Chapter 13: Business Cycle Models

with Flexible Prices and Wages

1. Real Business Cycle Model and

Link to Solow growth model

2. Keynesian Coordination Failure

Model

1-1
 How Economics Has Changed?
 A PhD economist returns to his university
for his class’s 50th anniversary. He asks to
see the current PhD comprehensive
exam. After looking at it, he declares in
shock: “But these are exactly the same
questions on the exam I wrote 50 years
ago”
 “True” said the professor, “but all the
answers are different.

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Classical Economists Believe:

• Market forces are fundamentally

stabilizing within any market;
• A general equilibrium can be reached;
• The invisible hand of market forces
moves (nudges) the market toward
equilibrium when it gets out of
equilibrium

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Philosophical Revolutions

• Rational Expectations and the New

Classicals (1980s+) – Micro
foundations; wage and price flexibility;
expectations matter, less role for
government

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 Why Micro Foundations?
The Lucas Critique
• It is naive to try to predict the effects of a change in
economic policy entirely on the basis of relationships
observed in historical data under a particular (old)
policy regime, if a new policy regime comes into
existence. Instead, need to model individual’s rational
expectation regardless of policy regime.
• Lucas recognized paradigm shifts that could only be
resolved by more emphasis on micro foundations (i.e.
deep parameters).

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Keynesian Economist Believe:

• Keynesianism – Prices are sticky and market

are often not in equilibrium. Fiscal policy
important
• Takes considerable time to move toward
equilibrium, so there is role for government.
• New Keynesians – Adopted money & rational
expectations but kept nominal rigidities (sticky
prices), imperfect information, and importance
of government policy.

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Real Business Cycle Model

• Business cycles are caused by

fluctuations in total factor productivity.
• Uses monetary intertemporal model
(Chapter 12) for a closed economy.
• There is no role for the government in
smoothing business cycles – cycles are
just optimal responses to the
technology shocks.
• Model fits the data well.

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Real Business Cycle (RBC)
Model
 Motivated by shocks to total factor
productivity (TFP)
 Linked to Solow growth model
 Developed by Kydland and Prescott

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Solow Growth Model

Y = TFP KαN (1-α)

Y = Real GDP (Output)

 K = Quantity of capital stock in constant
value (∑Investments-depreciation)
 N = Quantity of labour force,
 TFP = Total factor productivity (everything
else)

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What is TFP

 TFP captures quality issues of quality of

capital and labour:
– Skilled labour
– Technological progress
 There may be other factors at work
– Governance
– Institutions

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What are examples of TFP shocks?

• Technological breakthroughs
• Natural disasters (Tsunami)
• Educational/skills improvement
• Health breakthroughs

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How is business cycle linked to
Solow Residuals?
%∆Y= %∆z+ α %∆K + (1- α)%∆N + ε
%∆z+ε = %∆Y-[α %∆K + (1- α)%∆N]
----- ln(Y)=ln(KαN (1-α) )
----lnY = ln z + αlnK + (1- α)lnN
• z = TFP
• z + ε = Solow residuals
• α= Capital share;
• (1- α)= labour share

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The Real Business Cycle Model
is Based on Shocks to TFP
Given predictable growth from the
expansion of labour and capital,
it is all other things (TFP)
that determine the business cycle

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Solow Residuals are Correlated
with Business Cycle

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Effects of a Persistent Increase in Total
Factor Productivity in the Real Business
Cycle Model

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Effects of a Persistent Increase in Total
Factor Productivity in the Real Business
Cycle Model
1. Increase z ---increases MP of labour ---causes
labour demand to shift to the right Nd1 to Nd2.
2. Increase in Nd –shifts output supply to the right Ys1
to Ys2.
3. Increase in z’—increases I by firms coz of MP of
capital expected to increase. Increases future income
and lifetime wealth. Both increase output demand
curve from Yd1 to Yd2.
so, output rises but r might increase or decrease
depending on which shift dominates (output supply vs
output demand). Equi. r decrease and Y increase.

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Effects of a Persistent Increase in Total
Factor Productivity in the Real
Business Cycle Model
4. Decrease in r shifts labout supply curve to the left.
This shift is smaller relative to labour demand coz the SE
on labour supply from the change in r is relatively small.
Equi. w increase and N increase.
5. Increase in Y and decrease in r---increases MD and
hifts it to the right PL(Y1, r1) to PL(Y2, r2). So, P
decreases.

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Data Versus Predictions of the Real
Business Cycle Model with Productivity
Stocks

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Why is Money Pro-cyclical?
->Central Bank Stabilizes Price Level

• Endogenous money. MS is part of

money aggregates (bank deposits)

• In the money market, with fixed Ms, as

Y increases, central bank expands M s to
stabilize price level. If money is
endogenous, r falls and that expands
bank credit.

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Procyclical Money Supply in the Real
Business Cycle Model with
Endogenous Money

CB stabilizes the price level

and increases the money
supply

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Gvt role and Critique

• No role for gvt stabilization policy

---money neutral = monetary policy ineffective.
---all markets clear and no inefficiencies.
===business cycles are optimal responses of the
economy to fluctuations in z and nothing should be done
about them.

• Measurement problem of z if K and L do not adjust

fully (e.g. sticky L = labour hoarding)

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Keynesian Coordination Failure
Model
• Strategic complementarities imply that the aggregate
production function has increasing returns to scale,
and the labour demand function can be upward
sloping.
• There can be multiple equilibria.
• In an example, the model fits the data as well as the
real business cycle model.
• GDP fluctuates in the model because of self-fulfilling
waves of optimism and pessimism.

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A Production Function with Increasing
Returns to Scale

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Aggregate Labor Demand with
Sufficient Increasing Returns to Scale

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The Labor Market in the
Coordination Failure Model

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Multiple Equilibria in the
Coordination Failure Model

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Data Versus Predictions of the
Coordination Failure Model

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Stabilizing Fiscal Policy in the
Coordination Failure Model

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Stabilizing Fiscal Policy in the
Coordination Failure Model
1. Decrease in G – decreases PV of taxes ---decrease in
labour supply.
2. Decrease in Ns – shifts the output supply to the
right(decrease coz it’s downward sloping).
3. Decrease in G – decreases output demand and shifts
it to the left Yd1 to Yd2.
If the G reduction is the right amount there will be only
one equilibrium Y=Y* and r=r*.
Good or bad equil. Depends on starting position.

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 Critique

• Evidence of increasing returns to scale is weak.

• Expectations are unobservable.

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