No 09. Chapter 10 Classical Business Cycle Analysis
Before We Begin … • Before proceeding with Chapter 10, look at this handout from the material in Chapter 9: • Chapter 9 Appendix: The Model in Equations
Introduction • This Chapter: • Develops the Classical variant of the model we have been developing • Uses that model to provide an explanation for business cycles • Productivity shocks • Government spending shocks • Compares the implications of the Classical model with the business cycle facts • Considers an alteration of the basic Classical model that help it to fit the facts better
Real Business Cycle (RBC) Theory • The classical model assumes that the economy is constantly at its full-employment output level • This would appear to greatly limit the ability of the classical model to explain business cycles. • However, fluctuations resulting from “real” shocks can produce fluctuations in output and other variable • Because of the emphasis on “real” shocks, the Classical model is now often called the “Real Business Cycle Theory” • Real shocks include productivity changes, changes in real government spending, changes in population, and changes in the preferences of individuals • Productivity shocks are emphasized.
Robinson Crusoe • One might ask if a single individual, in an isolated environment, outside of all market contexts, would ever be subject to “fluctuations” • Clearly, seasonal variations, unusual weather, external environmental changes, as well as changes in ways of producing, could all affect an individual’s level of activity and output • Such fluctuations would be of the real business cycle variety
A Temporary Adverse Productivity Shock • We will analyze a temporary negative productivity shock • Perhaps an increase in the price of oil • Immediate Effects • Reduces MPN and demand for labor • Shifts the production function downward • Consequences: • The real wage falls • Output falls • The real rate of interest rises (as FE shifts left) • Investment and Consumption fall (because r rises) • P rises (as LM must rise to intersect IS and FE) • Recall Figure 9.8 (next slide)
RBC Theory and (Convenient) Business Cycle Facts • If the economy is frequently hit by shocks, business cycles can occur • Employment and output are procyclical • Real wages are procyclical • Investment and consumption are procyclical • Average labor productivity is procyclical • A fact difficult to explain if something other than a productivity shock causes labor input and output to change (because of diminishing marginal productivity)
RBC Theory and (Inconvenient) Business Cycle Facts • In the RBC theory price is countercyclical (price rose in the recession caused by a temporary adverse supply shock). • There is some dispute over the “facts” regarding cyclical behavior of the price level. • The “theoretical” correlation between productivity and output is “too large” • How is unemployment to be explained? • How do we explain the leading and procyclical relationship of money growth?
What are Productivity Shocks? • Productivity shocks could be associated with inventions, weather, natural disasters, and possibly “institutional change” • Energy price increases, reflecting increased scarcity of energy resources, are cited as negative productivity shocks that have been important in several recessions • But, more generally, identifying particular events with productivity shocks and resulting business cycles has been difficult
Solow Residuals (More) • If one assumes that Solow residuals are shocks to the production function, one can use calibrated real business cycles to simulate the reaction of the economy to such shocks • The resulting model cycles mimic real-world fluctuations rather well. • However, Solow residuals might NOT really measure shifts in technology • Suppose measured input usage and actual input usage differs, because of the intensity with which they are used • Consider labor hoarding (next slide).
Labor Hoarding • For example, suppose that when demand for its product falls, a firm does not immediately fire workers as production is cut, but instead assigns them to maintenance, cleaning, updating records, and other tasks • The firm may suspect that the drop in demand is temporary, and it does not want to incur substantial costs of rehiring and retraining new workers. • Output falls, but labor input does not drop in proportion. So measured productivity (the Solow residual) falls. • However, this is not really a technology shock. Variations in Solow residuals can be a consequence of business cycles; not a cause
Fiscal Policy Shocks • The classical model emphasizes technology shocks, but it permits impacts of other variables • Consider a government spending increase for a temporary foreign war. • The IS curve shifts to the right (consumers do not reduce consumption by the full amount of the government spending increase) • The diversion of output from civilian to military purposes leaves households less wealthy; this encourages work effort and a rightward shift of labor supply • Labor supply and FE curves shift to the right.
Fiscal Policy Shock (continued) • The preceding diagram showed shifts of NS, IS, and FE. • LM must adjust to reach the point where IS and FE intersect • For the case shown this requires an increase in price and a leftward shift in LM (this case is most likely, since the increase in the supply of labor due to the wealth change is probably small). • For this shock there are differing implications for business cycles (compared to the productivity shock): • P is procyclical • Labor productivity is countercyclical. • Both results may improve the overall ability of the model to fit the facts.
