Market-Clearing Models of the Business Cyclehuihe.weebly.com/uploads/1/3/6/1/13611032/ppt11.pdf ·...
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Chapter 11
Market-Clearing Models of the Business Cycle
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Goal of This Chapter
• In this chapter, we study three models of business cycle, which were each developed as explicit equilibrium (market-clearing) models with optimizing consumers and firms.– Friedman-Lucas money surprise model– RBC model– Keynesian coordination failure model
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• Each model differs from the others in terms of what is important in causing business cycles and the role implied for government policy.
• Each model allows us to understand one or a few features of the economy and some aspects of the economy’s response to macroeconomic shocks.
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Friedman-Lucas Money Surprise Model
• The theory was sketched out by M. Friedman in 1968, and formalized by Robert Lucas in 1972.
• It was the first attempt to construct a theory where changes in the level of the money supply could have real effects, with all markets clearing all the time.
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• The key element of the theory is that workers have imperfect information.
• They observe current nominal wage W. But they do not know the current price level P. Hence they cannot observe current real wage w=W/P.
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• Suppose there are two shocks that may hit the economy. One is temporary change in TFP z, another is a permanent increase in money supply M.
• Workers cannot observe either z or M during current period. But they can make inferences about the chances of a particular shock based on the movement of the nominal wage W.
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• Now recall the monetary model we have learned. When we have M, P
while w
unchanged. So W=wP. On the other hand, when z, causes w, P, probably W=wP also increase.
• Workers care about the real wage. Under perfect information, when M, they will not change labor supply, hence Y unchanged. But when z, they know w, hence will increase labor supply, Y increases.
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• Since they only have imperfect information about w, and they only infer the probability of the shocks. So when they observe W goes up, they have to put positive guess that the underlying shock is z, therefore labor supply will increase.
• This shows government can use unanticipated increase in money supply to “cheat” (or “confuse”) imperfectly informed but rationally expecting (as clever as economists!) agents to work harder.
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Figure 11.1 The Effects of an Unanticipated Increase in the Money Supply in the Money Surprise Model
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• Now money is not neutral. M Y, r, w, N, M/P
(P<M) • But this kind of “cheating” is bad
because under the perfect information, market clearing equilibrium is PO. The deviation from this first best is sub- optimal.
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• Market participants receive the wrong messages by misinterpreting the pure nominal increase in nominal wage as an increase in the real wage.
• But aftermath public will learn lesson and update their prior. Money surprise only works in short-run.
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Policy Implication
• Make the money supply as predictable as possible.
• Friedman Rule: constant money growth rate.
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Critique of the Money Surprise Model
• The model prediction is inconsistent with the data in terms of w, P and Y/N. (Recall business cycle facts: w is pro- cyclical, P is counter-cyclical)
• Information on aggregate price level and the money supply is widely available.
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Table 11.1 Data Versus Predictions of the Money Surprise Model with Monetary Shocks
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The Real Business Cycle Model
• It was introduced by Finn Kydland and Edward Prescott in 1982.
• Motivated by the observation of the close comovement b/w z and Y, they asked the question whether or not a standard model of economic growth subjected to random productivity shocks could replicate, qualitatively and quantitatively, observed business cycles.
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Figure 11.2 Solow Residuals and GDP
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• Since the change in TFP is persistent, let’s combine the increases in z and z’.
• Equilibrium EffectsY, r, w, N, C, I, Y/N, P
• All are consistent with the data. (Except that of money supply)
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Figure 11.3 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model
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Figure 11.4 Average Labor Productivity with Total Factor Productivity Shocks
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Table 11.2 Data Versus Predictions of the Real Business Cycle Model with Productivity Shocks
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RBC and the Behavior of the Money Supply
• RBC can also explain two key business regularities of money supply– The nominal money supply is procyclical.– The nominal money supply tends to lead
real GDP.
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• Rugularity 1: Endogenous MoneyIn practice, the money supply is not determined exogenously by the monetary authority but responds to conditions in the economy.It can explain the procyclicality of money in two ways.
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• If money supply measure is M1 or M2, it includes the bank deposits. z Y, bank deposits M
• Or suppose that central bank wishes to stabilize the price level. z money demand
(because Y
and r), P
in order to stabilize P, Fed needs to increase M
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Figure 11.5 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money
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• Regularity (2): statistical causality• The banking sector tends to lead other
sectors of the economy.• It takes time to let M affects the price
level. So the monetary authority may take action before the occurrence of the shocks.
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Policy Implication of RBC Model
• In the basic RBC model, there is no role for government stabilization policy!– Neutrality of money implies attempts to smooth out
business cycles through monetary policy have no effect
– All markets clear, there are no inefficiencies to correct (recall the First Welfare Theorem)
• Business Cycles are simply optimal responses to fluctuations in TFP.
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• But in practice, there is a role for government arising from the need to correct market failures and distortions.
• Government should act as a “referee” instead of a “player”.
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Critique of RBC Model
• There is a measurement error in using Solow residual to measure TFP.
