Chapter 20 Advanced Topics

Chapter 20 Advanced Topics
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Objectives Present an overview of the new ideas that are influencing the macroeconomic debate Understand the rational expectations model and its contribution to the development of modern macroeconomics Analyse the focus of models based on changes in aggregate supply Explain how Keynesian models have adapted in response to the rational expectations debate Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 20.1 An Overview of the New Macroeconomics
20.2 The Rational Expectations Revolution 20.3 The Microeconomics of the Imperfect Information Aggregate Supply Curve 20.4 The Random Walk of GDP: Does Aggregate Demand Matter, or is it all Aggregate Supply? 20.5 Real Business Cycle Theory 20.6 A New Keynesian Model of Sticky Nominal Prices 20.7 Bringing it all Together Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

20.1 An Overview of the New Macroeconomics
Rational expectations equilibrium models There are three key features. Economic agents do not know the future so base their plans on forecasts or expectations. These forecasts are made in a rational manner using all available information. Markets tend to equilibrium and clear immediately. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Rational Expectations Equilibrium Models
Rational expectations models assume a difference in reactions to anticipated and unanticipated changes in the money supply. Anticipated changes in monetary policy will impact immediately on prices. Unanticipated changes will have a delayed effect on prices. Rational expectations models predict policy irrelevance. Neither monetary or fiscal policy will affect equilibrium income in the long run. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

An Overview of the New Macroeconomics
The random walk of GDP Aggregate demand shocks are transitory as the AD–AS economy returns to the long-run AS curve. If the shock is permanent it must arise from another source. The source of fluctuations in real output must come from the supply side of the economy. Permanent changes in real GDP are modelled as a random walk (of the long-run AS curve). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Real business cycle theory Business cycle fluctuations in real output and employment are due to supply-side disturbances, like productivity changes. These shocks are propagated throughout the economy by workers who intertemporally substitute leisure for work. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

New Keynesian models of price stickiness Individuals are assumed to be rational and to maximise utility. Markets are not always in full employment equilibrium. Markets may be characterised by imperfect competition. Sticky prices may not fully adjust to clear markets. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

20.2 The Rational Expectations Revolution
Assumptions Agents use all available information to make forecasts as best they can. Markets clear immediately. While agents can make mistakes they do not make systematic mistakes. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Rational Expectations Revolution
Implications Anticipated monetary policy has no real effects. In response to a change in monetary policy, agents will expect an equi-proportionate change in prices. Prices and expected prices change in proportion to the change in the money supply. The real money supply remains unchanged. There is no change to production and employment. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Implications Lucas and Barro allow unanticipated monetary policy to have real effects. Assume some agents do not know the aggregate price level but do know the nominal wage or price they face. Workers think real wages have risen and supply more labour increasing output in the short run. There is no role for MP because it has to be random in order to have real effects. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Formal explanation Suppose agents expect the money supply to be me For the actual money supply, m, define the agent’s forecast error as: m = m – me Similarly, the potential output forecast error is: y = y* – y*e Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Substitute the forecast errors into the AD–AS model: AD: m + v = p + y AS: p = pe + (y – y*) Solving for output gives: (20.3) (20.4) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Use this equation to forecast p, denoted as pe, and solve for the expected price: pe = p = m + v – y* (20.6) This states that expected prices under rational expectations are the same as the perfect foresight model except that it is based upon limited information regarding expected money supply and expected output. The perfect foresight model assumes that people know the future value of all relevant variables. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Formal explanation Substituting pe into the AD–AS equations gives the solutions for real output and price: (20.5) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

An anticipated increase in the money supply, me, has no effect at all on real output, y. An unanticipated, m increase in the money supply increases real output by 1/(1 + ). An anticipated increase in the money supply increases price, p, by the same proportion. So systematic monetary policy has no real effect. Unsystematic monetary policy has real effects which only last in the short run as agents adjust their expectations. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

20.3 The Microeconomics of the Imperfect Information Aggregate Supply Curve
A model of aggregate supply curve based on the assumptions: Agents(firms) have imperfect information. They know the local market price, pi They do not know the overall price level, p. Agents cannot determine whether an increase in pi is due to: A general increase in prices p or An increase in demand zi for the local good. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Imperfect Information
If the increases in pi are associated with an increase in all prices, p. Local firms will not increase production (only .i increases). If the increases in pi are due to an increase in demand, zi Local firms will increase production to meet this demand. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Agents therefore react to an observed increase in pi By partially increasing local production and partially increasing local prices. This derives the upsloping AS curve. An increase in the price level increases real output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The degree of imperfect information will affect the slope of the AS curve. If agents become aware that there is no increase in demand: Then only prices will increase, giving a vertical AS (with no change in real output). If agents know the price increase is due fully to increased demand: They will increase output by the full amount, giving a flatter AS curve. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

20.4 The Random Walk of GDP If fluctuations are permanent, then changes in AD are of little importance. This is because AD shocks wear off over time because the long-run AS is vertical. Random (productivity) shocks shift the long-run AS according to a random walk. There is no reason for GDP to return to trend. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Random Walk of GDP Formal explanation
The trend in y can be represented by the time trend yt =  + ßt (20.22) Subtracting yt-1 =  + ß(t-1) gives: yt = yt ß or yt = ß (20.24) Equation (20.24) states that y rises by the constant amount ß in each time period. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Random Walk of GDP Are shocks permanent or transitory?
Adding an output shock ut into Equations (20.22) and (20.24) gives the respective equations: yt =  + ßt + ut or yt = ß + ut – ut - 1 (20.25) yt = yt ß + ut or yt =  + ßt + ut + ut - 1+ ut-2+ …+ u0 (20.26) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Random Walk of GDP Formal explanation Implications
According to Equation (20.25), the effect of a shock on real output lasts one period. According to Equation (20.26), the effects of a shock on real output are permanent. Implications According to the AD–AS model, AD shocks are short-lived. Shocks to AS may be permanent if they derive from permanent productivity improvements. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Random Walk of GDP Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Random Walk of GDP Empirical evidence The alternative view
There is evidence to suggest that economic fluctuations are dominated by shocks with permanent effects. Changes due to aggregate supply shocks could be permanent. The alternative view That permanent AS shocks occur infrequently. In between, AD shocks dominate year-to-year fluctuations. There may be a change in potential GDP trend. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

