BackCh. 12.1: Understanding the Business Cycle in Macroeconomics
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1) What is the main idea behind the mainstream business cycle theory?
Key Terms:
Mainstream Business Cycle Theory: theory that potential GDP grows at a steady rate while aggregate demand grows at a fluctuating rate.
Because money wage rate is sticky...
If AD grows faster than potential GDP --> real GDP moves above potential --> Inflationary Gap
If AD grows slower than potential GDP --> real GDP moves below potential --> Recessionary Gap
If AD decreases --> real GDP decreases (recession)
What are the four theories that are part of the mainstream business cycle approach. What are their characteristics?
Keynesian Cycle Theory: "Animal Spirits" - fluctuations in investment driven by fluctuations in business confidence = main source of fluctuations in AD
Monetarist Cycle Theory: fluctuations in investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money = main source of fluctuations in AD
Both ^ Theories simply assume that the money wage rate is rigid and don't explain that rigidity
Theories below seek to explain a sticky money wage rate and be more careful about its consequences
New Classical Cycle Theory: the rational expectation of the price level (determined by potential GDP and expected AD) determines the money wage rate and the position of the SAS curve.
only unexpected fluctuations in AD bring fluctuations in real and potential GDP
New Keynesian Cycle Theory: emphasizes the fact that today's money wage rates were negotiated at many past dates, which means that past rational expectations of the current price level influence the money wage rate and position of the SAS curve.
both unexpected and currently expected fluctuations in AD bring fluctuations in real and potential GDP
These theories don't rule out the possibility that AS shocks might occur, but supply shocks are not the normal source of fluctuations in the mainstream theories. (RCB has supply shock at center stage)
2) What is the main idea behind the Real Business Cycle (RBC) Theory?
RBC Theory: newest theory. Random fluctuations in productivity as the main source of economic fluctuations.
Thought to result mainly from fluctuations in pace of technological change
other sources: international disturbance, climate fluctuations, natural disasters
Real things (not monetary or nominal things) cause the business cycle......
if there is no real change (use of resources, potential GDP) - only price level changes
mostly positive (occasionally negative) higher-frequency shocks to productivity bring the business cycle
today, part of a broad research agenda called Dynamic General Equilibrium Analysis
RBC Impulse: The initial shock or disturbance that triggers the cycle (e.g., technological change, a productivity shock).
measured by the change in combined productivity of capital and labor --called Total Factor Productivity
fluctuations in productivity growth rate correlate with fluctuations in real GDP growth rate
believed to be generated by the process of research and development that leads to the creation and use of new technologies.
pace of tech change is not constant and occasionally falls --> Labor and capital become less productive
Expansion: period of rapid productivity growth
Recession: period of slow down or fall in productivity
if tech change makes existing capital obsolete, productivity can temporarily fall. (e.g. Human capital)
Firms expect future profits/productivity to fall --> cut back purchasing new capital --> lay off workers =
decreased investment demand, decreased demand for labor
RBC Mechanism: The process by which the impulse affects the economy, including how it propagates through markets
2 Effects follow from initial changes in productivity
Investment Demand changes (e.g. Technology shock)
(real interest rate : loanable funds)
Decrease in investment demand of loanable funds market:
Initially demand and supply of loanable funds at equilibrium -->
decrease in production = decreases investment demand --> DLF shifts leftward, real interest rate falls, equilibrium quantity of loanable funds decreases
Increase in investment demand of loanable funds market:
Initially demand and supply of funds at equilibrium -->
increase in production = increases investment demand -- DLF shifts rightward, real interest rate rises, equilibrium quantity of loanable funds increases ----->>>>
Demand for Labor changes (e.g. technology shock)
(real wage rate : Labor (employment) hours/yr)
Initial demand for and supply of labor determine real wage rate
Decrease in production = decrease in DLF and LD
a fall in real interest rate = decreased LS --> LS curve shifts leftward -->
employment decreases --> real wage rate falls --> recession
Increase in production = increase in DLF and LD
a rise in real interest rate = increased LS --> LS curve shifts rightward -->
employment increases --> real wage rate rises --> expansion
Criticisms and Defenses of RBC Theory
Criticisms:
The money wage rate is sticky, and to assume otherwise is at odds with clear fact
Intertemporal substitution is too weak of a force to account for large fluctuations in LS and employment with small real wage rate changes
Productivity shocks are as likely to be caused by changes in AD as by technological change
If AD fluctuations cause the fluctuations in productivity, then the traditional AD theories are needed to explain them. Fluctuations in productivity do not cause the business cycle - but are caused by IT!
critics also point out that the so-called productivity fluctuations that growth accounting measures are correlated with changes in the growth rate of money and other indicators of changes in AD
Defenses:
claim that the theory explains the macroeconomic facts about the business cycle and is consistent with the facts about economic growth
(a single theory explains both growth and the business cycle) - the growth accounting exercise that explains slowly changing trends also explains the more frequent business cycle swings
RBC theory is consistent with a wide range of microeconomic evidence about LS decisions, labor demand and investment demand decisions, and information on the distribution of income between labor and capital
What is the key decision in the labor market according to the RBC theory?
The Key Decision: When to Work?
Intertemporal Substitution:
behavioral response of consumers or workers to changes in the relative price of consumption or leisure over time.
captures how individuals allocate work effort across periods depending on wage difference - working more when wages are high and taking more leisure when wages are low
describes how individuals shift consumption or labor across time in response to changes in interest rates or wages, reflecting their willingness to trade present for future utility
People decide when to work by doing a cost benefit calculation; comparing the return from working in the current period with the expected return from working in a later period
workers behave like you. They work fewer hours, sometimes zero, when the real wage rate is temporarily low, and they work more hours when it is temporarily high.
depends on the real interest rate
ex: if real interest is 3%/year, a real wage of $1/hr earned this week will become $1.03 a year from now
a fall in real interest rate = decrease LS today
What happens to money in the RBC theory?
Similar to outcome of changing Quantity of money - no real change in use of resources and no change in potential GDP - the change in quantity of money changes only the price level. In RBC this outcome is true because the Aggregate Supply curve is the LAS curve, which pins real GDP down at potential, so when AD changes, only price level changes.