• During a boom, machines and workers are fully utilized.
• But in a recession, sometimes machines are sitting idle, the workforce tends to be underutilized. This phenomenon is called “labor hoarding”.
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• So the drop in output during a recession might simply due to the quantity of inputs in production drops, with no change in TFP.
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A Numerical Example
• Production function
• Suppose initially we have z=1, K=100, N=50. So Y=64.2.
• During the recession, the utilization of capital is 95%, that of labor is 90%. Z as same as before. K=95, N=45. Now Y=58.9.
0.36 0.64Y zK N
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• If we mistakenly used the measured K, measured N to calculate the Solow residual, we get
0.36 0.64
58.9 0.918(100) (50)
z :
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Shocks and the Post-1970 Recessions
• Focus on recessions of 1974-75, 1981- 82, 1990-91 and 2001.
• 1974-75. Conventional wisdom: negative shock to TFP caused by a sharp increase in the relative price of energy. zY, r, M
(consistent
with endogenous money theory)
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• 1981-82: “Volcker Recession”. Tightening in monetary policy to reduce the inflation caused the recession. There is also a real shock on the second oil crisis.
• 1990-91: There was a spike in the relative price of energy. Increases in money supply likely prevented the recession from being more severe.
• 2001: IT bust and terrorist attack • 2008: Oil Shock and Subprime Crisis
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Figure 11.6 Percentage Deviations From Trend in Money Supply and GDP
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Figure 11.7 Real and Nominal Interest Rates
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Figure 11.8 Relative Price of Energy
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A Keynesian Coordination Failure Model
• Difficulty in coordinating actions among private sector workers and producers
• Existence of Strategic complementarities: one person’s willingness to engage in some activity increases with the number of other people engaged in that activity.
• Example: party-going. Exist two possible equilibria. Everybody goes and nobody goes.
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• Extend this example to the whole economy. There are possible multiple equilibria for the aggregate economy. Output-employment is (high, high) or (low, low).
• Business cycles might be simply fluctuations between these high (good) and low (bad) equilibria, driven by the waves of optimism and pessimism.
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Model
• Strategic complementarities among firms imply that there can be increasing returns to scale at the aggregate level.
• Hence we have increasing marginal product of labor.
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Figure 11.9 A Production Function with Increasing Returns to Scale
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Figure 11.10 Aggregate Labor Demand with Sufficient Increasing Returns to Scale
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• In order to have an equilibrium, the aggregate labor demand curve must have a greater slope than the labor supply curve. (Why?)
• This implies a downward sloping output supply curve.
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• Both downward sloping output supply and demand curve determine the existence of multiple equilibria.
• Good equilibrium: higher Y, higher N, higher w, lower r, lower P.
• Bad equilibrium: lower Y, lower N, lower w, higher r, higher P.
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Figure 11.11 The Labor Market in the Coordination Failure Model
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Figure 11.12 The Output Supply Curve in the Coordination Failure Model
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Figure 11.13 Multiple Equilibria in the Coordination Failure Model
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• When the economy will hit the good equilibrium?
• Answer: Everyone is optimistic.• When the economy will hit the bad
equilibrium?• Answer: Everyone is pessimistic.
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• Business cycles could result if consumers and firms are alternately optimistic and pessimistic. (Keynes referred this to “animal spirits”)
• In the coordination failure model, it is possible that extraneous events that are completely unrelated to economic fundamentals can “cause” business cycles. Economists call such extraneous events “sunspots”.
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• Observe sunspot
a sign of optimism
everybody wants to invest, supplies
more labor, …
good equilibrium.• Vise versa.
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Model Prediction
• As well as the RBC model: “Good” equilibrium (boom) has Y, r, w, N, C, I, Y/N, P
• Can also accommodate the procyclicality of the money supply.– Money can be a sunspot variable that produces
self-fulfilling optimism or pessimism.– M
viewed as a “good” sign, people are
optimistic, economy in “good” equilibrium. Vice versa.
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Table 11.3 Data Versus Predictions of the Coordination Failure Model
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Figure 11.14 Average Labor Productivity in the Keynesian Coordination Failure Model
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Figure 11.15 Procyclical Money Supply in the Coordination Failure Model
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Policy Implication
• The government policies that promote optimism would be beneficial.– Encouraging statements by public officials
could bump the economy from the bad equilibrium to the good one.
• Policy could also be designed to smooth business cycles or to eliminate them altogether.
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• Example: G T lifetime wealth
labor supply output supply
curve shifts to right (recall it is downward slopping); on the other hand, G output demand curve
eliminate multiple equilibria• Caveat: public might take the gov policy
as sunspot, multiple equilibria might not be eliminated completely
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Figure 11.16 Stabilizing Fiscal Policy in the Coordination Failure Model
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Critique of the Coordination Failure Model
• The evidence about the existence of sufficient increasing returns to scale in aggregate production is weak.
• The underlying shocks that cause business cycles are expectations, and expectations are essentially unobservable.