So Now We Have a Theoretical Model Capable of Explaining All the Stylised Facts

In fairness, some results depend on some effects being greater or less than others (e.g. hours worked, interest rates etc) It is an empirical question whether this is actually the case. So Now We Have a Theoretical Model Capable of Explaining All the Stylised Facts

So we need to build a model economy like Chapters, 2, 4, 5 and 12, with realistic parameters for the production function, tastes for work and leisure, and investment function etc and check whether such an economy can replicate the observed stylised facts.

Evaluation and Assessment Readings (on reading list): Ryan & Mullineux- The Ups and Downs of Modern Business Cycle Theory in Reflections on the Development of Modern Macroeconomics, Snowden & Vane eds For a contrary view see paper by Dixon in same volume

Evaluation and Assessment Additional readings which I have placed on the J drive: Ryan - Business Cycle Theory: The Real Business Cycle in Encyclopaedia of Macroeconomics (Forthcoming 2002) Ryan – Business Cycle Theory: The Stylised Facts Real Business Cycle in Encyclopaedia of Macroeconomics (Forthcoming 2002)

What follows is no substitute for reading Ryan & Mullineux

Origins of the Real Business Cycle Theory 1.Theoretical Failures & Add ons 2.Lucas Critique 3.Rational Expectations

Origins of the Real Business Cycle Theory 1.Theoretical Failures & Add ons IS LM r y 1970’s No Supply side in ISLM Model Demand Side Model Only

IS LM r Then expected that if y went down P would fall. P0P0 AD y0y0 y y 1973 P 1973 So when observed P rising and y falling needed new construct

AD P0P0 y IS LM r y0y0 Added on Supply which when we had rational expectations had to be vertical y1y1 P1P1 AS 0 AS 1 Other possibilities but NO real Microeconomic Foundations

Origins of the Real Business Cycle 2. Lucas Critique Can’t use reduced forms to evaluate policy What’s a reduced form Cillian? Recall macro last year y=c+i+G-T If c=a+by d where y d is disposable income and y d =(1-t)y Then

Origins of the Real Business Cycle 2. Lucas Critique If change Government policy (e.g. G or T) then may change marginal propensity to consume, b. b is a derived parameter, and can’t rely on it not changing

Origins of the Real Business Cycle 2. Lucas Critique Need to use basic theory such as utility and production functions not derived consumption functions such as c=a+by d

Origins of the Real Business Cycle 3. Rational Expectations Up to 1970’s used to believe that Monetary Policy was very important BUT Rational Expectations showed that people could be expected to figure out the broad trust of monetary policy and thus ability if the government to ‘surprise’ them was limited So Monetary Policy is ineffective

Origins of the Real Business Cycle 3. Rational Expectations Monetary Policy is ineffective If still believe that Money is important then need a proper model of how money works in the economy – not a crappy LM curve SO again need to return to a more basic model

Origins of the Real Business Cycle Theory So have three reasons to return to basic micro modelling Theoretical Failures & Add ons Lucas Critique Rational Expectations

Origins of the Real Business Cycle Finally, a comment on shocks: What was causing a business cycle? How were these shocks propagated?

Origins of the Real Business Cycle Old belief: Supply Shocks small Demand and Monetary Shocks more important. But if government monetary policy is anticipated then monetary shocks must be less important And Demand side shocks must be due to MP K e that is, supply side shocks that effect D SO need to look more closely at Supply side shocks!

Real Business Cycle Model Original Kydland & Prescott Economica (1982) Utility Function Production Function

CALIBRATING the Model Utility Function Production Function Use MICRO econometric studies to decide on (the CES) form of the functions and appropriate values for  and 

WHY USE COBB-DOUGLAS? Utility Function Production Function Because Shares of K, N and C & L relatively constant over time: Remember 201 Test 1

Normal Good year Bad year Recall we said we could think of production function as – y N

Normal Good year Bad year y N ZtZt But need to include a shock Z t for good and bad years

y N ZtZt

So now we are ready for our computer simulation model Stick the Utility function, the production function and the investment Function in the computer, switch it on and …….

y N N0N0 y0y0 NBNB yByB NGNG yGyG

And the computer churns out: N 0, N B, N G,………………N t y 0, y B, y G,……………… y t c 0, c B, c G,……………… c t i 0, i B, i G,……………… i t p 0, p B, p G,……………… p t Etc etc for each state Z t

And now we are almost there: All we have to do now is look at how each variable fluctuates compared with real economy So how do we do?

Evaluation How does the Model Do? Answer: Simulation is reasonably CLOSE except for variability of hours worked But how can we be sure this is a good model? Some controversy!!

Evaluation 1. Are the facts a fact? Vary across country – broad results the same some difference Vary across time –E.g. Prices between – and now How are these facts determined? –How do we fit the Long Run Trend Line

Evaluation 2. How Close is CLOSE? No measure of Closeness –Not like Confidence Interval in Econometrics Can perform sensitivity tests –Use slightly different parameters for utility and production functions – New econometric techniques developed to cope with problem –Generalised Method of Moments

Evaluation 3. The need for labour Market modifications a) 40 Hour Week b) Allowing the intensity with which capital is worked to vary c) recognising that work effort in one period might influence desire to work in the next All these things improve performance of the model

Results of Exercise Topic 7 Bottom Line: Changes in w/p over the cycle will not induce much variation in hours worked However, changes in overtime rates will (pure substitution effect) Main effect will be on marginal individual making the work/no-work decision In particular for higher w/p people are more likely to make the effort to be in employment

W/PlSlS lDlD What are the implications of this for our Labour Demand & Supply diagrams?

W/PlSlS lDlD

lSlS lDlD l l l u lS’lS’

W/PlSlS lDlD l l l u lS’lS’

W/PlSlS lDlD l l l u lS’lS’

W/PlSlS lDlD l l l u lS’lS’

One other problem with labour market! The Dunlop-Tarshis Test

Policy implications: Macroeconomic fluctuations are the result of optimal responses to economic shocks. If responses are Optimal then Government can’t do any better Short-run Government policy responses distorts these optimal responses Particularly true of Monetary Policy

Policy implications: Doesn’t mean no role for government In fact would claim that the policy implications are very Keynesian in one sense The structure of the economy is all important So getting ‘balance and structure’ of government policy right is absolutely vital for the long-run growth path of the economy

Policy implications: Not about Right Wing Policy Agenda About Methodology Must have Macroeconomics with proper micro-foundations Need Better Labour market sector – but properly modelled ( Next part of Course) Next development-a Proper modelled monetary Sector