Policy Implications • The RBC model implies that all firms and workers are making optimal, maximizing decisions. • In a competitive economy, demand-supply equilibria produce “efficient” results. • So all outcomes in a RBC cycle are optimal responses to shocks, and require no intervention from government to improve matters (again consider the Robinson Crusoe analogy). • We see that added government spending can increase GDP, but even in a recession it would be inadvisable to increase spending for the purpose of stabilizing GDP.
Revisiting Two More Problems with RBC Theory • Recall that • The RBC model has no obvious implications about the cyclical behavior of the unemployment rate. • The RBC model has difficulty explaining why money growth is leading and procyclical • Is there any way to reconcile these problems with modified versions of the RBC theory?
Unemployment • An adverse productivity shock could result in higher unemployment if it increased the likelihood of mismatches between workers and jobs • However, positive (as well as negative) productivity shocks could produce mismatches. • The facts seem to be that many unemployed are not between jobs, but are temporarily laid off and waiting to be recalled • This is not an indication of a mismatch. • Also, more mismatches should see an increase in vacancies as well as unemployment • But in recessions unemployment rises while vacancies decline.
Money Growth • If markets equilibrate immediately, then a monetary expansion should affect only nominal variables. Money is neutral. • However, money growth is procyclical and leading—How can the RBC model account for this? • Reverse causality: • Firms may anticipate higher future output, and transactions and money demand may rise in advance of production • Further, the Federal Reserve Bank (Fed) may then increase money to meet demand (while permitting the price level to remain unchanged) • So the money supply rises in advance of output, but does not cause the increase in output • Does the Fed cause Christmas? The money supply regularly grows before Christmas
More Evidence that Money Causes Cycles • Despite the logic of the reverse causality explanation, there is more evidence that independent shocks to money can cause business cycles • There are historically documented cases where a central bank purposely altered monetary policy in order to head off inflation, even at the cost of a downturn • In fact, downturns followed (e.g. 1979).
Monetary Misperceptions: A Classical Reconciliation? • We may be able to reconcile procyclical money with a model that is classical in spirit • Lucas’s Monetary Misperceptions Theory is one such theory • This theory permits some imperfection in information, while maintaining the assumption of quick market-clearing.
The Lucas Model • Suppose that the money supply increases and that, in accord with the classical model, the price level begins to rise. • Consider an individual, say a baker. The baker watches the bread market carefully, and notices an increase in the price of bread. He does not immediately monitor the prices of all other goods. • Since the baker does not know what has happened to other prices, he is likely to suspect that the relative (real) price of bread has risen. • Thinking that the relative price of bread is high, the baker works more and produces more output. But so do those in other occupations, producing a business cycle.
The Lucas Model (continued) • The Lucas model can explain procyclical money while also maintaining the assumptions that markets clear. Imperfect information permits this result. • The key to the model is that AD shifts and price “surprises” are associated with cycles.
Price Surprises • In the absence of surprise (P = Pe), output is at the full-employment level • But if P > Pe, output is higher than the full employment level • And if P < Pe then output is lower than the full employment level • Explain the next two diagrams!
What if a Money Supply Increase is Expected? • If a money supply increase were perfectly expected, then both AD and SRAS would shift up, keeping the economy on the LRAS curve • An anticipated money supply increase does NOT have an impact on output
Policy Implications • Suppose that a central bank would like to use monetary policy to stabilize output in a recession. • When a recession starts, the Fed would like to increase output • According to the Lucas model, it would need to engineer a surprise increase in the money supply to raise output. • But what if the Fed always increased the money supply in recessions? • This behavior should become expected, hence ineffective.
Rational Expectations • The idea that the Central bank cannot repeatedly and systematically trick the public leads to the hypothesis of rational expectations. • If people cannot be repeatedly fooled, then systematic movements in policy should be anticipated • Only unsystematic variations in policy affect output, but unsystematic variations will not stabilize output (and are otherwise undesirable). • So, the Lucas model explains why money growth and output are correlated in real-world data, but simultaneously argues that any attempt to exploit that correlation to stabilize business cycles will be doomed to fail
Criticism of the Lucas Model • The Lucas model is clever, but it relies on the inability of the public to observe surprise policy changes by the Federal Reserve • Money supply statistics are reported with short lags, so expectational errors should be short-lived • This would seem to imply that business cycles arising from money surprises should be short (although it is possible that cycles could persist longer than the original misperception)