DSME3080 Macroeconomics

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Classical Business Cycle Analysis

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Rao Fu
Spring 2023

1
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Business Cycles in the Classical Model

 Real business cycle (RBC) theory
 Real shocks to the economy are the primary cause of
business cycles
a Real shocks are disturbances to the “real side” of the
economy. ucurr )
 Nominal shocks are shocks to money supply or demand

 The largest role is played by shocks to the production

function, which the text has called supply shocks, and
RBC theorists call productivity shocks

2
 RBC Theory
V supply shuc V
)
rrcessm efeor
 The recessionary impact of an adverse productivity
shock
 Results from before: ↓Real wage, ↓employment, output,
!

↓consumption, and ↓investment decline, while the real

interest rate and price level rise ↓ ↑ & yd
:
r

的象{
 The RBC theory is consistent with many
cycle facts
Q business

 The theory predicts countercyclical movements of the

⼀
⼀

price level, which seems to be inconsistent with the

data

3
Small Shocks and Large Cycles

( Pwduulhuy fuuu 7 on )

4
Does the Solow Residual Measure Technology Shocks?

 RBC theorists measure productivity shocks as the

Solow residual
 Given a Cobb-Douglas production function, the Solow
residual is Y
A = a 1−a
- K N
( lue resull )

 The Solow residual is strongly procyclical in U.S. data

 But should the Solow residual be interpreted

☆ 。 as a
measure of technology?
[K ] IIN ] 有 0
到
shon 到
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5
Does the Solow Residual Measure Technology Shocks?

 Define the utilization rate of capital uK and the utilization

rate of labor uN, the capital services as uK×K and the labor
services as uN ×N

 Rewrite the production function as Y = A(uK×K)a(uN×N)1-a

A may
uul pwcyuncal

∞
 Solow residual = AuKauN1-a
irale
 Utilization is procyclical, so the measured Solow residual is more
procyclical than is the true productivity term A.
q Hussmun = utrl 2 aliom
rare d

of
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6
 Fiscal Policy Shocks in the Classical Model: Effects of
a Temporary Increase in Government Purchases
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7
 Fiscal Policy Shocks in the Classical Model
ondul ny goverumenrCoceorT
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→

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 Should fiscal policy be used to dampen the cycle?
 Classical economists oppose attempts to dampen the
cycle, since prices and wages adjust quickly to restore
equilibrium to mom mly
hmy
om
mfe
,

 Besides, fiscal policy increases output by making

workers worse off, since they face higher taxes

龘{  Instead, government spending should be determined by

cost-benefit analysis
 Also, there may be lags in enacting the correct policy and
in implementing it

8
Unemployment in the Classical Model
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( you
 In the classical model there is no unemployment;
people who aren’t working are voluntarily not in the
labor force ①
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 In reality measured unemployment is never zero, and it

is the problem of unemployment in recessions that
concerns policymakers the most
tualFo or sU aftroled 叫
musous T
arges
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A
= ) explarn why
 Classical economists have a more sophisticated
version of the model to account for unemployment

9
Unemployment in the Classical Model
 The worker match theory can't explain all
unemployment

 So can the government use fiscal policy to reduce

unemployment?
 Doing so doesn't improve the mismatch problem
 A better approach is to eliminate barriers to labor-market
adjustment by reducing burdensome regulations on businesses or
by getting rid of the minimum wage
⼀

10
Money in the Classical Model
 Money is neutral in both the short run and the long run
in the classical model, because prices adjust rapidly to
restore equilibrium.

 If money is neutral, why does the data show that

money is a leading, procyclical variable?

