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ECON 313 Ch 22

Real Business Cycle Model
Developed by Edward Prescott and Finn Kydland. Assumes that…

“Real shocks”—shocks to productivity or the willingness of workers to work—cause fluctuations in potential output and long-run aggregate supply

All wages and prices are completely flexible, so that the short-run and long-run aggregate supply curves are the same, namely LRAS; and thus aggregate output always equals potential output

Real business cycle models is the aggregate production function
Yp = F ( K,L ) = AK^0.3tL^0.7t

Real business cycle theorists see shocks to productivity, A, as the primary source of shocks to potential output and long-run aggregate supply:
– A positive productivity shock, e.g., a new invention or government policy that makes the economy more efficient, causes the LRAS to shift to the right (while the AD curve remains the same), thus an increase in aggregate output YP and a decrease in the inflation rate ?
– A negative supply shock, e.g., permanent increases in the price of energy or strict government environmental regulations that cause production to fall, causes the LRAS to shift to the left (while the AD curve remains the same), thus a decrease in aggregate output YP and an increase in the inflation rate ?

Solow residuals
Named after Robert Solow, are estimates of productivity in the aggregate production function:

A = Y / (K^0.3tL^0.7t)

Real business cycle theorists view the positive comovement of the growth rate of the Solow residual and output growth as confirmation that productivity shocks are the primary source of business fluctuations

Employment and Unemployment in the Real Business Cycle Model
The real business cycle model explains fluctuations in employment and unemployment with “intertemporal substitution”—the willingness to shift work effort over time as real wages and real interest rates change

An increase (decrease) in productivity raises (lowers) the real wage today, so that workers are willing to work more (less), thus both employment and output will rise (fall) while unemployment will fall (rise)

The economy is always at full employment and all unemployment is voluntary because it arises out of choices workers make to maximize their well being, as implied by intertemporal substitution

Objections to the Real Business Cycle Model
1. Solow residuals and productivity shocks
– If the economy “slows down”, labor hoarding—workers sitting idly for a chunk of their workday but are still counted as “employed”—and idle capital gives the appearance of a productivity shock when none
2. Negative productivity shocks
– Critics of real business cycles question whether productivity shocks, such as the development of the Internet, can ever be negative
3. Procyclical inflation and employment
– The real business cycle model implies that increases in aggregate output are associated with declines in inflation and vice versa, but the data shows that inflation is procyclical (rises during business cycle booms and falls in recessions
4. Market-clearing assumption
– Many economists are skeptical of the market-clearing assumption in the real business cycle model, particularly in the labor market, as empirical evidence shows that wages and prices are far from flexible
New Keynesian Model
Based on similar microeconomic foundations as in real business cycle models, but embeds wage and price stickiness into the analysis

AKA dynamic, stochastic, general equilibrium (DSGE) models:
because they allow the economy to grow over time (dynamic), be subject to shocks (stochastic), and are based on general equilibrium principles

Building Blocks of the New Keynesian Model
1. Aggregate production
– The aggregate production function is similar to that in the real business cycle framework:
Yp = F ( K,L ) = AK^0.3tL^0.7t
and shocks to productivity, A, are an important source of fluctuations in potential output and in LRAS
2. A new Keynesian short-run aggregate supply (Phillips) curve
– Prices are sticky due to staggered prices (Ch. 8), and inflation depends on expected inflation tomorrow, the output gap and price shocks (markup shocks):
Pi^t = BEt+1+ y(Yt + Yt^p) + pt
– B = parameter that indicates how expectations of future inflation affect current inflation
– Et Pi t+1 = Inflation rate next period that is expected today
– (Yt + Yt^p) = output gap
– y = parameter describing the sensitivity of inflation to the output gap
– Pt = the price shock term
3. A new Keynesian aggregate demand (IS) curve
– The new Keynesian IS curve incorporate expectations of future output and the real interest rate today:
Yt = BEt Yt+1 – gri + dt
– B = parameter that indicates how expectations of future output affect current output
– g = how sensitive output is to the real interest rate
– dt = a demand shock
which implies that it is downward sloping, and aggregate output depends not only on today’s real interest rate and demand shock, but also on expectations of future monetary policy and demand shocks
Business Cycle Fluctuations in the New Keynesian Model
Effects of shocks to aggregate supply

Effects of shocks to aggregate demand

Effects of shocks to aggregate supply
A positive productivity shock shifts the LRAS to the right so that Y
Effects of shocks to aggregate demand
1. Unanticipated shocks
– A positive demand shock shifts the AD curve to the right and, because it is unanticipated, expectations about future output and inflation remain unchanged, so the short-run AS curve remains unchanged

2. Anticipated shocks
– Because the demand shock is anticipated, firms expect higher inflation the next period, so the short-run AS curve shifts up, but the shift in the short-run AS curve takes place only gradually because prices are sticky
– The new Keynesian model distinguishes between the effects of anticipated versus unanticipated aggregate demand shocks, with unanticipated shocks having a greater effect

Objections to the New Keynesian Model
– A key objection to the new Keynesian model is that prices are not all that sticky as assumed by the new Keynesian Phillips curve
– Some empirical research finds that businesses change prices very frequently
– Other research, however, point out that even if businesses change prices frequently, they may still adjust slowly to aggregate demand shocks, which are less worthwhile to pay attention to than shocks to demand for specific products they sell
How Do the Models Differ
– In the traditional Keynesian model (Ch. 12), expectations are not rational, but instead are adaptive or backward-looking; and prices are sticky and do not immediately adjust
– The real business cycle and new Keynesian models both assume that expectations are rational, but the real business cycle model is like a special case of a new Keynesian model in which prices become more and more flexible, so that the coefficient in the Phillips curve, y, and thus the short-run AS curve gets steeper until it becomes the same as the LRAS curve
– Both the new Keynesian model and the real business cycle model share the view that long-run supply shocks can shape the business cycle, but the new Keynesian model also suggests that demand shocks can also be important
Short-Run Output and Price Responses: Implications for Stabilization Policy
Suppose an expansionary policy, such as an easing of monetary policy or an increase in government spending, shifts the aggregate demand curve:
– In the real business cycle model, expansionary policy only leads to inflation, but does not raise output
– The traditional Keynesian model does not distinguish between the effects of anticipated and unanticipated policy: Both have the same effect on output and inflation
– In the new Keynesian model, anticipated policy has a smaller effect on output than when policy is unanticipated. On the other hand, in the new Keynesian model, anticipated policy has a larger effect on inflation than unanticipated policy
– The importance of expectations in policy decisions under the new Keynesian model suggests that policymakers must consider both the setting of policy instruments and the “management of expectations”—communication with the public and the markets to influence their expectations about what policy actions will be taken in the future
Anti-Inflation Policy
Suppose policymakers try to reduce inflation by applying contractionary policy:
– The real business cycle implies that reductions in inflation have no cost in terms of lower output
– In the traditional Keynesian model, reducing inflation is costly, because achieving lower inflation requires a reduction in output
– In the new Keynesian model, anti-inflation policy is costly in terms of lost output
– However, the cost is lower when the anti-inflation policy is anticipated

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