Chapter 19: Advances in Business Cycle Theory

Recent Macroeconomic Ideas Real business cycle theory –Prices are fully flexible, even in the short-run –Stabilizations policy must show “real” effects New Keynesian economics –Wages and prices are sticky in the short-run –Managing the Aggregate Demand (IS-LM model) is the key to economic stability

Real Business Cycle Theory Interpretation of the labor market Importance of technology shock Neutrality of money Wage and price flexibility

Interpretation of Labor Market Intertemporal substitution of labor: workers express preferences for the time periods they supply labor hours Time periods: 1 and 2 W = real wage rate r = real interest rate Intertemporal Relative Wage = (1 + r)W 1 / W 2

Importance of Technology Shock Technology refers the method of combining production factors (labor and capital) Robert Solow using Y = AK α L β attributes output growth to the growth of production factors (L,K) and technology (A) which is a residual factor; where ΔA/A = α(ΔK/K) - β(ΔL/L) Growth of technology causes the growth of output

Output and Technology Growth in the U.S.

The Neutrality of Money Money plays a “neutral” role in economic activity even in the short-run Monetary policy has no significant effect on output and employment growth; it only affects “nominal” values (e.g., nominal interest rate and price level change, leaving real interest rate unaffected) Critics of this idea assert that monetary policy appear to have strong effects on economic stability

Wage and Price Flexibility Wages and prices are not sticky; they are flexible even in the short-run The foundation of macroeconomics is microeconomics in which wages and prices respond to changes in market conditions

New Keynesian Macroeconomics Menu costs Imperfect labor markets Aggregate Demand externalities Recession as coordination failure Staggering of wages and prices

Menu Costs Prices are sticky in the short-run because of the costs associated with price adjustments –Printing and distributing new catalogs and menus –Distributing new price lists to sales staff The “menu” costs lead firms to adjust prices intermittently rather than continuously

Imperfect Labor Markets Nominal wages are sticky in the short-run because markets are generally regulated by labor unions which –Keep wages sticky downward –Regulate employment of union members to keep union wage rate above the market wage rate

Aggregate Demand Externalities When a firm lowers the price it charges, it slightly lowers the general price level, raising the real money balances The increase in real money balances expands aggregate income, hence increasing the demand for all products Increased demand for products requires price adjustments for all other firms in the market

Recessions as Coordination Failure Each firm must decide whether to cut prices after a decline in the money supply Firms make this decision without knowing the strategy other firms choose Inferior outcomes due to coordination failure would cause a recession

Game Theory Example Two firms: 1 and 2 Two strategies: Cut Price, Keep High price Firm 1’s best strategy is Cut Price to make highest possible profit Firm 2’s best strategy is Cut Price to make highest possible profit

Game Theory Example Firm 1 Cut Price Keep High Price Firm 2 Firm 1 makes $30 Firm 2 makes $30 Firm 1 makes $5 Firm 2 makes $15 Firm 1 makes $15 Firm 2 makes $5 Firm 1 makes $15 Firm 2 makes $15

Coordination Failure If both firms cut prices, the gain the highest level of profit ($30 each) If one firm cuts the price, the other firm would keep its price high, a recession would follow hurting the price cutting firm the most ($5 vs. $15 of profit) If both firms keep their prices high, a recession would also follow, lowering profits for both firms to $15 each. This outcome is highly probable if firms fail to coordinate pricing decisions

Staggering Price Variations Staggering makes the overall level of prices adjust gradually, even when individual prices change frequently. Firms change prices intermittently in response to a demand shift and change in profit. Prices change in the –beginning of a month –middle of the month –end of the month

Frequency of Price Change Less than More than FrequencyPercentage of Firms

Staggering Wage Variations A decline in the money supply reduces the level of Aggregate Demand, output, and employment. Lower employment requires nominal wage rate to fall But, workers and labor unions are reluctant to take the wage cut. The reluctance of a worker to be the first to take a pay cut makes the overall level of wages slow to respond to changes in the Aggregate Demand