Classical Business Cycle Analysis Chapter 10 Classical Business Cycle Analysis

Introduction This Chapter: Develops the Classical variant of the model we have been developing Uses that model to provide an explanation for business cycles Productivity shocks Government spending shocks Compares the implications of the Classical model with the business cycle facts Considers an alteration of the basic Classical model that help it to fit the facts better

Real Business Cycle (RBC) Theory The classical model assumes that the economy is constantly at its full-employment output level This would appear to greatly limit the ability of the classical model to explain business cycles. However, fluctuations resulting from “real” shocks can produce fluctuations in output and other variable Because of the emphasis on “real” shocks, the Classical model is now often called the “Real Business Cycle Theory” Real shocks include productivity changes, changes in real government spending, changes in population, and changes in the preferences of individuals Productivity shocks are emphasized.

Robinson Crusoe One might ask if a single individual, in an isolated environment, outside of all market contexts, would ever be subject to “fluctuations” Clearly, seasonal variations, unusual weather, external environmental changes, as well as changes in ways of producing, could all affect an individual’s level of activity and output Such fluctuations would be of the real business cycle variety

A Temporary Adverse Productivity Shock We will analyze a temporary negative productivity shock Perhaps an increase in the price of oil Immediate Effects Reduces MPN and demand for labor Shifts the production function downward Consequences: The real wage falls Output falls The real rate of interest rises (as FE shifts left) Investment and Consumption fall (because r rises) P rises (as LM must rise to intersect IS and FE) Recall Figure 9.8 (next slide)

A Temporary Adverse Productivity Shock (Diagram)

RBC Theory and (Convenient) Business Cycle Facts If the economy is frequently hit by shocks, business cycles can occur Employment and output are procyclical Real wages are procyclical Investment and consumption are procyclical Average labor productivity is procyclical A fact difficult to explain if something other than a productivity shock causes labor input and output to change (because of diminishing marginal productivity)

RBC Theory and (Inconvenient) Business Cycle Facts In the RBC theory price is countercyclical (price rose in the recession caused by a temporary adverse supply shock). There is some dispute over the “facts” regarding cyclical behavior of the price level. How is unemployment to be explained? How do we explain the leading and procyclical relationship of money growth?

What are Productivity Shocks? Productivity shocks could be associated with inventions, weather, natural disasters, and possibly “institutional change” Energy price increases, reflecting increased scarcity of energy resources, are cited as negative productivity shocks that have been important in several recessions But, more generally, identifying particular events with productivity shocks and resulting business cycles has been difficult

Solow Residuals If one assumes that Solow residuals (estimated changes in the A parameter) are shocks to the production function, one can use calibrated real business cycles to simulate the reaction of the economy to such shocks The resulting model cycles mimic real-world fluctuations rather well. However, Solow residuals might NOT really measure shifts in technology Suppose measured input usage and actual input usage differs, because of the intensity with which they are used Consider labor hoarding (next slide).

Labor Hoarding For example, suppose that when demand for its product falls, a firm does not immediately fire workers as production is cut, but instead assigns them to maintenance, cleaning, updating records, and other tasks The firm may suspect that the drop in demand is temporary, and it does not want to incur substantial costs of rehiring and retraining new workers. Output falls, but labor input does not drop in proportion. So measured productivity (the Solow residual) falls. However, this is not really a technology shock. Variations in Solow residuals can be a consequence of business cycles; not a cause

Fiscal Policy Shocks The classical model emphasizes technology shocks, but it permits impacts of other variables Consider a government spending increase for a temporary foreign war. The IS curve shifts to the right (consumers do not reduce consumption by the full amount of the government spending increase) The diversion of output from civilian to military purposes leaves households less wealthy; this encourages work effort and a rightward shift of labor supply Labor supply and FE curves shift to the right.

Temporary Increase in Government Spending

Fiscal Policy Shock (continued) The preceding diagram showed shifts of NS, IS, and FE. LM must adjust to reach the point where IS and FE intersect For the case shown this requires an increase in price and a leftward shift in LM (this case is most likely, since the increase in the supply of labor due to the wealth change is probably small). For this shock there are differing implications for business cycles (compared to the productivity shock): P is procyclical Labor productivity is countercyclical. Both results may improve the overall ability of the model to fit the facts.