20.5 Real Business Cycle Theory (RBC)
Equilibrium RBC theory asserts that fluctuations in output are the result of real shocks with markets adjusting rapidly to restore equilibrium. Why then, do shocks have long-term effects? The RBC theory argues that the propagation mechanism causes this. A propagation mechanism is a mechanism through which a disturbance is spread through the economy. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Real Business Cycle Theory (RBC)
The most common propagation mechanism postulated by RBC is the intertemporal substitution of work for leisure. Why are there large increases in output when real wages have increased slightly? There is a high elasticity of labour supply in response to temporary changes in the wage. Suppose within a two-year period an individual plans to work 4000 hours at the going wage. The person would work 2000 hours each year. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

If wages were 2% higher in the first year, the worker may decide to work 2200 hours in year 1, forgoing holidays and working overtime, and work 1800 hours in year 2. Thus, income has increased but total work has remained constant. If there is a permanent increase in wages, there is no gain from working more this period than the next. Hence, labour supply is sensitive to temporary wage changes only. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

RBC theory claims that productivity shocks and shocks to government spending are the most important disturbances. Given a favourable productivity shock, individuals will want to work more now to take advantage of the higher productivity and output. Hence, a small productivity shock may have a large effect on output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The RBC model attempts to indentify ‘deep’ parameters. Deep parameters are those that describe the preferences of individuals and the production of firms. the intertemporal substitution of labour is an example. If there is a transitory technology shock, the marginal product of labour, a, rises by %a. The wage rate equals the MPL so the total change in output will be given by Equation (20.34): %Y = %a + %L (20.34) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

A productivity improvement shock (increase in a) will increase real output, according to Equation (20.34). However, this shock will also be propagated to real output via changes in labour employed. The intertemporal substitution of work for leisure will be the propagation mechanism here. Assuming leisure hours are 3 times labour hours, the increase in labour is given by: %L = 3  [(1– )/(1 –  – )]  %a Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

A total change in output will be the combined effects shown in Equation (20.35): The decrease in leisure will be: [(1 – )/(1 –  – )]  %a Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

20.6 A New Keynesian Model of Sticky Nominal Prices
New classical models assumed perfect competition. Markets were efficient and tended to self clearing equilibrium. New Keynesian models assume imperfect competition. Markets do not clear all the time. Individual decisions do not lead to efficient social outcomes. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

A New Keynesian Model of Sticky Nominal Prices
The model of price stickiness developed by Gregory Mankiw assumes that prices are slow to adjust. The sticky price model allows for rational expectations but claims that markets do not quickly equilibrate to full-employment equilibrium output. Assumptions There is imperfect competition. There are menu costs associated with changing prices. Menu costs are the cost incurred when the nominal price of a good is altered. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Implications Rational individual firms in an imperfectly competitive market may leave nominal prices unchanged even if the nominal money supply changes. Since changing prices uses economic resources, firms will change prices only when the benefits of the price change outweigh the costs. Normally expect the benefits of a price change to always outweigh the costs? Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Mankiw (1985) showed that the private benefits of changing a price can be much smaller than the social benefits. This requires substantial monopoly power in the economy. Assume there are many small firms with some monopoly power. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Suppose a firm faces the following demand function where  ( > 1) is the elasticity of demand. Pi is the price charged by firm i and P is the overall price level. (20.36) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

If labour is the only input and the monopolist sets a mark-up over costs, the firm’s marginal cost is W/a. The firm will charge price (Equation (20.37)) and make nominal profit (Equation (20.38)) respectively: (20.37) (20.38) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Under the neoclassical case, a 2% increase in the nominal money supply has no effect on real demand. From Equation (20.38), it can be seen that money is also neutral as a 2% rise in the money supply increases prices and normal profits by 2%, so real profits remain unchanged. Now suppose that each firm has a menu cost associated with raising prices. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Each firm will compare the cost of maintaining its now ‘too low’ price with the potential increase in profit if it raises its prices by 2%. Potential profit may be very small if two conditions hold: If the deviation between optimal price and existing price is small, the profit opportunity is very small. If the elasticity of firm demand is low, profit is relatively sensitive to getting the price right. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The key to Mankiw’s findings is that firms face a downward-sloping demand curve. If a firm’s demand curve is almost horizontal, any deviation of prices from the optimal price causes huge swings in demand and a corresponding huge swing in profits. So in competitive markets, the private profit from getting prices right always outweighs a small menu cost. In contrast, with a downward-sloping demand curve, a small menu cost may be larger than potential profit changes. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Bringing It Together The macroeconomic debate highlights a number of diverse explanations of how the economy behaves: The empirical relevance of these theories is not clearly established. A partial convergence of some of these theories has become evident in the literature. A new set of dynamic stochastic general equilibrium models point to results which are surprisingly Keynesian at times. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter 20 Advanced Topics

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