Chapter 13 Business Cycle Models with Flexible Prices and Wages Copyright © 2014 Pearson Education, Inc.

1-2 © 2014 Pearson Education, Inc. Three Business Cycle Models Real Business Cycle Model Keynesian Coordination Failure Model New Monetarist Model

1-3 © 2014 Pearson Education, Inc. Key Questions in this Chapter How does each model fit the data? The first two models are intended to fit the “average” business cycle. The last one is intended to capture particular features of the financial crisis. What is the role for government policy in each model?

1-4 © 2014 Pearson Education, Inc. Real Business Cycle Model Business cycles are caused by fluctuations in total factor productivity. There is no role for the government in smoothing business cycles – cycles are just optimal responses to the technology shocks. Model fits the data well.

1-5 © 2014 Pearson Education, Inc. Figure 13.1 Solow Residuals and GDP

1-6 © 2014 Pearson Education, Inc. Figure 13.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model

1-7 © 2014 Pearson Education, Inc. Figure 13.3 Average Labor Productivity with Total Factor Productivity Shocks

1-8 © 2014 Pearson Education, Inc. Table 13.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Stocks

1-9 © 2014 Pearson Education, Inc. Figure 13.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money

1-10 © 2014 Pearson Education, Inc. Keynesian Coordination Failure Model Strategic complementarities imply that the aggregate production function has increasing returns to scale, and the labor demand function can be upward sloping. There can be multiple equilibria. In an example, the model fits the data as well as the real business cycle model. GDP fluctuates in the model because of self-fulfilling waves of optimism and pessimism.

1-11 © 2014 Pearson Education, Inc. Figure 13.5 A Production Function with Increasing Returns to Scale

1-12 © 2014 Pearson Education, Inc. Figure 13.6 Aggregate Labor Demand with Sufficient Increasing Returns to Scale

1-13 © 2014 Pearson Education, Inc. Figure 13.7 The Labor Market in the Coordination Failure Model

1-14 © 2014 Pearson Education, Inc. Figure 13.8 The Output Supply Curve in the Coordination Failure Model

1-15 © 2014 Pearson Education, Inc. Figure 13.9 Multiple Equilibria in the Coordination Failure Model

1-16 © 2014 Pearson Education, Inc. Table 13.2 Data Versus Predictions of the Coordination Failure Model

1-17 © 2014 Pearson Education, Inc. Figure Average Labor Productivity in the Keynesian Coordination Failure Model

1-18 © 2014 Pearson Education, Inc. Figure Procyclical Money Supply in the Coordination Failure Model

1-19 © 2014 Pearson Education, Inc. Figure Stabilizing Fiscal Policy in the Coordination Failure Model

1-20 © 2014 Pearson Education, Inc. A New Monetarist Model: Financial Crises and Deficient Liquidity Two classes of liquid assets in the economy: currency and financial liquid assets. Financial liquid assets include relatively safe assets that are widely-traded in the financial system – e.g. government debt, bank reserves, asset-backed securities.

1-21 © 2014 Pearson Education, Inc. Financial Liquid Assets Can be expressed as B = nominal government debt. k is a decreasing function of r, and k(r) denotes financial liquid assets that are “produced” in the private financial system.

1-22 © 2014 Pearson Education, Inc. Financial Liquid Assets Assume that, in the model, there can be two possible states of the world: adequate financial liquidity and deficient financial liqudity. Deficient financial liquidity occurs in a financial crisis due to factors that impair the ability of the financial sector to create financial liquid assets.

1-23 © 2014 Pearson Education, Inc. Modifying the Basic Monetary Intertemporal Model In the New Monetarist model, financial liquid assets, a, have a positive effect on output demand if there is deficient financial liquidity. Given equilibrium in the money market,

1-24 © 2014 Pearson Education, Inc. New Effect in the New Monetarist Model An open market purchase (M goes up, B goes down) shifts the output demand curve to the left, if there is deficient financial liquidity.

1-25 © 2014 Pearson Education, Inc. Figure A Reduction in Financial Liquid Assets, Producing Deficient Financial Liquidity

1-26 © 2014 Pearson Education, Inc. Figure Monetary Policy Response to Deficient Financial Liquidity

1-27 © 2014 Pearson Education, Inc. Excess Reserves and the Liquidity Trap If reserves pay interest, as is the case currently in the United States, and there is a positive supply of reserves in the financial system, then the interest rate on reserves determines the market interest rate. Open market operations have no effect.

1-28 © 2014 Pearson Education, Inc. Excess Reserves and the Liquidity Trap M r denotes reserve account balances, M c denotes currency Now, re-define financial liquid assets as:

1-29 © 2014 Pearson Education, Inc. Figure Monetary Policy with Excess Reserves and a Liquidity Trap, an Increase in the Interest Rate on Reserves is Beneficial