Policy Implications The RBC model implies that all firms and workers are making optimal, maximizing decisions. In a competitive economy, demand-supply equilibria produce “efficient” results. So all outcomes in a RBC cycle are optimal responses to shocks, and require no intervention from government to improve matters (again consider the Robinson Crusoe analogy). We see that added government spending can increase GDP, but even in a recession it would be inadvisable to increase spending for the purpose of stabilizing GDP.

Revisiting Two More Problems with RBC Theory Recall that The RBC model has no obvious implications about the cyclical behavior of the unemployment rate. The RBC model has difficulty explaining why money growth is leading and procyclical Is there any way to reconcile these problems with modified versions of the RBC theory?

Unemployment An adverse productivity shock could result in higher unemployment if it increased the likelihood of mismatches between workers and jobs However, positive (as well as negative) productivity shocks could produce mismatches. The facts seem to be that many unemployed are not between jobs, but are temporarily laid off and waiting to be recalled This is not an indication of a mismatch. Also, more mismatches should see an increase in vacancies as well as unemployment But in recessions unemployment rises while vacancies decline.

Money Growth If markets equilibrate immediately, then a monetary expansion should affect only nominal variables. Money is neutral. However, money growth is procyclical and leading—How can the RBC model account for this? Reverse causality: Firms may anticipate higher future output, and transactions and money demand may rise in advance of production Further, the Federal Reserve Bank (Fed) may then increase money to meet demand (while permitting the price level to remain unchanged) So the money supply rises in advance of output, but does not cause the increase in output Does the Fed cause Christmas? The money supply regularly grows before Christmas

More Evidence that Money Causes Cycles Despite the logic of the reverse causality explanation, there is more evidence that independent shocks to money can cause business cycles There are historically documented cases where a central bank purposely altered monetary policy in order to head off inflation, even at the cost of a downturn In fact, downturns followed (e.g. 1979).

Monetary Misperceptions: A Classical Reconciliation? We may be able to reconcile procyclical money with a model that is classical in spirit Lucas’s Monetary Misperceptions Theory is one such theory This theory permits some imperfection in information, while maintaining the assumption of quick market-clearing.

The Lucas Model Suppose that the money supply increases and that, in accord with the classical model, the price level begins to rise. Consider an individual, say a baker. The baker watches the bread market carefully, and notices an increase in the price of bread. He does not immediately monitor the prices of all other goods. Since the baker does not know what has happened to other prices, he is likely to suspect that the relative (real) price of bread has risen. Thinking that the relative price of bread is high, the baker works more and produces more output. But so do those in other occupations, producing a business cycle.

The Lucas Model (continued) The Lucas model can explain procyclical money while also maintaining the assumptions that markets clear. Imperfect information permits this result. The key to the model is that AD shifts and price “surprises” are associated with cycles.

Price Surprises In the absence of surprise (P = Pe), output is at the full-employment level But if P > Pe, output is higher than the full employment level And if P < Pe then output is lower than the full employment level Explain the next two diagrams!

Upward-Sloping SRAS

Long-Run and Short-Run

What if a Money Supply Increase is Expected? If a money supply increase were perfectly expected, then both AD and SRAS would shift up, keeping the economy on the LRAS curve An anticipated money supply increase does NOT have an impact on output

Policy Implications Suppose that a central bank would like to use monetary policy to stabilize output in a recession. When a recession starts, the Fed would like to increase output According to the Lucas model, it would need to engineer a surprise increase in the money supply to raise output. But what if the Fed always increased the money supply in recessions? This behavior should become expected, hence ineffective.

Rational Expectations The idea that the Central bank cannot repeatedly and systematically trick the public leads to the hypothesis of rational expectations. If people cannot be repeatedly fooled, then systematic movements in policy should be anticipated Only unsystematic variations in policy affect output, but unsystematic variations will not stabilize output (and are otherwise undesirable). So, the Lucas model explains why money growth and output are correlated in real-world data, but simultaneously argues that any attempt to exploit that correlation to stabilize business cycles will be doomed to fail

Criticism of the Lucas Model The Lucas model is clever, but it relies on the inability of the public to observe surprise policy changes by the Federal Reserve Money supply statistics are reported with short lags, so expectational errors should be short-lived This would seem to imply that business cycles arising from money surprises should be short (although it is possible that cycles could persist longer than the original misperception)

The End