Slides for Part III-A

The Great Divide in Business Cycle Theory The issues: Are mature, market industrialized economies inherently stable—that is, are they self- equilibrating in nature and tend to the full employment of resources? Should the powers of governments and central banks be deployed for purposes of counter- cyclical stabilization?

Development of Business Cycle Theory TheoryKey Figures ClassicalJ.B. Say, I. Fisher, A. Pigou KeynesianJ.M. Keynes, J. Hicks, A. Hansen, P. Samuelson, J. Tobin, P. Davidson, J. Stiglitz Monetarism (New Classical, phase I) M. Friedman, D. Meiselman, D. Laidler Rational Expectations (New Classical, Phase II) R. Lucas, T. Seargent, N. Wallace Real Business Cycle Theory C. Plosser, E. Prescott, F. Kydland

You can look at the Classical system as an application, or generalization, of the laws of supply and demand to the problems of total output, total employment, and the general price level

z The Classical theory of employment z Say’s law (time preference theory of interest) z The quantity theory of money

Y  Real GDP (Income) N  Employment of labor N S  Supply of labor services N D  Demand for labor services S  Saving I  Investment i  Rate of interest (or yield of bonds) p  Price level w  Nominal (money) wage W  Real wage = w/p M 0  (Exogenously-determined) nominal money supply v  Income-velocity of money Definitions

The short-run aggregate production function--again Y = f(N) (1) Y’(N) > 0 (1.1) Y”(N) < 0 (1.2) Y N 0

The labor market N D = f(w/p) (2) N D ’ (w/p) < 0  (2.1) N S = f(w/p) (3) N S ’ (w/p) > 0 (3.1)  Due the the diminishing marginal revenue product of labor The labor market equilibrium condition is given by: N D = N S (4) w/p N 0 W* N* NSNS NDND

Say’s Law “Supply creates its own demand.” The production of a given flow of output will result in the distribution of a flow of income (via factor market transactions) that is sufficient to give spending units the wherewithal purchase the output at prices that would enable firms to cover their costs of production (including a normal profit). Say’s Law apparently rules out the possibility of a “general” commodity glut.

Factor markets Product markets Costs of production Productive factors Sales revenue Land, labor, capital National income Consumption Goods Note: Goods includes consumer services Simple circular flow

Knocks on Say’s Law Since income is received in money, households can withhold spending power from the income-expenditure stream—that is, they can save. Even if leakages (savings) are made available to potential borrowers as “loanable funds,” a shortage of profitable investment opportunities may prevent an offset of leakages to injections (investment spending).

The loanable funds market S = f(i) (5) S ’ (i) > 0 (5.1) I = f(i) (6) I ’ (i) < 0 (6.1) The equilibrium condition is given by: I = S (7) 0 i (%) S,I i* S = f(i) I = f(i) Re-establishing the validity of Say’s law in a money-using economy?

The quantity theory of money The theory is formally articulated using Irving Fisher’s equation of exchange: Mv = pY (8) let  = 1/v. Now rewrite (8) M =  pY (9) Let Y* denote the value of real GDP corresponding to the equilibrium condition described in equation (4). Taking into account that M is presumed to be under the control of the monetary authority, (9) can be rewritten: M 0 =  pY* (9.1)

Equation 9.1 expresses the Classical neutrality of money postulate--that is, the time path of ‘real” variables Y, N, I, S, C, and I are invariant with respect to changes in the money supply. Money is a “veil” over economic activity which is capable of producing changes in the general price level--but not relative prices and quantities.

Y N N Y w/p p p M1vM1v M2vM2v w Y* N* W* NDND NSNS W = w/p i(%) S,I i* p1p1 p1p1 p2p2 p2p2 W2W2 W1W1 S = f(i) I = f(i) The complete Classical system

What can explain unemployment? Real wages Employment (millions) $12 $ NDND NSNS Answer: Labor market disequilibrium Actual wage = $12 Equil. Wage = $9 U = 89 – 65 = 24

Sources of friction in the labor market Minimum wage legislation Labor union truculence