Real Business Cycle

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Keynesian Model
Real Business Cycle
Advances in Business Cycle Theory
Rational E ions
New Classical Model
Monet odel
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Real Business Cycle Theory

• 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
  economys 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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The Interpretation of the Labor Market

• 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 high or if the wage is high
relative to the wage expected to prevail in the
future. According to real business cycle theory,
all workers perform this cost-benefit analysis
when deciding whether to work or enjoy leisure.
If the wage is high, or if the interest rate is
high, it is a good time to work. If the wage or
interest rate is low, then it is a good time to
enjoy leisure.
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• 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 dont clear and that wages do not
  equilibrate labor demand and labor supply.

Criticisms of Real Business Cycle Theory

• Real business cycle theorists reply
• Unemployment
• statistics are difficult to
• interpret.
• Simply because
• unemployment rate is high
• does not mean that
• intertemporal substitution
• of labor is unimportant.

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The Importance Of Technology Shocks
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Real Business Cycle Theory
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.
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• 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 shocks
• to technology.
• Events, although not
• technological, have a
• similar affect on the
• economy (i.e. weather,
• regulations, oil prices).

Criticisms of Real Business Cycle Theory
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The Neutrality of Money
Real business cycle theory assumes that money is
neutral, even in the short 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 monetary neutrality. They point out
that reductions in money growth and inflation are
almost always associated with periods of high
unemployment.
Advocates of real business cycle argue that their
critics confuse the direction 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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Flexibility of Wages and Prices
Real business cycle theorists believe that the
assumption of flexible prices is superior
methodologically to the assumption of sticky
prices.
Critics point out that wages and prices are not
flexible. They believe that this inflexibility
explains both the existence of unemployment and
the non-neutrality of money.
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New Keynesian Economics
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Most economists are skeptical of the theory of
real business cycles and believe that short-run
fluctuations in output and employment represent
deviations from the economys natural rate. They
think these deviations occur because wages and
prices are slow to adjust to changing economic
conditions. This stickiness makes the
short-run aggregate supply curve upward sloping
rather than vertical. As a result, fluctuations
in aggregate demand cause short-run
fluctuations in output and employment. But, why
are prices sticky? New Keynesian research has
attempted to answer this question by examining
the microeconomics behind short-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 firms price adjustment on
the demand for other firms products is called an
aggregate-demand externality.
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Recessions as Coordination Failure
Some new Keynesian economists suggest that
recessions result from a failure of coordination.
Coordination problems can arise in the setting of
wages and prices because those who set them must
anticipate the actions of other wage and price
setters.
The Staggering of Wages and Prices
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 and price adjustment. Staggering
makes the overall level of wages and
prices adjust gradually, even when individual
wages and prices change a lot.
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Key Concepts of Ch. 19
Real business cycle theory New Keynesian
economics Intertemporal substitution of
labor Solow residual Labor hoarding Menu
costs Aggregate-demand externality