1. 1 Introducing BC Lecture 1

2. 2 Schedule of the lecture Situating Modern BC Theory within the context of Macroeconomic theory (Mankiw, JEL 90) Fluctuations and facts

3. 3 Consensus in the 70’s: At the textbook level:  IS-LM (with fixed prices)  + a phillips curve to explain price adjustment  For some theorists, the Phillips curves exhibits the natural rate property  the economy is self- correcting in the long run At the applied level: this theory was used to construct large econometric models. 1. Situating Modern BC Theory within the context of Macroeconomic Theory

4. 4 2 reasons for the breakdown of the consensus An empirical reason: how to explain increasing inflation rates with high unemployment levels at the same time as was observed in the 70’s? A theoretical reason: the intellectual problem of the gap between micro and macro These 2 reasons appear in the famous prediction of Friedman et Phelps at the end of the 60’s

5. 5 Consequences A huge research effort and most of this research has been focused on what generated the breakdonwn of the consensus: the construction of macro on microfoundations A gap between theoretical and applied macro: even if macroeconometric models are no longer considered as serious by academic macroeconomists, they are still used (why?)

6. 6 Taxonomy of the research effort a. Modelling of expectations b. New-classical modelling c. New-keynesian modelling

7. 7 Modelling of expectations Large acceptance of rational expectations 1/ In monetary policy Sargent et Wallace (1975) 2/ Rule versus discretion : important question re- examined through rational expectations 3/ Expectations and empirical work, in particular consumption, Hall (1978)

8. 8 New-classical modelling Optimizing agents Markets at the equilibrium

9. 9 Imperfect information Lack of information   Produceurs think that the increase in the price only applies to their products: they believe it is a relative price change and not a general level of price change.  Workers wish to provide more work since they believe that the increase in nominal wage is an increase in real wage  Cycles at equilibrium (Lucas JET 1972, AER 1973 Barro JPE 1978) BUT : how realistic the assumption of a lack of information about prices?

10. 10 RBC (Long Plosser, JPE 1983 ; Barro king, QJE 1984). This theory has 3 strenghts: (i) Models are simple (ii) They are rigorously microfounded (iii) They do a good job at reproducing the behavior of macro variables.

11. 11 New-Keynesian models Economic fluctuations do not reflect the Pareto- efficient response of the economy to technological shocks but rather market failures on a large scale. 1) Fixed wages Long-term contracts Fisher JPE (1977) et Taylor AER 1979, 2) Monopolistic competition and fixed prices Menu costs (Mankiw 85 ; Ball Mankiw, Romer, 89). 3) Real rigidities Efficiency wages (Katz, NBER 86 ; Shapiro et Stiglitz, AER 84)

12. 12 Conclusion 1/ what is largely accepted 2/ no consensus in particular for what concerns the theory of cycles - New-classical theory - New-Keynesian theory

13. 13 King and Rebelo (1999) “Resuscitating RBC” "Business cycles research studies the causes and consequences of the recurrent expansions and contractions in aggregate economic activity" 2. Fluctuations and facts

14. 14 R. Lucas (1977) «Understanding Business Cycles» “…[understanding] business cycles means constructing a model in the most literal sense: a fully articulated artificial economy which behaves through time as to imitate closely the time series behavior of actual economies.”

15. 15 A new methodology Observe stylized facts Construct the model Generate artificial data Obtain « artificial stylized facts» Improve the model

16. 16 Burns and Mitchell [1946] “Measuring business cycles”, NBER “Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own.”

17. 17 Source: Public Information Office National Bureau of Economic Research, Inc.Public Information Office Business Cycles expansions and contractions

18. 18 Source: Public Information Office National Bureau of Economic Research, Inc.Public Information Office Business Cycles expansions and contractions (f’d)

19. 19 Estimated instantaneous standard deviation of 4-quarter growth of GDP per capita Source : Stock and Watson 2003

20. 20 Estimated instantaneous standard deviation of 4-quarter growth of GDP per capita (f’ed)

21. 21

22. 22 Stock and Watson (1988) « Variable trends in Economic Time Series »

23. 23 O. Blanchard and S. Fischer [1989] Lectures on macroeconomics “the picture that emerge is […] that of an economy on which both types of shocks play an important role. Transitory shocks matter and have a hump- shaped effect on output before their effects die out. But the path of output would be far from smooth even in the absence of those transitory shocks. What emerges is a more complex image of fluctuations, with temporary shocks moving output around a stochastic trend that itself contributes significantly to the movements in the real GNP”

24. 24 Linear filter 1: HP filter : cycle component : trend component : controls the properties of the trend component generated by the filter

25. 25 King and Rebelo (1999)

26. 26 King and Rebelo (1993) linear

27. 27 King and Rebelo (1993)

28. 28 Stock and Watson (1998)

29. 29 Linear filter 2: BP-filter (Baxter and King, 1999) The ideal band-pass filter has the following 2-sided infinite moving average representation: : L : lag operator. Symmetry ( ) is imposed. For stationary time-series: : random periodic components

30. 30 BP filter (f’d) Then : Frequency-response function : with, and One can then show that :

31. 31 M. Baxter and R. King (1999), « Measuring BC: Approximate Band-Pass Filters for Economic Time Series »

32. 32

33. 33

34. 34 Goods’market

35. 35 Inputs

36. 36 Labor market

37. 37 Source: Stock and Watson (1998) All variables (except r) are in logarithms and have been detrended using HP filter

38. 38 Stylized facts for Europe Switzerland 1967:1-1984:2 Germany 1967:1-1984:2 UK 1967:1-1984:2France 1970:1-1990:2