Chapter 13

Business Cycle Models with Flexible Prices and

Wages

Copyright © 2014 Pearson Education, Inc.

1-2© 2014 Pearson Education, Inc.

Three Business Cycle Models

• Real Business Cycle Model: Business cycles are caused by fluctuations in total factor productivity (real shocks) => fits the data well in normal times.

• Keynesian Coordination Failure Model

• New Monetarist Model: goo to explain the facts related to the recent financial crisis.

1-3© 2014 Pearson Education, Inc.

Figure 13.3Average Labor Productivity with Total Factor Productivity (TFP) Shocks

1-4© 2014 Pearson Education, Inc.

Figure 13.1Solow Residuals (proxy for TFP) and GDP

1-5© 2014 Pearson Education, Inc.

Figure 13.2Effects of a Persistent (but temporary, not permanent) Increase in Total Factor Productivity in the Real Business Cycle Model

a) ↑TFP=>Nd ↑: w ↑,N ↑b) N ↑ =Ys ↑ • r MUST ↓ because z is higher today

than in the future, so Y is expected to ↓ in the future=> consumption smoothing=> save more today (this makes r ↓) and consume in the future

• Yd ↑ because of r ↓ and future Y ↑ (investment ↑, consumption ↑)

c) Md ↑ because of r ↓ and Y ↑=>P ↓

1-6© 2014 Pearson Education, Inc.

Table 13.1Data Versus Predictions of the Real Business Cycle Model with Productivity Stocks

Model fits the data well

1-7© 2014 Pearson Education, Inc.

Figure 13.4Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money

1-8© 2014 Pearson Education, Inc.

A New Monetarist Model: Financial Crises and Deficient Liquidity

• Two classes of liquid assets in the economy: currency and financial liquid assets.

• Financial liquid assets include relatively safe assets that are widely-traded in the financial system – e.g. government debt, asset-backed securities, (bank reserves).

1-9© 2014 Pearson Education, Inc.

Financial Liquid Assets

• Can be expressed as

• B = nominal government debt.

• k is a decreasing function of r, and k(r) denotes financial liquid assets that are “produced” in / “supplied” by the private financial system.

( )B

a k rP

1-10© 2014 Pearson Education, Inc.

Financial Liquid Assets

• Assume that, in the model, there can be two possible states of the world: adequate financial liquidity and deficient financial liqudity.

• Deficient financial liquidity occurs in a financial crisis due to factors that impair the ability of the financial sector to create financial liquid assets.

1-11© 2014 Pearson Education, Inc.

Modifying the Basic Monetary Intertemporal Model

• In the New Monetarist model, financial liquid assets, a, have a positive effect on output demand if there is deficient financial liquidity.

• Given equilibrium in the money market,

( , )( )

BL Y ra k r

M

1-12© 2014 Pearson Education, Inc.

New Effect in the New Monetarist Model

• An open market purchase (M goes up, B goes down) shifts the output demand curve to the left, if there is deficient financial liquidity.

1-13© 2014 Pearson Education, Inc.

Figure 13.13A Reduction in Financial Liquid Assets, Producing Deficient Financial Liquidity

1-14© 2014 Pearson Education, Inc.

Excess Reserves and the Liquidity Trap

• If reserves pay interest, as is the case currently in the United States, and there is a positive supply of reserves in the financial system, then the interest rate on reserves determines the market interest rate.

• Open market operations have no effect.

1-15 © 2014 Pearson Education, Inc.

Excess Reserves and the Liquidity Trap

• Mr denotes reserve account balances, Mc denotes currency.

• Now, re-define financial liquid assets as:

( ) ( , )( )r

c

M B L Y ra k r

M

Monetary Policy with Excess Reserves and a Liquidity Trap, an Increase in the Interest Rate on Reserves can be beneficial.

Conventional Open market operations have no effect.