear essential for
explaining why shifts in aggregate
demand have smaller and short-lasting
effects in high inflation economies
Fixed prices help explain why
announcing disinflation policy in
advance doesnt have big effect on
ultimate cost

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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.

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Chapter 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
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Chapter 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 failures
staggering of wages and prices

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Advances in Business Cycle Theory

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CHAPTER 19

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