 The classical answer: Reverse causation

 Reverse causation means money growth is higher
because people expect higher output in the future; the
higher money growth doesn't cause the higher future
output

11
 。

Money in the Classical Model

Y
 Why would higher future output cause people to
increase money growth? usT ⼀

UDT
 Firms, anticipating higher sales, would need more money
for transactions to pay for materials and workers

 The Fed would respond to the higher demand for money

by increasing money supply; otherwise, the price level
would decline
↑ ) ↑
告 ( (y i "
= ,

12
The Nonneutrality of Money: Additional Evidence

 Friedman and Schwartz have extensively documented that

often monetary changes have had an independent origin;

in economic activity 4
they weren't just a reflection of changes or future changes
the Us suddeuly

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unexpeened

 More recently, Romer and Romer documented additional

episodes of monetary nonneutrality since 1960 ( we dosl
olfur
momy
insk )
 So money does not appear to be neutral owlpul

 There is a version of the classical model in which money

。
isn't neutral—the misperceptions theory discussed next
.

13
The Misperceptions Theory and the
Nonneutrality of Money
 In the classical model, money is neutral since prices adjust
quickly
 But if producers misperceive the aggregate price level, then

vertical
↓
the relevant aggregate supply curve in the short run isn't
bul supplres
donnhau
 This happens because producers have imperfect information
about the general price level
 As a result, they misinterpret changes in the general price level
as changes in relative prices
 This leads to a short-run aggregate supply curve that isn't
vertical
 But prices still adjust rapidly

14
The Misperceptions Theory and the
Nonneutrality of Money 时
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helnem
relaiMonshp
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 The misperceptions theory is that the aggregate quantity of

output supplied rises above the full-employment level when
the aggregate price level P is higher than expected

 This makes the SRAS curve slopeNupward

 So an increase in the price level that is higher than expected

induces people to work more and thus increases the economy’s
output

 Similarly, an increase in the price level that is lower than

expected reduces output

15
 版加

eYanpoumyelarsTheory and the

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The Misperceptions
Nonneutrality of Money Pope When

= ∴| 7 可
 The equation

Y =0
Y +0
b( P − P0e ) wmen

后 Mtrrs
also

<

y
0
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summarizes the misperceptions
↓ theory
Sol
Juul
wefhurenl
 In the short run, the aggregate supply (SRAS) curve slopes
upward and intersects the long-run aggregate supply (LRAS)
curve at P = Pe

 Because of misperceptions, unanticipated monetary policy has

real effects; but anticipated monetary policy has no real effects
because there are no misperceptions

16
The Aggregate Supply Curve in the
Misperceptions Theory

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17
 ,

An Unanticipated Increase in the Money Supply

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An Anticipated Increase in the Money Supply

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19
The Misperceptions Theory and the
Nonneutrality of Money emrtyralinalexpacnalimhod forecane 号到

 Rational expectations and the role of monetary policy &

smom
very 时

 The rational expectations hypothesis suggests that the public's

kum

evenytry
forecasts of economic variables are well-reasoned and use all
the available data

 If the public has rational expectations, the Fed won't be able to

surprise people in response to the business cycle; only random
monetary policy has any effects

。 the business cycle were desirable, the

 So even if smoothing
combination of misperceptions theory and rational
expectations suggests that the Fed can't systematically use
monetary policy to stabilize the economy > ② ( y )
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The Misperceptions Theory and the
Nonneutrality of Money Ynol _

的傳播
 Propagating the effects of unanticipated changes in the
money supply
⼀

 It doesn't seem like people could be fooled for long, since

money supply figures are reported weekly and inflation is
reported monthly
却不⾥有 us ②
←
 Classical economists Q
啊
argue that propagation mechanisms
_

allow short-lived shocks to have long-lived effects

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Readings
 The Minimal Impact of the Stimulus by Mulligan
 http://economix.blogs.nytimes.com/2011/03/02/the-
minimal-impact-of-the-stimulus/

 Time-varying disagreement and monetary transmission

 https://bankunderground.co.uk/2023/03/02/time-varying-
disagreement-and-monetary-transmission/

 Will the pandemic exacerbate or reduce economic

inequality in the US?
 https://thehill.com/opinion/finance/513308-will-the-
pandemic-exacerbate-or-reduce-economic-inequality-in-
the-us

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