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A PowerPointTutorialto Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

Mannig J. Simidian

®

CHAPTER NINETEENAdvances in Business Cycle Theory

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Real Business Cycle

New Classical Model

Keynesian Model

Rational E ions

Monet

odel

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• The interpretation of the labor market: Do fluctuations in employment reflect voluntary changes in the quantity of labor supplied?• The importance of technology shocks: Does the economy’s production function experience large, exogenous shifts in the short run?• The neutrality of money: Do changes in the money supply have only nominal effects?• The flexibility of wages and prices: Do wages and prices adjust quickly and completely to balance supply and demand?

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• Real business cycle theory emphasizes the idea that the quantity of labor supplied at any given time depends on the incentives that workers face. • The willingness to reallocate hours of work over time is called the intertemporal substitution of labor.

Consider this example: Let W1 be the real wage in the first period. Let W2 be the real wage in the second period.Let r be the real interest rate.If you work in the first period, and save your earnings, you will have(1 + r)W1 a year later. If you work in period 2, you will have W2.

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Intertemporal Relative Wage = (1 + r) W1

W2

Working the first period is more attractive if the interest rate is highor if the wage is high relative to the wage expected to prevail in the future.

According to real business cycle theory, all workers perform thiscost-benefit analysis when deciding whether to work or enjoyleisure. If the wage is high, or if the interest rate is high, it is a goodtime to work. If the wage or interest rate is low, then it is a good time to enjoy leisure.

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Criticisms of

Real BusinessCycle Theory

Critics of the real business cycle theory believe:• Fluctuations in employment do not reflect changes in the amount people want to work.• Desired employment is not sensitive to the real wage and the real interest rate– unemployment fluctuates over the business cycle.• The high unemployment in recessions implies that markets don’t clear and that wages do not equilibrate labor demand and labor supply.Real business cycle theorists reply: • Unemploymentstatistics are difficult tointerpret.• Simply becauseunemployment rate is high does not mean that intertemporal substitution of labor is unimportant.

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The ImportanceOf Technology

Shocks

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Real business cycle theory assumes that our economy experiences fluctuations in technology, which determine our ability to turn inputs (capital and labor) into output (goods and services), and that these fluctuations in technology cause fluctuations in output and employment.

Real Business Cycle Theory

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Criticisms of

Real BusinessCycle Theory

Critics of the real business cycle theory:

• Are skeptical that the economy experiences large technology shocks, and propose that technological improvements happen more gradually.

• Believe that technological regress is especially implausible.

Real business cycle theorists reply: • Adopt a broader view of shocksto technology.• Events, although not technological, have a similar affect on the economy (i.e. weather, regulations, oil prices).

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Real business cycle theory assumes that money is neutral, even in theshort run. That is, it is assumed not to affect real variables such as output and employment.

Critics argue that the evidence does not support short-run monetaryneutrality. They point out that reductions in money growth andinflation are almost always associated with periods of high unemployment.

Advocates of real business cycle argue that their critics confuse thedirection of causation between money and output. They claim the money supply is endogenous: fluctuations in output might cause fluctuations in the money supply. For example, when Y rises, because of a tech shock, the quantity of money demanded rises. The Fed may then increase the money supply to accommodate greater demand.This gives the illusion of non-money neutrality.

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Real business cycle theorists believe that the assumption offlexible prices is superior methodologically to the assumptionof sticky prices.

Critics point out that wages and prices are not flexible. They believe that this inflexibility explains both the existence ofunemployment and the non-neutrality of money.

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New KeynesianNew KeynesianEconomicsEconomics

New KeynesianNew KeynesianEconomicsEconomics

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Most economists are skeptical of the theory of real business cyclesand believe that short-run fluctuations in output and employmentrepresent deviations from the economy’s natural rate. They thinkthese deviations occur because wages and prices are slow to adjustto changing economic conditions. This stickiness makes the short-runaggregate supply curve upward sloping rather than vertical. As aresult, fluctuations in aggregate demand cause short-run fluctuationsin output and employment.

But, why are prices sticky? New Keynesian research has attempted toanswer this question by examining the microeconomics behindshort-run price adjustment.

Most economists are skeptical of the theory of real business cyclesand believe that short-run fluctuations in output and employmentrepresent deviations from the economy’s natural rate. They thinkthese deviations occur because wages and prices are slow to adjustto changing economic conditions. This stickiness makes the short-runaggregate supply curve upward sloping rather than vertical. As aresult, fluctuations in aggregate demand cause short-run fluctuationsin output and employment.

But, why are prices sticky? New Keynesian research has attempted toanswer this question by examining the microeconomics behindshort-run price adjustment.

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One reason prices do not adjust immediately in the short run is that there are costs to price adjustment. To change its prices, a firm may need to send out new price lists to customers. The costs of this price adjustment are called menu costs. When a firm reduces its price, it marginally decreases the overall price level, thereby raising real balances.This macroeconomic impact of one firm’s price adjustment on thedemand for other firm’s products is called an aggregate-demandexternality.

One reason prices do not adjust immediately in the short run is that there are costs to price adjustment. To change its prices, a firm may need to send out new price lists to customers. The costs of this price adjustment are called menu costs. When a firm reduces its price, it marginally decreases the overall price level, thereby raising real balances.This macroeconomic impact of one firm’s price adjustment on thedemand for other firm’s products is called an aggregate-demandexternality.

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Some new Keynesian economists suggest that recessions result from afailure of coordination. Coordination problems can arise in the settingof wages and prices because those who set them must anticipate theactions of other wage and price setters.

Not everyone in the economy sets new wages and prices at the same time. Instead, the adjustment of wages and prices throughout the economy is staggered. Staggering slows the process of coordination andprice adjustment. Staggering makes the overall level of wages and pricesadjust gradually, even when individual wages and prices change a lot.

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Real business cycle theoryNew Keynesian economicsIntertemporal substitution of laborSolow residualLabor hoardingMenu costsAggregate-demand externality

Real business cycle theoryNew Keynesian economicsIntertemporal substitution of laborSolow residualLabor hoardingMenu costsAggregate-demand externality